#298 | Malice – or Mechanics?

This is the last post of 2021. It’s been a heck of a year – thanks for continuing to support The Life Product Review. Happy Holidays and a Merry New Year!

I remember well when, several years ago, a spate of life insurers began to increase Cost of Insurance charges on in-force blocks. Uproar came from every corner of the independent side of the business. There was much saber rattling at major BGAs and aggregators about the potential repercussions of the changes for new business sales. But, as I wrote in #215 | The Fable of the Frog, the threats ultimately proved hollow. The uncomfortable reality of our business is that we sell lifelong contracts with terms that can change in ways that are completely out of the control of the distributor, the agent and the client.

There are, however, other forces at work. For some companies – particularly mutual companies – the concept of doing right by policyholders is law, judge and jury. For other companies, doing right by policyholders is a cultural norm, a default setting, that is only overruled in extreme circumstances and with much angst. For still other companies, policyholders fall further down the priority stack below distributable earnings, but a fundamental tension still remains because of new business and ethical considerations. And for the very few, policyholders are simply lumps of cash waiting to be grabbed. My experience is that the vast majority of insurers fall in the first two camps, but producers assume that basically all companies fall in the bottom two camps.

The collision happens whenever a life insurer makes a change to their in-force block. The problem is that it’s virtually impossible to know, from the outside, all of the reasons why a life insurer did what it did. No matter how reasoned, how circumspect, how justified the action may be, producers and distributors immediately attribute it to malice and greed.  But that’s the worst possible explanation for a producer to give to a client. What life insurance salesperson wants to tell their clients that a life insurer is evil? If one is evil, then what about the rest?  This explanation casts life insurers in the worst possible – and least accurate – light.

Hanlon’s Razor states that one should “never attribute to malice that which is adequately explained by stupidity.” We might modify it to a less-elegant version for a life insurance application: “never attribute to malice that which could be adequately explained by the Chief Actuary.” The problem is that most Chief Actuaries are (usually purposely) insulated from the field by several layers. You don’t know what they’d say. But the exercise is still a good one – before you chalk something up to malice, consider the alternative.

With that in mind, let’s take a look at 3 recent in-force actions made by carriers – COI increases by Transamerica, Whole Life loan rate increases by Nassau Re and Indexed UL cap reductions by Nationwide.

Transamerica Increases COI Rates – Again

With almost wanton disregard for the vitriol thrown its way by former distributors and their agents, Transamerica has consistently raised COI rates on in-force blocks of business for the past several years. The past COI increases were met with class action lawsuits that resulted in massive settlements that, from my reading, essentially eliminate the economic benefit of the COI increase to Transamerica. Furthermore, Trans was prohibited from increasing COIs on those blocks of business for the next 5 years and can’t increase COIs after that point to make up for the losses in the settlement. I don’t know how anyone could characterize the settlements as a win for Transamerica. They are, by my reading, a complete victory for the plaintiffs and a repudiation of the idea that the COI increases were, in fact, justified on the basis of pure mortality experience.

It’s mystifying, then, that a few weeks ago Transamerica made distributors aware that it had sent letters to policyholders for Universal Life policies issued from the mid-1990s through the mid-2000s to alert them that their COI rates would be increasing. Why would Transamerica willingly invite more bad press and more lawsuits without any real economic upside? Let’s go back to our modified Hanlon’s Razor – don’t attribute to malice what could be adequately explained by a Chief Actuary. What else might be going on?

The first clues are in the explanation provided in the letter to clients about why this is happening: “we’re increasing the monthly deduction rates for all policyholders of this insurance product based on our current expectations about future costs of providing this coverage.” Note that the letter doesn’t actually refer to Cost of Insurance – it says “monthly deduction rate.” Technically, that could mean any charge that’s deducted monthly. The only tip that they’re talking about COI is that the letter says in the following sentence that “the increase is in addition to customary increases associated with age.” Why would Transamerica want to be a bit vague about what’s going on? Because the key argument successfully made by the plaintiffs in the lawsuits was that Transamerica didn’t actually have any adverse mortality experience that justified increasing the COI rates.

That makes sense. Even COVID claims haven’t been enough for life insurers to begin increasing COI rates across the board – and COVID is arguably the worst thing to happen to anticipated mortality experience since the AIDS crisis in the 1980s. It’s unlikely that Transamerica’s COI increases ever had anything to do with mortality. In the most recent announcement, Transamerica lists the products being hit with COI increases. I remember some of those products because they were still being sold when I got into the business 15 years ago. They were not particularly competitive. I even dug back through some old (really old) files and found some illustrations and COI slopes from Trans products of about the same vintage and I would argue that the COI rates actually are on the high side relative to their peers. From every perspective – including victorious lawyers and their multitude of clients – the COI increases at Transamerica have never been about mortality.

Then what are they about? I have a theory. Look closely at the wording of the letter – “we’re increasing the monthly deduction rates for all policyholders of this insurance product based on our current expectations about future costs of providing this coverage.” I put the emphasis where I think it should be. There are three pieces to the story, I think – current expectations, future costs and “this coverage,” which I take to mean the policy as a whole, not just the death benefit component that’s directly funded by the COI charges. In other words, Transamerica is saying that based on today’s interest rates, these policies are projected to have negative distributable earnings and, therefore, Transamerica is remedying that problem by changing the “monthly deductions.”

