#273 | The New IUL Illustration War

Indexed UL is besieged by falling caps that imperil the core story of the product and the ways that it has traditionally been sold. What’s the solution? In the same way that life insurers previously changed the identity of the product using charge-funded multipliers to maximize illustrated performance under AG 49, they are now changing its identity yet again with new proprietary index account options that produce nearly identical gains in illustrated income under AG 49-A. The illustration war is heating up again and with an entirely new arsenal at play.

If you’ve seen me give a presentation in the last 3 years, then chances are good that you’ve seen this slide:

I use it so often because it tells a concise and powerful story – life insurance products are cyclical. But that doesn’t make any sense. As humans living in an age of progress, we’d like to believe that new is generally better. Driving dynamics aside, cars today are vastly superior to cars even a decade ago. Shouldn’t life insurance work the same way? If a product is growing in popularity, then isn’t it a structurally superior solution? Isn’t it the next phase of progress?

But that’s not the way life insurance works. Our products are, first and foremost, financial products. The waxing and waning of certain product types has little to do with progress or structural superiority and everything to do with macroeconomic environments that are particularly conducive to one product or another. The history of product in our industry ties perfectly to macroeconomic regimes. Universal Life exploded to 40% market share in 5 years because it was a new money product competing against portfolio products in a rising rate environment and its share fell when interest rates did. Variable Life became the best selling product in the industry by the year 2000 because it tapped into the “irrational exuberance” (to borrow Shiller’s phrase) about equities in the late 1990s, only to fall off the map as the bubble popped. Guaranteed UL, even, was a creature of newly-low interest rates and life insurer demutualizations.

Indexed UL is no exception to the rule. The past decade, as I’ve written before, was a near-perfect time for Indexed UL. Portfolio rates were high and options were cheap, thanks to both low volatility and low interest rates. The combination of the two allowed for caps that were unrealistically and unsustainably high. This led to fateful decision made by regulators, with the support of Indexed UL writers, to tie maximum illustrated rates in Indexed UL to the currently declared cap. That was a great idea in 2014 when the cost to hedge a 10% cap was hovering around 4% and, consequently, carriers were offering 12-13% caps.

Now, though, the industry is undoubtedly regretting its decision. Option prices have consistently increased since 2014, which is at least somewhat due to the overwhelming demand for options related to hedging FIA and IUL. Take a look at one company’s price to hedge their options (in orange) relative to their currently declared cap (in blue), as reported in their statutory filings:

Despite the fact that the life insurer has decreased their cap from 13% in 2016 all the way down to 8.5% currently, their price to hedge has basically stayed the same. Thanks to the AG 49/AG 49-A maximum illustrated rate calculation that ties the illustrated rate to the current cap, the illustrated rate for this product has fallen from 7.43% to 5.17%. Is that fair? Has the product really changed? No – it hasn’t. The life insurer is obviously spending about the same amount of money for options. The fair market value for the product has remained pretty stable. Illustrating IUL based on its fair market valuation would have led to a much more stable view of illustrated values that ties back to the actual underlying economics of the product, not the twists and turns of the options market.

This insurer’s history with caps is obviously not the exception. I’ve written so many articles about falling caps that it takes a lot for me to come back to this topic – but a lot has happened since the last time I did (#234 in July of last year). Since then, cap reductions have come hot and heavy. PacLife is down to 8%, a number that I’m fairly certain they would have laughed off as an impossibility as recently as 2017. Both Lincoln and Securian are down to 8.5% and Securian even went a step further to reduce the indexed bonus on their in-force policies by 10%. Symetra, once an outlier at 12%, is now squarely in the middle of the market at 9% down from 9.5%. Principal recently made the same reduction. John Hancock – despite their adamant protestations about the sustainability of their caps not even 12 months ago – is down to 9.75% in their BIA from 12% early last year. Allianz, traditionally another holdout for higher caps, has dropped from 10.5% to 10%. Global Atlantic dropped from 12% to 10.5% on its Lifetime Builder Elite 2020 product that was specifically built to generate an industry-high cap. The cap carnage has spared few victims.

Despite the fact that life insurers’ option budgets have only gradually been declining, these types of cap decreases have pushed illustrated rates to levels that were unimaginable back when AG 49 was being crafted. Back then, PacLife was limiting illustrated rates to 8%. Now, those same products have a cap of 8% and an illustrated rate just above 5%. This is a new era for Indexed UL. The last era was defined by a heady combination of high portfolio yields and cheap options. The dawning new era, however, is defined by portfolio yield dilution and pricy options. That’s a very, very bad combination for Indexed UL – at least, Indexed UL as we’ve traditionally understood it.

As a result, traditional Indexed UL is beginning to fade away. A decade ago, the story about Indexed UL was that it was a way to get exposure to the upside performance of a well-known equity index while providing downside protection. That story doesn’t sound nearly as attractive at an 8% cap and 5% illustrated rate as it did in 2014 at a 13% cap and 8% illustrated rate. There are furtive whispers in Indexed UL circles about the fact that Indexed UL products aren’t so far from being outperformed by Whole Life on an illustrated basis. Pitting PacLife PIA 6 at the maximum AG 49-A rate against PennMutual Guaranteed Whole Life using the same premium, death benefit and compensation is a toss-up. PennMutual wins on cash value, PIA 6 wins on illustrated income. This is the first time that I can remember where Whole Life and Indexed UL are within spitting distance of one another. What is Indexed UL if not the best illustrating fixed life insurance product? This is a crisis of identity for Indexed UL.

