#291 | Rethinking IUL Renewal Caps

One of the most common criticisms of Indexed UL is that it’s the ultimate “trust me” product. No other product relies on as many opaque or complex assumptions as Indexed UL for both its real-world and illustrated performance. Like any other Universal Life, the policy charge structure is non-guaranteed. But unlike Universal Life, Indexed UL doesn’t have a declared interest rate that is readily comparable to market-priced alternatives. Instead, Indexed UL offers declared participation in the performance of an external index, which we’ll refer to as caps for simplicity’s sake. The client has no way to know if the cap they’re getting is fair or not – and neither does the agent.

For skeptics, this opacity at the heart of Indexed UL is a dank, dark corner for life insurers to hide. These folks tend to believe that if a life insurer has an opportunity to screw the client, they’re going to take it. And Indexed UL offers ample opportunity and sufficient cover to do it. They will point to consistently falling caps as evidence that Indexed UL isn’t doing what it’s supposed to do and that carriers are taking advantage of the fact that policyholders are locked into their contracts by lowering their rates. On the surface, that’s a pretty compelling argument. Take a look at the history of caps for one prominent Indexed UL writer:

But these caps apply to both new business and in-force policyholders. A life insurer with identical in-force and new business caps can’t make an adverse change to in-force without also simultaneously affecting their competitive positioning for new business. Keeping consistency of caps across the block is the easiest way for a life insurer to mitigate (or eliminate) the “trust me” problem with Indexed UL. A skeptic of Indexed UL may rightly point out that caps have fallen, but they can’t say that the life insurer is using falling caps as a means to rake in profits, at least not without harming their new business franchise as well. With this carrier, you can easily see the relationship between their hedge prices and their cap movements:

When their hedge prices spike, the cap drops. When hedge prices are persistently increasing, which has been happening since 2014, it would follow that the life insurer would have to reduce the cap in order to maintain their target hedge cost. Falling caps over the past decade is not an indication of a fatal flaw in Indexed UL. It’s an indication of a properly functioning Indexed UL block doing exactly what it should be doing.

So far, many carriers have made the decision to set the same rates for both in-force and new business Indexed UL products. That decision has engendered a lot of trust in the carrier and in the product category itself. However, it’s going to be an increasingly difficult decision to keep as these blocks mature. All Indexed UL products have fixed policy charges for the first 5-15 years of the contract that go a very long way in recapturing commission payouts, covering corporate overhead and, in many cases, supporting caps that would otherwise be unaffordable.

The classic example of this is Global Atlantic Lifetime Builder Elite, which was rolled out in 2018 and was virtually identical to the outgoing Lifetime Builder product except that it had higher policy charges in the first 5 years and a higher cap. What happens after the fixed charge period is somewhat of an open question for all products, not just this one. The vast majority of Indexed UL has been sold in the past 10 years. We’re not even past the fixed charge period for most products. Theoretically, nothing should change because the company priced in a certain asset spread for the product based on the initial pricing. But in practice, we’ve seen companies do all sorts of things with in-force Universal Life products to produce distributable earnings, including Lincoln’s move to drop crediting rates on its entire block of business to the guaranteed minimums nearly a decade ago. Why would we think Indexed UL would be different?

We are starting to see a bit of a hint in Global Atlantic which, if you’ll recall, is the former Aviva/AmerUs/Indy Life block. That entity was by far the largest seller of Indexed UL until 2009 when Pacific Life took the crown. If any company can show what real long-term renewal rates in Indexed UL will look like, it’s Global Atlantic.

And it ain’t good. Global Atlantic isn’t exactly super forthcoming about renewal rates on in-force products, but we can piece together the story by looking at Schedule DB of their statutory filings to see what kind of rates they’re paying on in-force Indexed UL products. The former Aviva block is now housed in Accordia Life and the statutory filing clearly states the use of the hedge for Indexed UL products and both of the strike prices for the trade so you can easily see the indexed crediting floor and the cap. If you’d like to see for yourself, just head to Global Atlantic’s website and you can download the statement. The fun starts on page 161 of the 2020 FY filing.

I spent way too much time on a recent plane ride porting over the data from Schedule DB for the trades related specifically to annual point-to-point caps for in-force policies, which you can actually see in Global Atlantic’s trade because GA uses an 11-month crediting period for its newly issued policies rather than the standard 12 month. Overall, Global Atlantic hedged about $4 billion worth of Indexed UL notional last year broken up into about $165 million every two weeks.

