#329 | AG 49-B Takes a Leap Forward

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Quick Take

The glaring loophole in AG 49-A that allows life insurers to augment illustrated performance of Indexed UL products by combining fixed interest bonuses with engineered indices almost guaranteed that there would be a follow-up regulation, which I’ve pre-emptively called AG 49-B. Last week, AG 49-B became almost inevitable as regulators determined that they need a quick and credible fix for the issue. One solution maintains the problematic lookback provision, which keeps the door open to more potential issues in the future. Other solutions, which received some vocal regulator support, eject the lookback in favor of hedge budget or fixed account-based rates. But no matter what happens, Indexed UL illustrations are in for yet another change – just in time for regulators to potentially take up the bigger issue of Regulation #582, which governs illustrations for all life insurance products with non-guaranteed elements.

Full Article

Since life insurers have begun incorporating engineered indices and fixed interest bonuses with abandon, I’ve somewhat jokingly referred to the inevitable forthcoming regulation to deal with them as AG 49-B. I’ve written about it with such certainty that a few folks have asked me where they can find a copy of the language (which doesn’t exist yet, obviously). Last summer, I felt confident that regulators would take up the issue as more and more companies began to shift to engineered index designs. But then nothing happened. Radio silence.

And then, out of the blue, Fred Andersen of Minnesota, chair of the IUL Illustrations Subgroup, opened up an exposure period in February probing the issue of what he termed “volatility-controlled funds.” The response from the industry and its groups ranged from a tepid acknowledgement of the issue to, in my view, strategically feigned surprise that regulators are even asking questions about IUL illustrations. Then, again, radio silence for months.

Then came a letter from the Subgroup asking about four options: doing nothing, a quick fix, a more comprehensive fix and some form of hard cap. The exposure period was a very short 3 weeks. Several life insurers submitted letters that generally recognized the problematic combination of engineered indices and fixed interest bonuses and recommended a quick fix. Only Allianz even attempted to come to the defense of the strategy. ACLI was uncharacteristically silent. Sheryl Moore and I teamed up to submit a letter that could be briefly summarized as follows: doing nothing is not an option and the other options could actually be accomplished simultaneously. The message was clear across the board – something must be done.

Last week, the Subgroup met at the summer NAIC meeting and Indexed UL illustrations was on the agenda. I couldn’t make the call but I received extensive notes from a friend and chatted with a few folks who listened in. It seems to me as though there were three main takeaways.

First, this time is different. It really is. There seems to be universal acknowledgement amongst regulators that life insurers are gaming the system. As one regulator said, “this is AG 38 all over again,” which is a damning statement considering that AG 38 was a long, drawn out, embarrassing fight that exposed the ways life insurers were blatantly arbitraging the statutory reserving formula for Guaranteed UL, even if it resulted in unintended negative consequences for consumers. What life insurers are currently doing in Indexed UL is indefensible and no one attempted to defend it. Not even the ACLI, which has been the dominant force in all previous discussions. All of the momentum this time is on the side of the regulators.

Second, there seems to also be universal acknowledgement that there needs to be a solution – and that regulators are not nearly as concerned about collateral damage for Indexed UL sales as they’ve been in the past. This is embodied, in my mind, in a comment made by Fred Andersen about potentially using the Fixed Account rate as the maximum illustrated rate for the product in order to close the loophole. In all previous Indexed UL illustration discussions, life insurers successfully argued for solutions that preserved their ability to illustrate with the lookback. But it seems as though the lookback is very much on the table for this round.

Third, it seems as through regulators are intent on not just solving this particular issue with Indexed UL, but expanding their inquiry into all life insurance illustrationsby opening up the Illustration Model Regulation (#582). Birny Birnbaum, a long-suffering consumer advocate to the NAIC, has been advocating for this for years without any real audience from regulators. This time around, though, there seems to be a broad acknowledgement amongst regulators that 582 can’t address Indexed UL fully and needs to be revised. To paraphrase one regulator, illustrations were meant to be disclosure documents, but as soon as the model regulation was passed, they became competitive weapons. That has to stop. I couldn’t agree more. Writing a new illustration regulation is going to be a long, drawn-out process, but the end result is going to change the industry – hopefully for the better.

