#222 | An Independent View of AG 49

One of the funny things about regulatory proceedings is that nothing happens – and then everything happens very, very quickly. The process to update AG 49 in light of growing market for Leveraged IUL has certainly followed this pattern. Back in October of last year, regulators seemed to be knee-deep in trying to decipher the differences between various product and multiplier designs with input from life insurers when, suddenly and seemingly out of nowhere, a regulator vote was called to decide how multipliers should be illustrated. There was a bit of protest, but the vote went through anyway. The result was that the majority of regulators wanted products with multipliers to illustrate the same as products without them. A few weeks later, those same regulators voted that products with buy-up caps should illustrate the same as products without buy-up caps. And that settled that.

Except, of course, it didn’t. Not even close. The matter still remained of how to take these abstract concepts and put them into a concrete revision to the AG 49 language. Life insurers were divided on how to approach potential revisions, as evidenced by the fact that numerous individual companies and factions submitted separate recommendations. Regulators repeatedly asked the life insurers to go back and find more common ground using their trade organization, the American Council of Life Insurers (ACLI) as the catchment area. And then COVID hit and all NAIC meetings were put on hold until further notice. It seemed as though nothing was happening and nothing would happen any time soon. But behind the scenes, the ACLI was hammering out the differences between its members with, from what I understand, nearly daily calls amongst the life insurers. Suddenly, the ACLI made a formal proposal that appears to reflect the will of the industry. That proposal was quickly exposed for comment letters and discussed on a subsequent regulator call last week.


If this whole process strikes you as a bit odd, then you’re not alone. Why would regulators rely on the same life insurers who they agreed flouted the original guideline to craft a new one? Because they don’t seem to have a choice. One of the most curious things about writing regulation is that, far too often, the only available experts on a particular topic are the people being regulated. The more niche, arcane or technical the issue, the more likely that is to be true. Indexed UL certainly qualifies. Anyone who knows anything about Indexed UL either sells it, distributes it, manufactures it or provides consulting services to people who do. Therefore, what else could the regulators do but rely on life insurance companies to help them?


But this is a false choice. Fortunately, life insurers aren’t the only experts on Indexed UL. An Independent Proposal was submitted and signed by 13 independent life insurance experts, including myself, even prior to this latest version of the ACLI proposal. And yet this proposal has struggled to find traction. The first time it was presented, the chair of the IUL Illustration Subgroup, the regulators tasked with making the update to AG 49, brushed it aside with an ambiguous comment about the Independent Proposal requiring changes to the overall Illustration Model Regulation, which it absolutely does not. Subsequently, the ACLI presented its proposal to the regulators during the time when meetings were frozen for COVID and the Subgroup chose to expose it for comment anyway without a parallel exposure for the Independent Proposal. As the preface for last week’s call, the chair of the Subgroup stated his intent and desire to accept the ACLI proposal after a few technical revisions and recommend it for implementation in July. ACLI appeared to be fait accompli.


However, there were three comment letters that slowed the train. Each of the authors of these comment letters was given time to speak on the call. I went first to represent the Independent Proposal and here was my statement:



Thanks, Fred [Andersen from Minnesota, chair of the Subgroup]. I appreciate the opportunity present the comment letter on behalf of my twelve co-signers of the Independent Proposal. We have joined together for no purpose other than to voice our concern about the state of Indexed UL and to present a solution that we believe is in the best interest of our industry and all of its constituents.


Fundamentally, we believe that the ACLI proposal is a highly complex, overly engineered solution that requires significantly more disclosure, makes illustrations less understandable for consumers and leaves the door open for future product designs that will take advantage of its many grey areas and ambiguities. Our letter explores each one of these aspects of the ACLI proposal in detail and paints the contrast between the ACLI proposal and the Independent Proposal, which represents a simple but comprehensive solution to the mandate from LATF.


For context, it’s helpful to understand how we got here in order to also understand why the ACLI proposal is flawed. The original AG 49 prescribes a methodology for determining the illustrated value of the hedges used to create indexed credits in Section 4(A). This methodology is based on hypothetical historical backtesting – hypothetical in that the calculation assumes that the currently available, non-guaranteed indexed parameters based on today’s hedge costs never change. Historical in that the index returns used for the backtesting are actual historical index returns. The net result of combining a hypothetical assumption of constant index parameters with historical index returns is not a historically indicative valuation of the hedges – it is a purely hypothetical valuation. To our knowledge, this hypothetical historical hedge valuation methodology has no empirical or theoretical basis and is not used anywhere except in indexed insurance products.