This should not be a surprise. Transamerica is literally the last European-owned life insurer in the US with a significant in-force Universal Life block. European insurers have to use today’s risk-free rates to value their liabilities. They can’t assume that interest rates revert to the mean like their US-based counterparts. We saw the blatant effect of this in 2009, when virtually every European company immediately bowed out of the Guaranteed UL market once interest rates collapsed. Transamerica even went so far as to create a convoluted daily-priced GUL concept called Real Time Pricing before it pulled out of the market entirely. Trans has also been dramatically trimming its annuity line to essentially eliminate all tail interest rate risk. There is no doubt that the new business enterprise at Transamerica is heavily impacted by its European ownership.

And I think the same goes for its in-force policy management. Transamerica is sitting on a block of Universal Life policies with 3% (or higher) minimum guaranteed interest rates, well above current risk-free rates. American companies may be able to tread water on those policies because of their actual earned rates, but not Transamerica. They don’t have the same luxury because they have to value the policy based on risk-free rates. As a result, they have to raise COI charges to offset the damage. That’s the only lever they can pull.

The letter, I think, alludes to the fact that the problem is really policy valuation in a risk-free framework when it says that “our expectations about our future costs of providing coverage are subject to change over time.” Yes, that’s certainly true for any life insurance policy, but it’s doubly true for a US subsidiary of a European company that has to value its policies using risk-free rates that change regularly. The proof will be in the pudding. Is it possible that Transamerica might even reverse its COI rate increases if interest rates go up or if the company is spun off? If, in fact, the reason for the COI rate change is actually interest rates, then I think it’s possible. But not probable. As Lincoln has proved, once a company goes all the way to the guarantees, it’s hard to reverse the decision even if there’s justification to do so and would clearly benefit your clients if you did.

Going back to our modified Hanlon’s razor, what might the Chief Actuary at Transamerica say? Probably that they had no choice. They were stuck between the rock of European accounting and the hard place of profitability requirements. The only way to escape was to make the policyholder pay for it. It’s an unfortunate and, I think, unintended consequence of Transamerica’s European ownership – not necessarily malice.

Nassau Re Increases Loan Rates on Whole Life

A couple of weeks ago, a long-time producer friend sent me an illustration for one of his clients with a Nassau Re Whole Life policy originally written on Phoenix Home Life paper back when it was a mutual company with stellar ratings. By the mid-2000s, Phoenix had refashioned itself as a HNW client-oriented stock company selling boatloads of Guaranteed UL, even cracking the top 5 sellers of Universal Life for a few years. It promptly had its face ripped off by STOLI and a money-losing mutual fund arm. The company went into a death spiral and was retrieved from the scrap heap by Nassau Re. Since then, it has stabilized into a moderately successful, mid-sized fixed annuity seller under the Nassau Re brand.

The reason my friend was sending me this Whole Life policy was an interesting one – the adjustable loan rate on the policy had inexplicably jumped from 2.7% to 5.5%. The policy was heavily loaned and this news came as something of a disaster for the client because it significantly increased the minimum premium required to keep the policy in force. Not two days later, I got an email from someone else with a client with a heavily loaned Phoenix Whole Life policy where the loan rate jumped from “around 4%” to 6.5%. Both loan rates are theoretically tied to prevailing bond yields and bond yield have remained stubbornly low. What in the world is going on?

Malice is, of course, one explanation. It could be that Nassau Re is just raiding the coffers. It is, after all, owned by a PE-backed offshore reinsurer. In terms of perceived villainy, it doesn’t get much better than that. This might be just yet another example of financial wizards bleeding an in-force block of business dry at the expense of clients. But could there be another, more reasonable explanation?

Consider that these two policies were issued in 1991 and 1987. The 1991 policy is the one with the new loan rate of 5.5% and the 1987 policy has the new loan rate of 6.5%. The agent who sent me the first policy from 1991 made an incredibly perceptive observation – he surmised that, maybe, the minimum guaranteed rate for the policy is 4.5% and Nassau Re is simply aligning the loan rate with the guaranteed minimum rate, plus 1%. He pointed out that a lot of contracts from this vintage have provisions like that.

I don’t have the actual contracts for the two policies, but I do have two data points. Life insurer statutory filings show (in aggregate) blocks of business by vintage and guaranteed minimum rates. If he’s right, then we should be able to find blocks of business at Nassau Re that were sold in 1987 with a 5.5% minimum guaranteed interest rate and other blocks sold in 1991 with a 4.5% rate. And that’s exactly what we find. Nearly $2.6B of reserves at Nassau Re are tied up in policies that use a 5.5% minimum guaranteed interest rate and were sold in years including 1987, which makes up a whopping 30% of Nassau Re’s overall $8.7B in Life reserves.

