#234 | PacLife Reduces Caps, Again

PacLife announced this morning that they are reducing caps to 8.5% in September from 9.0% currently and 9.25% at the beginning of the year. My first instinct was to write a commentary on the rate action, but I kept having déjà vu – and for good reason. I’ve written 3 posts specifically about certain carrier cap reductions (#193, #197, #142), a post about how carriers play games with setting caps (#178), posts talking about how cap reductions change the competitive landscape (#229, #221, #210), posts detailing the obvious reasons why current caps are unsustainable (#197, #203, #207, #227), posts discussing how carriers are designing products to escape pressure from falling caps (#181, #184, #188), how falling caps blow up financing strategies (#124, #145) and an entire series on why Indexed UL isn’t what people think it is, largely because of cap variability (#109, #110, #111). I think I’ve said everything I need to say about falling caps. Just one look at the IUL Benchmark Index will tell you that yields are down and option prices are up. That’s really all you need to know.

Well, actually, there’s one more thing left to say.

Life insurers have always marketed their current caps as more or less permanent. The current caps are often marketed as if they are an intrinsic part of the product. Carrier marketing materials compare their product to other products on the basis of their currently declared caps informing illustrated performance. Carriers with higher caps, all else being equal, have better performance and therefore give clients the idea that higher caps indicate a better product. How else can you explain that sales follow illustrated performance which is driven directly or indirectly by currently declared caps? Think about that – why in the world would someone choose a permanent product designed to be held for 50+ years on the basis of the currently declared, non-guaranteed cap? The only explanation is that clients don’t understand how caps work and that they can and will change. And I think it’s safe to say that life insurers had a hand in creating and propagating that misunderstanding.

But it goes way beyond that. The fact is that life insurers knew, or should have known, that caps were going to fall in the future and did nothing to prepare brokers, advisors or policyholders for that inevitability.Instead, they used temporarily advantageous pricing to their advantage to produce more sales by inducing customers to buy products with cap rates that they knew were inflated and not supportable and, to make matters worse, were illustrated in perpetuity. Why in the world would life insurers do that?

I don’t think they really had a choice. I’m not talking about the fact that a company that went around telling people their cap was going to fall would be at a competitive disadvantage. I’m talking about the fact that actuarial guidelines preclude the concept of demonstrating that today’s rates are not sustainable. Life insurance illustrations are governed by current performance and recent historical performance. That’s how the model regulation works. There is no provision for future inevitabilities. Current is permanent. Current is all that matters. And that’s just the way it is. Life insurers played by the rules in setting caps they knew were completely unsustainable and illustrating accordingly. The rules are bad – which is precisely why the NAIC is now beginning the process to open up the illustration model regulation and change the rules.

But in the real world, current is current, not permanent, and life insurers knew or should have known that they were way out over their skis on their caps a few years ago. Recall that caps are set so that the price of the options to completely hedge the cap are equal to the yield on the life insurer’s portfolio supporting the product. Portfolio rates have obviously been under siege for over a decade from falling reinvestment yields. Every life insurer that writes any fixed life insurance product knows that, absent a miracle, their portfolio rates are going to be crushed over the next few years. It’s like gravity. Portfolio rates eventually and inevitably fall to new money rates, which right now are floating at around 2.75-3.5%, depending on how exactly the life insurer invests. It is literally only a matter of time. That’s the easy and obvious reason caps are inevitably going to fall.

The tougher and less obvious reason is that option prices were dirt cheap for a long time and have now reverted to something that is probably a more realistic view of long-term pricing. Take a look at the price of a 13% cap on a daily basis going back to 1/1/2001.

Imagine you’re an actuary and you’re setting your cap back in 2014 during the AG 49 proceedings but before implementation. You go with 13% because that’s about what a 4.5% option budget would buy. You then allow for up to an 8% illustrated rate in the product based on backtesting historical performance but also, if you’re being honest, putting your finger to the wind. This cements your position as the #1 Indexed UL writer in the country. Forget the actuarial guidelines – is it reasonable to illustrate a 13% cap forever? Absolutely not. You know two things. You know your portfolio rate is taking a beating, but more importantly, you know that a 13% cap ain’t going to cost 4.5% forever. In fact, the average price of a 13% cap going back to 2001 is 5.1%. If you were to take average option prices into account, you would have set your cap at 10%, not 13%.

Hmm. This is a problem. A 10% cap back in 2014 was laughably low. Insinuating that any life insurer currently offering a 13% cap would ever, under any circumstance, drop their cap to 10% was heresy. I regularly listened to life insurers tell regulators that their current caps in 2013 and 2014 were “sustainable” and that illustrated rates in Indexed UL should therefore be about 7%, an idea which is still implanted in the heads of too many regulators. So what do you, the actuary, decide to do? You set the cap at 13% and keep your mouth shut.