So where do we go from here? Modifying 582 is a huge issue that has to be kicked up to various NAIC entities for discussion and debate before it’s undertaken. It would be something like a 5-year project that will likely start next year, if they decide to move forward with it. More immediately, regulators are still intent on implementing a quick fix to deal with engineered indices and fixed interest bonuses. They’ve extended the comment period for another 3 weeks to gather suggestions. In my view, there are three viable quick fix options.

The first is to modify AG 49-A so that the illustrated options profits on all accounts is equal to the illustration option profit on the BIA (the standard S&P 500 capped point-to-point account that governs the illustrated rate for all accounts in the product). This would immediately drop the illustrated rates on all engineered index accounts.

How far? Let’s use National Life SummitLife as a case study. The BIA Cap for SummitLife is 8.75%, which costs about 4.4% and illustrates at 5.64%. This implies an illustrated annual option profit of 28% (5.64% / 4.40% – 1). Currently, the product also offers an engineered index that also illustrates at 5.64% but has an option cost of just 3.11%, implying an illustrated annual option profit of a whopping 81%. Forcing that product to illustrate at the same option profit as the BIA would result in an illustrated rate of just 3.99%, bringing the total illustrated performance to just 5.19%, significantly worse than the BIA.

This is how Indexed UL illustrations are supposed to work – if the option budget is reduced, then the overall illustrated rate is also reduced. The fixed interest bonus makes the account look more like a fixed account, so it should illustrate more like a fixed product, too. The fact that carriers are reducing their option budgets, reallocating values to fixed interest bonuses and then increasing their illustrated performance is evidence of how broken AG 49-A really is. It’s non-sensical and it completely contradicts the logic that life insurers have employed to defend the status quo in Indexed UL illustrations since regulators first took up the issue of Indexed UL illustrations in 2013. It is, as I’ve said, indefensible.

However, this fix is not comprehensive. There are still some very gray areas in AG 49-A. S&P 500 accounts with fixed interest bonuses may still illustrate better income than those without. Carriers may still be able to play games with a hypothetical BIA. If we’ve learned nothing else over the past 7 years since AG 49 was adopted, it’s that where there’s a lookback, life insurers will find ways to game the system. Period. End of story. As I’ve written before, the lookback is a cancer – the only way to cure the patient is to get rid of it.

This leads us to the second quick solution, which is to strip AG 49-A of the lookback provision altogether and replace it with another approach for illustrating indexed accounts, potentially a Black-Scholes derived formula that would approximate the fair market value of the index participation. From there, regulators could add some sort of a small profit factor to allow a smidge of an illustrated return advantage for Indexed UL. One regulator mentioned something like 5% versus the current 45% limit.

Swapping out the lookback method for Black-Scholes makes theoretical sense, but there are some practical challenges. Option prices change continuously. Attempting to smooth them out will lead to periods of time where there could be a substantial disconnect between the estimated Black-Scholes valuation and the actual cost of the option, particularly in extremely volatile environments and for certain crediting strategies such as spread and par rate S&P 500 accounts. Black-Scholes valuations for Cap accounts would be much more stable. Ironically, the only place where Black-Scholes would reliably stick the landing is with engineered indices because they have constant volatility. But in my view, these disconnects can be handled by some specificity around the inputs and a few hard limits. There is no doubt in my mind that Black-Scholes absolutely can work. The fact that it isn’t perfect shouldn’t disqualify it from consideration. After all, the lookback certainly ain’t perfect either.

Another option is force life insurers to illustrate at their hedge budget for each account. Prior to AG 49-A, this would have been unthinkable because life insurers adamantly refused to disclose their hedge budget. However, AG 49-A actually incorporates the hedge budget into the illustrated rate calculation, which means that life insurers are declaring it implicitly, if not explicitly. Forcing carriers to expose their hedge budget and run actuarial supportability tests off of it would nix almost any gamesmanship specific to Indexed UL, although life insurers could still employ the usual Universal Life illustration tactics (chiefly lapse-supported features).

