#339 | The New Breed of Protection-Oriented IUL

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Quick Take

Historically, there was a clear distinction between protection-oriented and accumulation-oriented Universal Life products. The latter tended to have higher liquidity but also higher long-term policy charges, particularly COIs, whereas the former tended to have lower liquidity but also lower COIs, an effective combination for lowering illustrated minimum premiums. Times have changed. New protection-oriented contracts are designed to provide more cash value that can earn high illustrated rates, particularly with engineered indices in fixed interest bonuses, in order to override high COI slopes that mirror accumulation-oriented contracts. The result is products that are specifically designed to inflate illustrated performance while simultaneously increasing the penalties for underperformance. The operative advice for dealing with these products is simple – tread carefully, illustrate conservatively. Very conservatively.

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Over the past few years, the vast majority of the focus in Indexed UL has been on accumulation-oriented products – and rightly so. Through the 2nd Quarter of this year, only about 15% of Indexed UL sales are oriented towards minimum premium protection sales. These types of products have always been the smaller bit of the Indexed UL market. In my experience, agents who sell life insurance primarily for protection tend to focus on products with lifetime guarantees. They’re very hesitant to introduce financial and performance risk into a sale that is chiefly oriented around transferring mortality risk. There are some exceptions, as John Hancock’s long-standing success with Protection UL has shown, but the rule still holds.

That hasn’t stopped life insurers from introducing protection-oriented Indexed UL products. I’ve written about these products before, chiefly in two part series from 2018 (Part 1 and Part 2). The main point of the series was that, essentially, protection-oriented Indexed UL products illustrate very well but have a greater than 50% chance of failure if illustrated at the maximum rate. Why? Because that’s how the AG 49 maximum illustrated rate is calibrated. It uses the average of hypothetical historical return data.

If you solve for a minimum premium at the maximum rate, you’re basically assuming a 50% chance of policy lapse even if the Cap doesn’t change and future equity returns look like past equity returns, which means a 12.5% average total return and a distinct pattern of swift declines and prolonged rallies, the perfect pattern for Indexed UL crediting. My point in that article series was very simple – with protection-oriented IUL sales, illustrate at or below the option budget. That’s the only way to ensure that the client isn’t rolling the dice with their death benefit.

Although much has changed since 2018, that bit of advice has not. AG 49-A still relies on the same lookback mechanism from AG 49. It’s still calibrated for a 50/50 chance of success. In the context of policies funded for maximum accumulation that end up at the wrong end of the distribution, they’ll need to reduce or eliminate income via policy loans in order to keep the contract in force. In the context of policies funded for minimum premium, the client may end up having to pay quite a bit more premium than originally intended. That much is still true.

What has changed, however, is the focus in both accumulation and protection products away from (relatively) straightforward S&P 500 crediting strategies and towards crediting strategies that use engineered indices. And, as I’ve written about extensively, most of those strategies also leverage fixed interest bonuses to augment illustrated performance. In accumulation products, these strategies have wreaked havoc on the competitive landscape by allowing strategies with engineered indices to outperform their S&P 500 counterparts by huge margins. The effect is obvious – the companies that have most aggressively used these strategies for their accumulation products have also seen the biggest increases in sales, with several companies more than doubling their sales over last year.

In protection products, the effect of accounts using engineered indices with fixed interest bonuses is more muted relative to accumulation products. The simple explanation why is that protection products are funded at lower levels than accumulation products, which means there’s less account value to put to work earning indexed interest. Or, to put it another way, illustrated performance in accumulation products is (say) 85% dependent on illustrated crediting performance whereas illustrated performance in protection products is primarily dependent on the policy charge structure. As a result, porting a crediting strategy from an accumulation product that produces a 60% increase in illustrated income won’t have nearly as profound of an effect on the illustrated level premium in a protection-oriented product.

So how big is the impact? I ran 6 products with account options that use an engineered index with a fixed interest bonus to get a feel for it. I also chose to run these with a younger client (45) to reflect the usual younger age of protection IUL buyers and to give the differences in crediting more time to work their magic. I ran the illustrations to endow at age 121 using the base S&P 500 strategy (the high premium for each company) and the engineered index account (the low premium) with the biggest fixed interest bonus. Level pay premiums are below:

There’s a lot to pull out of this chart. First, in many ways, these results like up directionally to what we see in the accumulation space – products with the biggest gap between the S&P 500 illustrated rate and the engineered index illustrated rate (plus the bonus) exhibit the biggest gap between the two premiums. North American, for example, has a whopping 1.95% gap between their Fidelity AIM Dividend account and their S&P 500 cap account and the difference between the two premiums is 24%. Corebridge (formerly AIG) has the smallest at just 80bps and the difference between the two premiums is half of North American’s. On average, the difference between the illustrated level pay premium for an engineered index and the S&P 500 account is 17.08%. Within a particular product, the engineered index is a powerful tool for reducing the illustrated premium relative to the S&P 500 account. Little wonder that all of these products set the default allocation to the engineered index account.

But what about comparisons between products? That’s where things get a bit more interesting. As I wrote earlier, illustrated rate isn’t the only factor at play, especially in protection-oriented products. To give you a sense for how overall illustrated rate interacts with illustrated premium, I took the same chart as above but swapped out the premium numbers with the illustrated rates for each scenario. Illustrated rates are inclusive of any asset bonuses (with the exception of John Hancock) or asset-based charge. Take a look:

The top 3 products all demonstrate very similar performance at the maximum illustrated rates for the engineered index and the S&P 500 account despite the fact that the rates themselves are different – and the highest illustrated rates don’t necessarily correspond to the lowest premiums. North American has a similar maximum illustrated rate to Symetra but a premium that is substantially higher. The same comparison holds for Lincoln and Corebridge. And relative to the maximum illustrated rate for the product, Prudential actually shows extremely well, even though it’s the most expensive product of the bunch.