To get a feel for what a typical month looks like, I pulled the trades for November 10^th to create the graph below showing the cap, the price to hedge the cap and the percentage of that month’s total notional at each cap level:

As you can see, caps are all over the map at Accordia, ranging from 2.88% all the way up to 12%. When I first started digging through Accordia’s books, I thought the 2.88% Cap was a fluke, perhaps some Fixed Indexed Annuity business that got accidentally bundled in with the Life block and mislabeled as an Indexed Universal Life Hedge, which is how all of these trades are categorized. Not so. There is nary a penny of FIA reserves at Accordia Life and Annuity Company, according to the statutory filing. That means the 2.88% cap is a real Indexed UL cap and therefore real IUL policyholders are actually getting that cap, as shocking as that may be. Below is the breakdown of caps and the share of Notional (or policyholder Account Value) earning each cap:

All told, something like 90% of Account Value at Accordia has a 9% cap or less. This is an astonishing figure considering that their new money cap for Lifetime Builder ELITE 2020 is 12%. The disconnect between in-force caps and new money caps is the biggest I’ve seen for any company by a country mile. And this isn’t a new phenomenon for Accordia. I’ve been watching Schedule DB filings for years and Accordia has always had a huge range of in-force caps relative to other insurers. It’s also obviously not a November phenomenon – the same massive range of caps appears in every month of 2020.

What’s not up for debate is that Accordia is clearly offering better rates to some customers than others. What is up for debate is why. It could be that they’re screwing their customers. Or it could be that these are old policies where the cap is no longer being subsidized by fixed charges and, therefore, the cap drops. Or it could be that these are old policies and with lower charges and higher investment spreads, which would naturally lead to lower caps than Accordia’s modern, high-charge, low-spread products. Or perhaps these policies have different portfolios supporting them and, therefore, have different earned rates and caps.

The core problem with Indexed UL is that it’s literally impossible to know if the cap you’re getting is fair. The ratesetting process is obscured and opaque at every single life insurer. No life insurer has come right out and said “here’s our option budget for this particular [block or product] and we’re setting all of our caps, participation rates and spreads accordingly by using the actual hedge costs we get from our trading counterparties.” If they did, then we’d have a better feel for what cap is fair because we’d know what the life insurer is paying to get it. We could equate that number to crediting rates on Universal Life or even market interest rates. There would be an external barometer.

As it turns out, the data is there in Schedule DB, you just have to know where to look and how to parse it out. Below is the breakdown of caps and the cost the hedge the cap in November of 2020:

From this angle, the story from these hedge prices isn’t that Accordia is screwing policyholders by reducing caps. Quite the contrary, actually. Think about crediting rates on in-force Universal Life products – how many of them have you seen with rates below 3.5%? Plenty. The fact that Accordia is offering 70% of its block with caps of 6.75% or higher means that Accordia is delivering fair or more-than-fair rates relative to what we would see in an in-force Universal Life policy as long as you look through the cap itself and to the cost to hedge it.

These hedges prices also highlight the fact that many of the new business caps being offered in the market were flat out unsustainable. Just take a look at how much it cost for Accordia to hedge its current new business rate on Lifetime Builder Elite 2020 throughout last year:

Back in the middle part of last year, Accordia was shelling out more than 6% to hedge its 13.5%. Even after the cap reduction to 12%, the hedge cost was still floating around 5.4%. To put these numbers into perspective, Moody’s Baa bonds are currently yielding 3.37% (10/6). The ICE BofA US High Yield Index Effective Yield is sitting at just 4.34% – and that’s high yield debt. The only fixed income index currently over 6% is the ICE BofA CCC & Lower US High Yield. There was literally no way that could continue.

And it didn’t. Take a look at the latest trades on Accordia’s block trades at the end of June of 2021:

The weighted average cap for all of Accordia’s business hasn’t materially changed – 7.67% in November vs. 7.62% in June. The weighted average cost to hedge, however, has come down meaningfully from 3.88% to 3.53% because option prices have generally fallen since the end of last year.

But by far the biggest change was in the highest available cap rate in the market. From June 2020 to June 2021, Accordia has dropped its top cap from 13.5% to 10.5% with a stop at 12%, as shown in the previous graph. That move has reduced the hedge price for the top cap from an average of 6% for the 13.5% cap last year to just 4.22% for the 10.5% cap in June. In short, it’s not hard to spot an unsustainable cap. And it should also be no surprise when the carrier reduces the cap to reflect the market rate environment.

At the end of the day, Indexed UL is an economic proposition. When a client chooses an IUL policy, they are swapping a fixed crediting rate for index exposure based on current option prices. We should not blanche, therefore, when caps fall as yields fall and option prices increase – and that’s exactly what has happened. We should also not blanche when life insurers set different rates for their in-force and new business policies because there are a variety of good (and bad) reasons why that could make sense. We should assume that an abnormally high cap is unsustainable.

And Indexed UL should be illustrated accordingly. As rates fall and option prices increase, caps will continue to fall. It’s like gravity. If you want to see what a new money, fair-market cap is in today’s environment, just look at the Benchmark Index that I maintain on this site. Right now, the benchmark is floating between a 5% and 5.5% cap. What that tells you is that if you froze time right now and just let carrier portfolio yields eventually blend down to the new money rate, that’s where caps would be. I would argue that on that basis, illustrating Indexed UL at 3.5% isn’t conservative – it’s the base case scenario.