#311 | The Shifting Winds of AG 49-A

white sailboat on body of water

For the third time, the IUL Illustration Subgroup of the Life Actuarial Task Force (LATF) of the A Committee of the NAIC – yes, that’s really how the hierarchy goes – will take up the question of what to do about Indexed UL illustrations. That much was decided on the LATF call a few weeks ago. What happens next is anyone’s guess, but the particular and peculiar way the LATF call unfolded provides, in my view, a bit of a preview of what may be coming down the pike for Indexed UL illustrations. And if that’s the case, then this round of discussion could prove to be markedly different from the previous ones. It feels like the winds have begun to shift.

First – the letters. In previous debates about Indexed UL illustrations, life insurers have been divided in their views of whether the perceived problem was actually a real problem. This time around, however, there is a near-universal acknowledgement that AG 49-A can be gamed by using strategies with high lookback “option profits” and fixed interest bonuses. There is also a general consensus that this outcome is not what regulators intended and should be addressed.

The split, of course, is in the proposed solutions. In general, there appear to be four solutions proposed by groups that submitted letters:

1 – Disclosure

As usual, this is the default response. Disclosure is the easiest and most painless way out for life insurers. It is also, by far, the least effective. As Birny Birnbaum, the omnipresent consumer advocate from the Center for Economic Justice, always points out, a few paragraphs inserted into an already bloated illustration will do exactly nothing to educate consumers. He’s probably right, but that’s not going to stop life insurers and the ACLI from starting the opening bids on the low side – and that’s exactly what disclosure is, a low bid.

2 – Apply the 145% Option Profit Ceiling to All Accounts

As I’ve written before, the necessary ingredient to juicing illustrated performance under AG 49-A is an indexed crediting strategy that illustrates ultra-high “option profits,” which is a shorthand way of describing the ratio of hypothetical lookback performance to the current cost of the option. The higher the ratio, the higher the “option profits.” AG 49 and AG 49-A put a 145% ceiling on the ratio, but AG 49-A crucially only applied the ceiling to the Benchmark Index Account, which is the S&P 500 point-to-point strategy with a 0% floor and currently declared cap that is present in almost every product in the industry and, if it’s not present, the life insurer has to create a hypothetical version of it.

The problem is that the illustrated “option profits” from many proprietary indices are vastly in excess of 145%. This allows life insurers to lower their option budget while still achieving the same illustrated rate as the BIA and then redeploy the savings into a fixed interest bonus that can be added back to the BIA rate to increase the maximum illustrated rate. Out of one pocket and into the other. But, under AG 49-A, there’s an illustrated benefit for doing so, as I’ve written about at great length before.

The simplest solution, then, seems to be to apply the 145% to all accounts rather than just the BIA. But what this solution has for simplicity it gives up in effectiveness. Currently, BIA accounts are illustrating “option profits” closer to 120%. Allowing non-BIA strategies to use up to 145% would give plenty of room to still use the same fixed interest bonus strategy. Think about it in dollar terms – with a 4% option budget, 25% extra option profit could generate around a 75bps fixed interest bonus. That’s plenty enough to push the product to the top of the competitive heap. In my view, applying the 145% limit across all accounts would do effectively nothing to solve the problem except in the most egregious and extreme designs.

3 – Apply the BIA Option Profit to All Accounts

This is the same concept as the previous solution, but instead of using 145% as the option profit limit, it would use the lesser of 145% or the current “option profit” being illustrated by the BIA. In other words, if the BIA is illustrating a 20% “option profit,” then that’s what every indexed account would use for illustration purposes. This would effectively cut the fixed interest bonus strategy off at the knees.

But as we all know from the famous Black Knight scene in Monty Python and the Holy Grail, cutting your enemy off at the knees is not enough to stop them from fighting. AG 49 allowed for multiple BIAs, one for each class of accounts that shared the same option budget. AG 49-A moved to using a single BIA across the entire product, even if the BIA is purely hypothetical. This opens the door to life insurers playing games with their BIA ratesetting in order to juice Illustrated “option profits,” particularly for hypothetical BIAs, in order to give breathing space for fixed interest bonus strategies.