The backdrop, of course, is policy charge structure. Historically, life insurers have calibrated protection-oriented products towards higher initial expenses in exchange for lower, flatter long-term cost of insurance charges. The simple logic behind that approach is that protection contracts, because they are thin-funded, carry more net amount at risk, so the primary driver of performance is cost of insurance charges.

But with protection-oriented IUL products, that logic changes a bit. A carrier can price realistic (or even aggressive) cost of insurance rates as long as the illustrated performance is enough to offset them. How do you get maximum exposure to illustrated rate? By providing lower policy charges that generates greater early liquidity. As a result, protection-oriented IUL products look much more like their accumulation-oriented brethren than we’ve seen historically.

Of the 6 products, I would argue that only Prudential and John Hancock fall into the camp of constraining liquidity in order to make the product cheap – and there’s a catch for both of them. I wrote recently about John Hancock’s complex mechanism of offsetting relatively high COI charges with a Policy Value Credit, which creates the look and feel of a relatively flat COI product without actually having flat COIs. Deficiencies in funding or performance will bring out the teeth in the structure because the Policy Value Credit diminishes relative to the COI, meaning that net deductions actually increase faster than you’d think just based on net amount at risk. Prudential has an explicit second tier in its COI slope that is also triggered by policy performance. As a result, neither product has truly flat COIs, but they both look and feel like that’s what they do.

The rest of the products actually look much more like accumulation-oriented contracts, with stronger up-front liquidity that provides more basis for earning indexed interest. Take a look at the comparison of cash value relative to cumulative premiums paid in year 20 and year 40 when funded at the minimum premium and maximum engineered index illustrated rate (ranked by the year 20 values):

John Hancock and Prudential are clearly in a different camp from the rest in terms of account value that is available to earn interest credits. They’re also in a different camp when it comes to long-term COIs, as shown in the graph below. The only caveat to this chart is that I had to derive the John Hancock COI rate by subtracting the Policy Value Credit from the COI on a level pay scenario and then adjusting to make it comparable to the rest, all of which were run using Option 2 to isolate a single net amount at risk figure.

So why do Prudential and John Hancock exhibit relatively low sensitivity to the shift from the maximum engineered index illustrated rate to 4%? Because they are fundamentally built differently, with less liquidity and more focus on long-term expenses for the premium solve. The rest of the products – particularly Lincoln and North American – have huge tail COI charges that create more sensitivity to interest rate changes. Viewed through the historical lens of product design, these are essentially accumulation products masquerading as protection products.

To put an even finer point on that, consider that PacLife specifically put a block into their illustration software when they rolled out PDX in 2017 because otherwise it would have illustrated the lowest premiums in the industry for protection solves, and that’s not what PacLife intended. When I ran the accumulation variants of these products, I ran into a couple of minimum premium restrictions but, where I could get the premiums, they weren’t lightyears different than on the protection-oriented products. The chief difference seems to be in the Target premiums, which are much higher on the accumulation variants, rather than the actual product structure itself.

I would argue that this trend represents something of a turning point in the design of protection-oriented products. These new variants pose a different set of risks than the old breed of protection-oriented products. The benefit to a consumer of flat COI rates is that it puts limits on the risk of underperformance. The worst-case scenario is the level COI rate. In some products, that rate wasn’t substantially higher than the level pay premium, essentially creating something that looks like the flat COI products found in Canada.

By contrast, these new variants have mountains of underperformance risk. The worst-case scenario is that the client is faced with a high and steep cost of insurance rate on an ever-expanding net amount at risk as the cash value in the policy drops off. The situation is reminiscent of UL from the 1980s – and not just because of the COI slope. The problem in the 1980s was massively inflated expectations that didn’t match up to reality. The same may very well hold true for these newfangled engineered indices being combined with fixed interest bonuses to inflate illustrated performance beyond what was intended by the regulation. This new breed of protection-oriented Indexed UL is a dual threat – there is a high likelihood of underperformance and the consequences of underperformance are steep.

The stakes for protection-oriented sales are high. With an accumulation product, the worst-case scenario is that the income from the policy isn’t quite what was expected. Clients should know when they buy a life insurance policy for accumulation and distribution that things will change. However, that’s not always the case for protection-oriented sales. People buying these policies are relying on them to protect their families, their businesses, their legacies – the things they care the most about. Their tolerance for failure is very, very low and often so is their capacity to avoid failure by paying additional premiums. This combination is toxic for protection-oriented Indexed UL when sold at the maximum illustrated rate.

In my experience, clients don’t tend to draw a distinction between Whole Life and Universal Life. When they buy UL, they think they’re buying Whole Life. They mistake a flexible premium for a fixed premium, believing that – somehow – Universal Life offers the same protection benefits of Whole Life but at a lower cost. While that can be technically true for UL with Secondary Guarantees, it is certainly not true for traditional Universal Life and doubly so for Indexed UL. These are flexible premium products. The illustrated premium is merely an assumption-driven estimation. At the point of sale, no one has any idea how much the premium actually will be to carry the policy to maturity. By contrast, you know exactly what the premium is for Whole Life because it’s right there in the contract.

The operative advice for protection-oriented Indexed UL is simple – tread carefully, illustrate conservatively. What you see with these products is not what the client will get. That’s not a slam on the product category, it’s a factual statement about the nature of Universal Life. But it’s especially true for the new variants of protection-oriented Indexed UL that are specifically designed to artificially inflate illustrated performance while simultaneously increasing the penalty for underperformance. Tread carefully. Illustrate conservatively. Very conservatively. And by the time you’re done doing that, you might as well just sell something with lifetime guarantees.