The solution that life insurers have used before is to change the identity of the product. Multipliers and buy-up caps fundamentally transformed the nature of the product by offering more upside potential if the client was willing to take less downside protection. But those strategies no longer “work” – at least in terms of illustrated performance – under AG 49-A. What works under AG 49-A? Another identity transformation, but this time to new crediting strategies using proprietary indices. I’ve written about this topic numerous times, both in independent series and as a part of product reviews. The short version of the story is that proprietary indices solve the problem of pricy options and low caps by artificially forcing the index to maintain a specified volatility level and then by reducing the return of the index either with implicit or explicit fees. Then, in order to overcome the inherent deficiencies in doing so, the index employs an algorithmic asset allocation strategy that generates stellar lookback performance. That’s the magic and, make no mistake, it really is magical. A proprietary index simultaneously solves the option pricing problem and lookback performance problem in one fell swoop.

AG 49-A is extremely friendly to proprietary indices. I was a part of the group of folks who submitted numerous letters to the NAIC pointing out the deficiencies of the proposed AG 49-A and proposing an alternative Independent Proposal. In those letters, we detailed exactly what strategies life insurers might employ to generate maximum illustrated performance under AG 49-A and reignite the illustration war. We even went so far as to recreate the spreadsheet that the ACLI was using to show the efficacy of AG 49-A and put in examples that clearly showed how it could be gamed. Nonetheless, AG 49-A was adopted as the industry wrote it. The final modification, made after the guideline had already been pushed through to the final vote, allowed for fixed interest bonuses to be added to illustrated loan arbitrage. Unbeknownst to the regulators, that was akin to throwing gas on a smoldering flame.

The strategy to generate maximum performance under AG 49-A is very simple – add a fixed bonus to a proprietary index allocation. I’ve written about this in separate articles (#251) and product reviews for AIG (#181) and Allianz (#254), so I’ll spare you all of the gory details. This strategy works wonders in terms of illustrated performance for income for two reasons. First, the proprietary index can illustrate up to the BIA or (even better) hypothetical BIA maximum illustrated rate at a lower option budget. This allows the life insurer to take the savings and reinvest it into a fixed interest bonus. Second, thanks to the final negotiations between the regulators and the industry, the fixed interest bonus can be added to illustrated loan arbitrage. The effects are huge. Take a look at 5 products currently in market that offer a proprietary index with a fixed interest bonus under an income scenario:

To put this into some perspective, consider that I ran a similar analysis in 2019 looking at the effects of charge-funded multipliers on income from Indexed UL products. Using PacLife PIA 6, a 5% charge-funded multiplier (the “Performance” option) yielded a 30% increase in illustrated income over the base, no-multiplier S&P 500 account option (“Classic”). The Performance Plus option and its massive 7.5% charge-funded multiplier yielded just a 45% increase in illustrated income over the base S&P 500 account. Life insurers can now generate the same magnitude of increases in illustrated income under AG 49-A simply by using proprietary indices and fixed interest bonuses.

It’s worth noting, however, that although charge-funded multipliers and proprietary indices with fixed interest bonuses might generate similar increases in illustrated income, they are opposites of one another. With charge-funded multipliers, life insurers were artificially augmenting the option budget with charges in order to maximize illustrated performance. They argued to their regulators that charge-funded multipliers were good for consumers because more option exposure generates – in their view – better long-term performance courtesy of option profits.  But with proprietary indices and fixed interest bonuses, life insurers are artificially shrinking the option budget in order to maximize illustrated performance. If option exposure is good, then why are life insurers now reducing option exposure in favor of fixed interest bonuses?

You know the answer. Indexed UL illustrations are not and have never been about anything other than winning the illustration war. They are not projections of future performance or even rough approximations of it. There is no actual economic underpinning to why these products illustrate the way they do. Illustrations are a game with real-world stakes and life insurers will do whatever it takes to win the game, even if that means implicitly tossing their previously held and adamantly argued beliefs out the window. That’s exactly what these strategies using a proprietary index with a fixed interest bonus represent. There is no way to believe that these strategies will outperform a proprietary index strategy without a fixed interest bonus if you believe that Indexed UL will outperform Universal Life – and yet, because it illustrates better, life insurers are doing it anyway.

I’ve written from the beginning that illustrations under AG 49-A need to be treated as fundamentally unreliable, even for their basic explanatory and comparative properties. This new wave of account options (and there will surely be many more) are yet another reason to think twice before you illustrate these products using maximum rates and default allocations. Take control of your case designs. Take control of the conversation. If the regulators aren’t going to do it, then you have to. That’s the unfortunate world we’re in. And it’s only going to get worse.

It’s also worth noting that gamesmanship with proprietary indices can take a variety of forms and doesn’t always present itself as a straightforward fixed interest bonus. Another strategy is to use the profitability of the proprietary index options to prop up the cap for the S&P 500 account (see the review for Nationwide New Heights IUL). Lincoln allows for a higher illustrated rate on its non-bonused proprietary index than its other accounts courtesy of a high BIA. North American charges a 0.8% asset-based fee and provides an offsetting fixed interest bonus of 1% beyond the 10th year, but waives the fee for the proprietary index account, although they also offer the same strategy on an uncapped S&P 500 account as well and have a lower illustrated rate for both. With the exceptions of Symetra and Securian, if you see a proprietary index, then you can be assured that the company is using some sort of strategy to boost illustrated performance.