#306 | The New Indexed UL Narratives – Part 1

Over the past 15 years or so, the Indexed UL narrative has evolved quite a bit. Early on, the story was all about the characteristics of the product as an asset class – upside potential with downside protection. That story naturally resonated with clients in the wake of the 2008 Financial Crisis. And in those days, the tradeoff was compelling. It didn’t take much effort to convince a customer to eliminate all of their equity risk in exchange for giving up index upside above 12%, which was the going rate for caps at the time.

But the narrative for Indexed UL quickly pivoted to illustrated performance. That shift arguably started with AIG Elite Index IUL and its 10.25% illustrated rate, which rocked the market and reoriented the competitive landscape towards maximizing illustrated rates using whatever tools were available. In the wake of AG 49, the narrative moved to charge-funded multipliers and buy-up caps, both of which traded on the idea of taking more risk to get higher returns, essentially betraying the original positioning of the product for full downside protection (not including policy charges) in the name of maximizing illustrated performance.

After AG 49-A clamped down on the illustrated benefits of charge-funded multipliers and buy-up caps, life insurers pivoted to the new narrative that proprietary indices and/or exotic payoff structures can deliver attractive upside potential in an environment that has pushed caps down to levels that were unthinkable even as recently as 5 years ago. That narrative is further bolstered by the fact that life insurers have been exploiting a vulnerability in AG 49-A that allows for better illustrated performance for these non-traditional indexed accounts. Regulators have already opened an inquiry into those types of accounts. Nary a comment letter to LATF on this issue defended the practice and most openly condemned it. The only question now is how to fix the problem.

This leads us to the next obvious question – if a forthcoming AG 49-B closes the vulnerability and potentially goes even further, perhaps even eliminating the illustrated benefit of IUL over UL altogether, then what will be the new Indexed UL narratives?

I would argue that we’re moving to a post-illustration era for Indexed UL. Given that I’ve been an ardent critic of Indexed UL illustrations since I stood in the back of a ballroom at the Bellagio in 2007 just 2 months out of college and heard a carrier representative say from stage that it is “irresponsible” to illustrate his product at less than 10%, you might think that I’m excited for Indexed UL to enter this new era. And to the extent that the Indexed UL narrative goes back to the core structural value proposition of upside potential with downside protection, I am.

But I don’t think that’s what’s going to happen. Instead, I think four new narratives are emerging that are reshaping the way that Indexed UL is positioned – for better, in some cases, but also for worse. We’ll cover the first two in this post because they apply to the category as a whole and the next two in a subsequent post because they deal with two particular product features that, I think, are about to go mainstream.

Narrative 1 – Stellar Actual Indexed UL Policy Performance

Recently, I’ve heard a lot of producers contrast the actual performance of Indexed UL policies that they’ve sold over the past few years with what AG 49/AG 49-A allows them to illustrate. The narrative for consumers that I’ve seen producers give firsthand goes something like this – “I’m only allowed to show you an illustration at 5.5%, but Indexed UL policies have actually performed at closer to 8%, so this 5.5% that I’m showing you is very, very conservative. In reality, the performance will be much better. Think of this 5.5% as the worst-case scenario.”

The reality, however, is that the AG 49 maximum illustrated rate is not conservative. Not by a long shot. It represents the 50^th percentile return from applying today’s currently declared cap to historical S&P 500 returns which, on average, have been about 12.5% on a total return basis. Illustrating at the AG 49 maximum rate is roughly equivalent to illustrating a Variable UL allocated to an S&P 500 fund at 11% gross – assuming the cap doesn’t drop which, as I wrote about last week, is a very bad assumption.

But the problem is that relative to the past decade, the AG 49 maximum illustrated rate looks very conservative. Take a look at S&P 500 performance from 2009 until now versus the period of time captured in the AG 49 calculation prior to 2009:

Clearly, the period of time over which most of Indexed UL policies were sold has been anomalous in terms of S&P 500 performance, to put it mildly. S&P 500 returns over the last decade are nearly double what they were historically with just 1/3 of the usual years of drawdowns. Couple that with the fact that caps for Indexed UL products were historically much higher than they are today, and it’s little wonder why in-force Indexed UL policies have performed so well.

Producers who sell Indexed UL seem to be interpreting this outperformance as structural rather than circumstantial. In other words, they’ve taken it as proof that Indexed UL will deliver 7-8% annualized returns with no risk to the policyholder because that’s what Indexed UL has actually done over the past decade without asking the question of whether the circumstances of the last decade that led to the performance of the policies will be repeated in the long run. Will Indexed UL perform as well in the next decade as in the last? Consider what would have to happen – caps would have to increase from 8% to 13% and S&P 500 price returns would have to average 13.5% with very few (and swift) drawdowns. It’s an impossible scenario.