This leads us to the last solution, which also happens to be the simplest, most comprehensive and undoubtedly the most controversial – use the Fixed Account interest rate as the maximum illustrated rate for the product. This approach has some clear virtues. All Indexed UL products have Fixed Accounts. Fixed Accounts already must pass illustration actuary testing. There is consistency between how Fixed Accounts in Indexed UL illustrate and how other fixed insurance products illustrate, specifically Universal Life and Whole Life. Using the Fixed Account as the limiter for the illustrated rates across the product would completely mitigate the effect of using fixed interest bonuses beyond what is already standard in Universal Life.

The problem with this approach is twofold. First, Indexed UL writers will universally hate it. Right now, IUL writers seem to be split between those who recognize the problem in AG 49-A and want to eliminate it and those who recognize the problem and are taking advantage of it. A very quick way to unify them into a single camp is to get rid of the lookback and switch to the Fixed Account. But in my view, even their unified opposition may not matter. Times have changed. It doesn’t seem as though the regulators are particularly keen to hear what industry has to say. What they seem to want is a quick and comprehensive fix – and this would certainly qualify.

The second problem is that most Indexed UL writers sandbag their Fixed Account rates in order to provide some subsidization to the rates in the indexed accounts. It’s somewhat comical to see 2% fixed account rates in products with 10% Caps that cost 5% to hedge. Only a few carriers make a point to equalize their fixed account rate with their option budget. Allianz is the chief example of this practice. F&G is close. But beyond that, carriers are clearly taking more margin in their fixed accounts. If this regulation comes into effect, they’ll have to show their cards and bump up their fixed account rates lest they be stuck with a 2% illustrated rate. You can bet that they’d change Fixed Account rates in a hurry.

However, all of these approaches suffer from a broader problem – they don’t really portray Indexed UL and how it works. As a couple of regulators pointed out on the call, 582 never contemplated Indexed UL. Variable returns must be a part of the story. That’s how Indexed UL actually works, but it’s impossible to illustrate them in the current regime. Hence, the push to change 582 to better accommodate Indexed UL. The question is simply what happens in the interim.

Framed like that, it seems to me that regulators really have a choice between allowing Indexed UL to continue to be inconsistent with other fixed insurance products, which it is today, or to force it to adhere to 582 as the fixed product that it is while the actual work on 582 begins in earnest. Maintaining the lookback would allow Indexed UL to continue to be inconsistent. Switching to either the Black-Scholes, Hedge Budget or Fixed Account illustrated approach would push Indexed UL into conformity with 582 as a fixed product. Getting to an answer on this question should be the first order of business. From there, we can figure out the appropriate fix.

My gut is that is that – as crazy as it sounds – the momentum is currently on the side of the hedge budget / Fixed Account approach. Life insurers would do well to pause to consider how hard they fight to change the momentum. If Indexed UL is sold correctly, reducing illustrated rates even to the Fixed Account level should have absolutely no impact on sales. If a client is willing to buy an Indexed UL product because it illustrates at 7% (with bonuses) but won’t buy it at 4.5%, then that client shouldn’t be buying Indexed UL. There’s no ambiguity about it. Illustrations are not projections. If they’re being used as projections that are swaying a client’s buying decision, then that’s even more of a reason to push Indexed UL in line with other fixed products.

Indexed UL sold properly is a story about an asset class that delivers downside protection with index-linked upside potential. The illustration should have nothing to do with it. Historically, these policies have performed remarkably well, although I would argue that most of the strong performance is attributable to a honeymoon decade of cheap options, high portfolio yields and stellar equity returns. But, regardless, it should be easy to sell an Indexed UL without an illustration. If that’s not the case, then the last thing regulators should do is continue to give life insurers a tool to sell a product that, apparently, clients don’t actually understand, as evidenced by the fact that they’re only buying it based on illustrated performance.

Should life insurers vehemently fight a more conservative approach while 582 is being sorted out, then they’re admitting that they’re relying on uninformed customers for sales. That’s not a good look. Life insurers, in my view, are in a catch-22. To fight admits the fault. To stay silent may result in a regulation that cuts the legs off of the Indexed UL market. I hope that isn’t what happens. I hope Indexed UL is completely unaffected by any change to the illustration regime. That would validate both the product and the way it’s sold. But I tend to side with some of my friends who say that Indexed UL sales will drop by 75% or more if the lookback is abolished. If that’s true, then the past 15 years of the lookback are a tragedy. And I think we’re long overdue to find out.