Switching back to multiple BIAs, as in the original AG 49, would solve this problem but potentially open up new loopholes that were closed with AG 49-A, particularly in regards to multipliers and buy-up caps. But all in, setting each account’s maximum illustrated “option profit” with an applicable BIA would probably knock out 90% of the illustration games being played in the current crop of Indexed UL products.

4 – Use Fair-Market Illustrations

The fourth potential solution has been proposed and rejected at each previous round of regulation – fair-market illustrations. In short, the IUL product would illustrate a rate that reflects the fair-market valuation of the options being used to provide indexed exposure. Illustrating IUL this way would eliminate any designs to juice illustrated performance that rely on “option profits” because there would be no “option profits” or, in the case of Equitable’s proposal, a defined “option profit” that is small enough to limit any real benefits (think 5% or 10%).

Using a fair-market value approach is the simplest and most comprehensive solution. It would also align IUL illustrations with other option valuation methodologies used the world over. But it also would mean Indexed UL would illustrate no better than a comparable UL (or not much better, in the case of Equitable’s proposal), which is something most IUL writers would rather die than see.

Now, to the call itself. In some ways, it was just another relatively bland procedural call wherein regulators agreed to take up the question by sending it to the IUL Illustration Subgroup for review. That much was fait accompli. The Subgroup will kick up meetings in early May and we’ll see what happens.

But in other ways, the call was jaw-dropping. I’ve been on countless calls with these regulators on this issue. I feel like, maybe more than most folks who haven’t been involved from the very beginning of all of this, I have sense for what’s normal and what’s not. That call was not normal. Regulators rarely voice a strong and impassioned opinion. That’s just not how they roll. They listen, maybe ask a clarifying question or two, perhaps share a guarded insight – and that’s pretty much it.

However, on this call, Tomasz Serbinowski of Utah seemed like he was on the war path. Tomasz is a highly technical actuary who isn’t afraid to get his hands dirty on an issue. He also has the benefit of having essentially no major domestic insurers to bend his ear towards a particular position. In the context of the usually docile and subdued conversation on these calls, Tomasz absolutely ripped IUL illustrations, even going so far at one point to say that “I don’t’ understand how any actuary can think it’s appropriate to use a lookback.”

Once he started, a few others started to chime in, including Bill Carmello of New York, who pointed out that the differences between IUL and UL should be explained in a 1-year snapshot, not the ledger values. Then came Birny Birnbaum with a stinging rebuke of illustrations in general and IUL illustrations in particular – and Tomasz (and, I think, a couple of other regulators) chimed in with their support of his position. Tomasz then pressed the point by asking about practices for Variable UL and pointed out that not even VUL attempts to use any sort of lookback or historical approach for setting illustrated rates for the product and especially not for individual accounts, as in Indexed UL.

I was listening to the call and kept waiting for a regulator to come to the defense of the current IUL illustration practices. None spoke up. I recognize that it’s very early in the process, but this feels like the first shifting of the winds. Add to that the fact that Fred Andersen, chair of the Subgroup, explicitly said at the end of the last round of regulation that IUL writers wouldn’t like the result of the next round, should it come to pass. Well, here we are. From my vantage point, this time feels different.

But if I had to weight the probabilities, I’d weight them like this – 10% chance of #1 (because it doesn’t solve the problem), 40% chance of #3 (because it’s unpalpable for insurers) and 50% chance of #2 (because it does just enough to solve the problem with the least collateral damage from the insurer’s point of view). There’s the line. Now we get to see what happens.

In the meantime, life insurers appear more than willing to continue to the play the game available to them. Symetra just rolled out a new Bonus option on their latest Indexed UL product that tacks a fixed interest bonus onto a proprietary index account – while simultaneously referencing a hypothetical BIA rate that’s significantly higher than the actual S&P 500 strategy available in the product. The net result is that illustrated income increases nearly 50% just for selecting the new Bonus option with a proprietary index.

Nationwide just filed a similar account for their street Accumulation IUL product but, crucially, not their New Heights product developed with Annexus. Why? Because, in my view, New Heights already leverages proprietary indices to juice the BIA rate, which is less effective in terms of pure illustrated performance than using an account-specific fixed interest bonus. Irony of ironies, the new street product will have the ability to illustrate better performance than New Heights. That’s the power of a fixed interest bonus combined with a proprietary index – and hopefully a power that is on its way out.