And yet, that’s the narrative now starting to percolate through the Indexed UL market in part because life insurers are aiding and abetting it by publishing the historical performance on their in-force blocks. This is extremely dangerous. There’s a reason why investments always have the fine print that past performance does not predict future results. Because it doesn’t. No, really, it doesn’t.

That’s especially true for a highly complex financial instrument like Indexed UL that is influenced not just by equity returns but also fixed income cycles and option pricing dynamics. Carriers touting the historical performance of their IUL block are like a lottery winner running out of the gas station holding their ticket high and screaming at the top of their lungs – “Look at me! I’m the best ticket picker in the county!”

Indexed UL has had a great run. No doubt about it. But extrapolating those returns forever or even believing that they are remotely indicative of future results is a recipe for disaster. If this is part of the new narrative for Indexed UL, then we have a real problem on our hands – one that will very likely result in more litigation than the industry has had since vanishing premiums.

Narrative 2 – Third-Party Proxy Illustration Modeling

If actual performance has been better than what AG 49/AG 49-A allows carriers to show, then it would stand to reason that that argument is doubly true for charge-funded multipliers. Just yesterday, a subscriber sent me a proposal for a hyper aggressive premium financing proposal using a Pacific Life policy with this note at the top: “Performance Plus rider selected. After AG 49-A, the multiplier values cannot be illustrated.” Clearly, part of the pitch is the value of the Performance Plus rider, which has a 7.5% charge to buy a multiplier, even though the values don’t appear on the illustration. But wouldn’t it be great if they did?

Allianz first broached the concept of a non-illustration illustration that could demonstrate what a hypothetical Indexed UL policy performance would look like without being constrained by AG 49-A with the now-defunct Allianz Showcase, which I wrote about in #258 | The Allianz Showcase. The idea was simply to give producers a tool to demonstrate the effectiveness of a multiplier under a few performance scenarios for a few generic cells. Showcase just had a few data points and didn’t show year-by-year ledger values. It was pretty bare-bones and that may very well have been the reason why it wasn’t well adopted.

However, I’ve increasingly heard folks talk about certain firms, usually in the premium financing space, that are beginning to produce their own reports that can model Indexed UL policies outside of the confines of the illustration for use with producers and clients. The most prominent example of this is Breadbox, which allows producers to model “Hypothetical Synthetic Assets that act as a proxy for…indexed universal life insurance policies,” but there are apparently others that follow a similar approach.

There is nothing inherently wrong with this sort of analysis. My own Dynamic Illustration Tool (DIT), which I’ve used since 2018 to underpin analysis that I’ve used for presentations and on this website, does essentially the same thing. But these sorts of tools should be handled with caution. First and foremost, they must be accurate – and that’s a tall order. I’ve always viewed the DIT as directionally indicative, not replicative, and I think that should go for any third-party tool attempting to model product performance outside of the confines of carrier illustration software. If you can’t validate the model with results from the illustration software, then how can you know for sure that it’s right?

Second, and more importantly, the regulations around illustrations are there for a reason. Ignore them at your own risk. You may have a gripe about the fact that AG 49-A clamped down on your ability to illustrate hypothetical perpetual benefits of using a charge-funded multiplier, but if you throw out AG 49-A when you use a third-party modeling approach, then why not throw out AG 49? Why even bother using the standardized lookback approach? Why not use just the last 10 years? Why not assume that caps are going to increase with interest rates? Why not assume that the life insurer makes future COI reductions? Why not assume that policy loan rates drop to 0%?

It’s a very slippery slope. Because third-party modeling doesn’t create compliant illustrations, there is really no reason for a third-party model to follow any part of the illustration model regulation. The more of the Reg that you throw out, the better the modeling is going to look. You can make assumptions about rising interest rates or mortality improvements, for example, that a carrier could never certify as supportable for illustration actuary testing. Where does a third-party provider draw the line?

I expect these tools to proliferate. It’s just not that hard to reverse engineer an illustration system to create your own. And these tools can be extremely helpful to get a sense, directionally, for what the policy may do under various circumstances that can’t be modeled with compliant illustrations, particularly for modeling volatile returns over time. That’s what I’ve always used my DIT to do. It has given me some really valuable insights into how these products perform that aren’t necessarily intuitive and I would have only been able to see them outside of the confines of the illustration.

But there’s a risk that these tools will be used for competitive positioning at the point-of-sale – and that is extremely dangerous, in my view. If the new narrative for Indexed UL becomes “take a look at this hypothetical report that shows the real performance of the ‘policy’ at 8% with multipliers but I’ll need you to sign this compliant illustration at 5% without multipliers just for record-keeping purposes” then we’re going to have a real problem on our hands, one that we should avoid at all costs.