This methodology is also at odds with how the hedges are actually valued in the marketplace. Life insurers purchase hedges at market prices that can be understood through the universally used and empirically validated Black-Scholes valuation methodology. For example, a 10% cap purchased last year would have cost approximately 4.6% of the notional value. That is the market valuation for the option. However, using the unique hypothetical historical backtesting methodology in AG 49, the illustrated valuation for the option would be 6.12%. This implies a perpetual illustrated valuation arbitrage between the empirically proven, universally used, market-driven Black-Scholes option valuation methodology and the unique, untested, entirely hypothetical option valuation methodology prescribed in AG 49.


This disconnect between the price of options and their illustrated value is what allows Indexed UL to illustrate superior performance to traditional fixed insurance products by a significant margin. It is also what allows Indexed UL products with multipliers and buy-up caps to produce superior illustrated performance to otherwise identical products without them. It also follows that, if the entirety of the account value were to have been used to purchase hedges, that the illustrated performance of that variant of product would have dramatically outperformed even the most aggressive multiplier-driven products on the market today.


As a result, it is clear that the problem with multipliers and b uy-up caps is not actually multipliers and buy-up caps. The problem with multipliers and buy-up caps is the assumption of a hedge valuation arbitrage embedded into every Indexed UL illustration, courtesy of the hypothetical historical lookback methodology employed by AG 49 in Section 4(A).


The ACLI proposal is a tacit acknowledgement of that fact. The way that the ACLI has proposed to satisfy the mandate from LATF to limit the illustrated benefits of buy-up caps and multipliers is by bifurcating Indexed UL illustrated rates into two segments – the Hedge Budget, which can illustrate with hedge valuation arbitrage, and the Supplemental Hedge Budget, which does not illustrate perpetual hedge valuation arbitrage.


This segmentation of the illustrated rate is both incongruous with the original letter and spirit of AG 49 and entirely artificial, created for the sole purposes of fulfilling the LATF mandate. This is why the ACLI proposal is so cumbersome, complex and opaque. In order to mechanically accommodate creating an artificial bifurcation of illustrated indexed credits and implement different solutions for each, nearly every clause in AG 49 had to be modified in some way, including the introduction of new definitions, formulas and clauses. By our count, 51 of the 61 clauses in AG 49 were modified by the ACLI proposal.


These modifications and additions to AG49 create their own set of problems. Virtually all of these new factors are uncertified rates determined internally by the life insurer and not disclosed on the illustration. Furthermore, because these factors will be interpreted, defined and set internally at the discretion of the insurer, there will be natural inconsistencies between how life insurers apply them. These inconsistencies will undo the chief goal of the original AG 49, which was to create consistency across illustrated rates for products with identical index parameters. The ACLI proposal manages to simultaneously make illustrations less transparent and less consistent, a combination that renders them almost unintelligible except to the company issuing the product.


But more importantly, the ACLI proposal leaves significant latitude to life insurers, providing them with ample opportunity to find new ways currently not contemplated by the drafters or LATF to generate higher illustrated performance while remaining in technical compliance with the guideline. In our letter, we have detailed at least 5 potential product designs that would produce outsized performance while remaining in compliance with the ACLI proposal, all of which already exist in some form in today’s market. It is only a matter of time before these designs are tuned for optimal illustrated performance under the new AG 49 in the same way that life insurers tuned designs for optimal illustrated performance after the original AG 49 was implemented.


As a result, we believe the ACLI proposal to be fundamentally flawed. It is a limited solution for the particular problem of multipliers and buy-up caps. It relies on internally inconsistent logic that is only tenuously bound together through overly complex and ambiguous language. It is not, by any stretch, a long-term holistic solution to the general problem of prolific, repeated and – most importantly – generously rewarded gamesmanship in Indexed UL illustrations, of which multipliers and buy-up caps are merely the most recent manifestation and hardly the last.


By contrast, the Independent Proposal is a simple and holistic solution. It requires that the illustrated value for the hedges be calculated using the Black-Scholes formula, which will roughly align the actual market price of the hedges with their illustrated value. This will eliminate the possibility for any sort of illustrated valuation arbitrage in the Indexed UL illustration, including excess interest from multipliers and buy-up caps. This simple alignment of actual market hedge valuation and illustrated hedge valuation will satisfy LATF’s mandate without any further modifications to the guideline. But more importantly, it will eliminate the ability for gamesmanship with future product designs for Indexed UL. The proposal is as simple as that. It requires a change to just one section of AG 49, Section 4(A).