The problem, of course, is that now you’re stuck. There are 3 possible scenarios of how the future will unfold. Here they are:

These are all ugly scenarios for caps, but they represent the best cases. All of these scenarios have evil twins. Volatility back in 2014 was incredibly low and volatility skew was relatively tame. An uptick in either volatility or volatility skew will dramatically increase the price of the options in every scenario, but particularly the scenarios with low rates. Any actuary worth their salt back in 2014 should have known that they were setting caps based on absurdly low option prices and a temporary portfolio rate subsidy. The only thing caps could do was go down. Actuaries are smart people. They knew what was going to happen – and it did.

This brings us to now. We have the #1 seller of Indexed UL dropping caps to 8.5%, which is just a half a percent higher than the default illustrated rate for the product pre-AG 49. The new illustrated rates for PacLife’s products will be 5.41%, what would have been seen as an unrealistically and absurdly conservative figure during the AG 49 debate. But was it? Empirically, it was not. Here we are, 6 years later, and that’s the default rate for the product using the same (flawed) methodology that yielded an 8% illustrated rate pre-AG 49. This should not be any surprise to life insurers. And yet, they said nothing.

So what? Here’s what. Clients who bought products from 2010-2017 have not a snowball’s chance in hell of getting what was originally illustrated because caps have fallen so drastically, but the situation is actually worse for clients who bought leveraged IULs after 2017. Let’s take PacLife’s products for example. When PDX was launched with a 10.25% cap, the default illustrated rate was 6.21%. Now, with an 8.5% cap, the maximum illustrated rate will be 5.41%, a nice and neat 0.8% decline. In a normal Indexed UL like PacLife’s PIA 5 (at the time), an 0.8% decline in the crediting rate would equate to approximately a 0.8% decline in the cash value IRR for the product. The relationship is pretty linear except in situations where the policy is underfunded.

Not so for the #1 best-selling PDX and its much-celebrated, little-understood Performance Factor. PacLife PDX generated performance that made producers drool courtesy of leverage in the Performance Factor mechanism that would have made Bear Stearns blanche. But leverage cuts both ways. For PDX, a 0.8% decline in the illustrated rate translates into 1.4-1.6% decrease in the cash value IRR. To put that in sheer dollar terms, the 30 year projected cash value on a 7 Pay funding basis for a 45 year old drops by a whopping 35% when the illustrated rate falls from 6.21% to 5.41%. Accordingly, illustrated income drops by about the same 35%. In the space of just 3 years, PacLife PDX buyers have seen a 35% illustrated reduction in the benefits of their products. Live by the sword, die by the sword.

And there’s more to come. Caps are going to continue to get crushed in the long-run. Portfolio rates are still under siege. Option prices have remained stubbornly high for the last 2 years due in large part to volatility skew, which has proven to be resilient since March even as volatility has gone up. The IUL Benchmark Index is now indicating fair-market caps of less than 5%. But even if you don’t believe any of that, then believe this – PacLife has been and always will be the best indicator of what “fair market” cap for a competitive Indexed UL should be. They have the biggest block. They don’t subsidize their caps because they can’t. If PacLife sets a cap at 8.5%, then that’s where everyone else is going to go. It’s just a matter of time.

If you’re selling Indexed UL, prepare your clients for a continued decline in caps. There is a distinct possibility that caps could increase if volatility ticks back, but don’t be fooled. The long-term pressure is higher than ever. Illustrate accordingly. If you’re not sure what to use as your benchmark, look at the IUL Benchmark Index. Even if you use the hypothetical historical lookback rate and its absurd option profit assumptions, current fair-market caps would indicate illustrated rates of less than 4%. Illustrate above that level only if you believe caps will ultimately go up or option profits will bail you out. That’s up to you to decide. But one thing is for certain – whatever you do, don’t let a life insurer tell you what is reasonable for you to illustrate to your clients.

One last thing. Falling caps does not mean that Indexed UL won’t work. The core of Indexed UL is that it transforms a fixed rate into a crediting strategy that delivers upside potential with downside protection. That’s what Indexed UL does. The upside has and always will be variable based on yields and option prices. The question of whether the trade is a good one is secondary to whether or not Indexed UL meets a client’s needs in terms of the product structure and crediting profile. If it does, then you shouldn’t care what the cap is, as long as it’s set fairly. How do you know it’s set fairly? Well, that’s a problem. You don’t. You can’t see the portfolio yields and option prices. If you want to trust that a cap is fair, you need to know those two factors. So if a life insurer wants to build trust with its producers and clients in the long-run by ensuring that clients always receive a fair cap – even if not a stable cap – then they’re going to have to completely rethink how they set rates. Life insurers should declare the option budget, not the cap, because the cap is simply a function of option prices. Now that would be a change for the better.