Does this 1987 policy have a 5.5% minimum guaranteed interest rate? It’s not only possible, it’s likely. There are less than $2B in reserves for tranches sold in years including in 1987 that use less than a 5.5% rate. Statistically speaking, it’s more likely than not that this policy with a 6.5% loan rate has a 5.5% minimum guaranteed interest rate. The same goes for the 1991 policy. Of the $2.7B of reserves for policies sold with dates that include 1991, $1.8B is at 4.5%.

For both policies, it looks like Nassau Re is reverting the loan rate back to 1% plus the guaranteed minimum interest rate. This makes a lot of sense from the standpoint of risk mitigation. Loans against these policies are essentially earning a rate that is below the minimum guaranteed rate for the policy, which means every loan is a net loss on Nassau Re’s balance sheet. That’s exactly why MassMutual has a long-standing provision in its policies that floors the adjustable loan rate at 1% plus the guaranteed minimum interest rate as well. It’s just prudent risk management – and it’s hard to fault Nassau Re for increasing the rates, even if some clients are no longer going to have the huge (and completely unwarranted) benefit of an inverted relationship between the guaranteed rate in the policy and the loan rate. Malice? Hardly.

Nationwide Reduces Indexed UL Caps

Last year, there was a huge flurry of cap reductions on Indexed UL products in the wake of the initial increase in market volatility and dramatic drop in investment yields when COVID came bursting onto the scene. Only one carrier – Transamerica – escaped without a cap reduction and most of those reductions were material. But this year has been much calmer. Off the top of my head, I don’t recall a major cap reduction in the past 9 months. Option prices have stabilized to more normal levels and although interest rates are down, that’s a slow burn on life insurer portfolios.

In light of all of that, Nationwide’s announced cap reduction feels like it’s coming out of the blue, both in terms of timing and magnitude. Here’s a quick summary of what they did for the core S&P 500 Point-to-Point account:

A couple of things pop out right off the bat. First, the reduction for the currently issued contract is way less than for the in-force contracts, just 0.5% versus 1% or more, in the case of the 2018 vintage. Second, the overall caps are less for in-force policies than new business. The story, at first blush, writes itself – Nationwide is harming in-force policyholders to support new business rates in order to maintain competitiveness, particularly in the 2018 vintage, which has both the lowest cap and steepest drop. In other words, malice at work. But as we’ve already seen, malice isn’t usually the best explanation. We should dig a bit deeper.

Right off the bat, we need to separate the 2018 vintage from the rest. 2018 was, you may recall, the height of the multiplier craze and Nationwide was a participant in that. The 2018 product had an embedded 15% multiplier, so that needs to be factored into the rates. How do you do that? Convert the caps to option prices and then gross up the cost of options for the 2018 product by the multiplier (1.15). But while we’re doing that, we should add a couple of other data points into the mix. The 2018 product also had a 50% multiplier option for a 2.25% annualized charge. The 2015 product actually also offered a 15% multiplier for a lower cap, so I’ve included that one as well. It’s also worth noting that the Based on last week’s option data, here’s the estimated current cost of hedging the caps:

Based on this data, the 2018 vintage doesn’t stand out nearly as much. Yes, the 6% cap is jaw-droppingly, unimaginably low based on the fact that this product was released with a 9.25% cap for that account, which would cost about 5.05% at today’s option prices – and that was a mere 3 years ago (the illustration I have in my files was run on 12/3/2018). But a net option cost of 3.57% isn’t exactly highway robbery. Given where most in-force Universal Life crediting rates are right now, it’s probably pretty close to average.

The same goes for the non-multiplier accounts. The 2015 vintage IUL Accumulator illustration I have on hand was run in September of 2017 with an 11% cap, which would cost 4.97% in today’s option prices – basically dead even with the Accumulator II rate that was used for the new product a year later. Now, that account has a 7.5% cap that costs 3.73%. That’s 15bps richer than the current 2018 vintage cap with the 15% multiplier, but the same as the 2015’s own 15% multiplier account. Nationwide doesn’t appear to be discriminating between the two policies.

Before we attempt to draw some conclusions, I think it’s also worth noting how the product chassis itself has evolved over time. The 2011 vintage has a 15-year low unit charge, but that transitioned to a more traditional 10-year unit charge for 2015. Expenses increased by 20% or so for the 2018 update and the charges remained untouched for the most recent product. All of the products are relatively lean on policy expenses relative to their peers, which means that investment spread plays a bigger role than in many other IUL contracts.

That, I think, is at the heart of what’s going on. It looks like Nationwide has two different pricing spreads – one for the 2020 vintage and one for the older vintages, despite the fact that the policy charges are the same between the 2020 and 2018 versions. The explanation, I think, is probably pretty straightforward. Early in the life of the contract, having a thin spread isn’t a problem because there isn’t a lot of account value at play. But as time progresses, spread becomes a bigger and bigger factor for distributable earnings.

Given that these policies are all pretty lean on expenses, it would make sense that in-force rates should lag new business rates precisely because spread actually is a factor in profitability for these products and not necessarily for other Indexed UL’s. As you might intuitively expect, the tradeoff for lower policy charges is lower upside potential. It’s just that Nationwide seems to have managed to avoid the tradeoff for new business – and I wouldn’t necessarily expect that to last. Malice? No. It’s just simple mechanics.