We have also recommended that the supplemental crediting reports in Section 7 of AG 49 be augmented to allow life insurers to display the mechanics and potential return profiles of their various crediting strategy, but – and this is key – only in the context of the crediting rate and not in the illustrated scale. Our proposal recommends a methodology for these supplemental crediting reports that would align them to the crediting reports available in Fixed Index Annuity illustrations. This methodology was broadly supported by industry for the purposes of FIA illustrations and recognized as an effective way to educate consumers about the mechanics, variability and potential performance of indexed crediting. To be clear, these supplemental crediting reports are not a part of the illustrated scale and do not have any interaction with the illustration model regulation. The Independent Proposal in its entirety is in conformity with the illustration model regulation. The augmentation of these supplemental reports also does not constitute “new disclosure” because they already exist in the guideline.


In summary, we believe that the basis for Indexed UL illustrations should align market hedge values with illustrated hedge values. This view is also shared by the ACLI’s proposal – but, in their view, only for the multipliers and buy-up caps specifically called out by LATF and only then because of the LATF vote. We would remind LATF that prior to the vote, many life insurers and their professional advocates voiced support for the continued illustration of multipliers and buy-up caps. These insurers have not changed their minds about the merits of these strategies. They’re simply complying with LATF’s request in order to keep the franchise going and, by that, I mean the franchise of illustrated valuation arbitrage that generates double-digit internal rates of return in Indexed UL illustrations even without multipliers and buy-up caps. As long as that exists, and it certainly will with the ACLI proposal, then gamesmanship in Indexed UL illustrations will continue unabated and we will certainly be revisiting AG 49 in the future.


The Independent Proposal, in contrast, is a simple, holistic solution that rests on a universally-used and empirically proven hedge valuation methodology that will end Indexed UL illustrated performance gamesmanship once and for all. Furthermore, the Independent Proposal maintains the ability for life insurers to demonstrate the mechanics and potential performance of indexed crediting methodologies, but only in the context of supplemental crediting reports that are not a part of the illustrated scale. The Independent Proposal strikes the appropriate balance between restricting illustrated gamesmanship while still providing life insurers a means to demonstrate the mechanics of their indexed crediting methodologies in a way that will both educate consumers as to their mechanics and highlight their potential to perform well in certain environments. We urge LATF to consider the Independent Proposal.


For those interested, here is the link to the actual Independent Proposal and most recent comment letter.


My comments were followed by Birny Birnbaum, an appointed consumer advocate for the NAIC, who vehemently supported the Independent Proposal. Equitable followed with a broad support for the Independent Proposal as a baseline for future edits to AG 49 and offered its own view of potential edits. The American Academy of Actuaries also submitted a letter and opined on the many meaningful ambiguities remaining in the ACLI proposal. Finally, individual life insurers addressed comment letters regarding specific treatment of indexed loans. The most comical part of these comment letters were the repeated references to a desire to make sure illustrations are understandable and transparent (which the ACLI proposal prevents) and to potential gamesmanship with designs not currently contemplated (as discussed at length in the Independent Proposal).


Despite the clear desire of the chair of the subgroup to move the ACLI proposal, the Independent Proposal was exposed for comment the day after the call. So where do we go from here? I’m not exactly sure, honestly. The unfortunate reality is that the Independent Proposal is dead without support from major life insurance companies. Without a handful of companies breaking from the ACLI proposal to support the Independent Proposal (or a modification of it submitted by another insurer), regulators will just go with what the ACLI has given them.

Adopting the ACLI proposal will usher a new era of illustration warfare even more damaging than the last one. Companies will again have to scramble to find new and creative product designs and interpretations that give them an illustrated edge. But my hope, maybe my foolish hope, is that some life insurers see clearly what is at stake. Our industry is at its worst when illustration warfare passes for innovation. Life insurers have poured countless resources into creating new weapons that they aim at one another in an ever-escalating arms race. The collateral damage of the war is clients, their advisors and our reputation as an industry. As one life insurer put it to me after the call last week – ‘It’s time to get back to fundamentals.” I couldn’t agree more. The ACLI proposal will simply change the weapons used in the war. The Independent Proposal will end the Indexed UL illustration war itself, once and for all. Then, and only then, can we get back to the fundamentals.


If you’d like to get involved in the process, it’s easy – review all of the materials from the last call and write a comment letter. It will get airtime. For more details, check out a post from a few months ago on how to get involved in the AG 49 process.