#342 | AG 49-B & The Next Phase of IUL

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Quick Take

AG 49-B is likely to be adopted in the next couple of weeks and implemented in March of 2023. The immediate effect will be dramatic – some accounts will see reductions in illustrated income as large as 50%. As effective as AG 49-B is, it comes with some unintended consequences. To meet the regulators’ stated goal of a “quick” fix, the changes to AG 49-A are scant, which leaves open the door for some “creative” interpretations and makes maximum illustrated rates harder to understand and explain. More importantly, though, AG 49-B is amplified with high Hedge Budgets and therefore provides a huge incentive for life insurers to switch to new money crediting to take advantage of today’s higher investment yields. The next phase of Indexed UL isn’t about new product features – it’s going to be about maximizing the all-encompassing Hedge Budget in order to juice illustrated performance. And in doing so, Indexed UL writers are going to potentially force the hand of regulators to release a stricter regulation on Indexed UL (call it AG 49-C) and a broad reopening of the Illustration Model Regulation (#582) to deal with the problem for all fixed life insurance products. In the meantime, what choice do producers have? The choice to ignore the illustration wars and continue to focus on what delivers long-term value. In the end, that’s what matters.

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At long last, the discussion about what to do with AG 49-A has solidified around the proposal submitted originally by Securian that will very likely be adopted at the NAIC Fall National Meeting in Tampa on December 11th. As with AG 49 and AG 49-A, the Securian proposal – we’ll go ahead and call it AG 49-B – will fundamentally reshape the competitive landscape, although not necessarily in the way you might think.

With AG 49 and AG 49-A, the impact of the regulation was obvious because of what carriers subsequently added to new products that exploited the regulatory loophole to augment illustrated performance. Before AG 49, carriers were using exotic tenor and payoff strategies to juice illustrated performance. Those strategies essentially vanished from new products when AG 49 standardized the lookback and implemented the concept of the 1 year, S&P 500-based Benchmark Index Account (BIA). But in the wake of AG 49, life insurers added buy-up multiplier strategies that massively increased illustrated performance. Since AG 49-A eliminated the illustrated benefit of those strategies, not a single company – not a single company – has added a buy-up multiplier to their street Indexed UL contract. What did they do instead? They added accounts that use engineered indices with fixed interest bonuses to juice illustrated performance. That’s what AG 49-B is designed to address.

And to Securian and Penn Mutual’s credit (Penn Mutual signed on later), it is highly effective. The core problem with AG 49-A was that life insurers interpreted its notoriously ambiguous language to mean that they could assume any level of “option profits” for non-BIA accounts. In other words, they could (and did) add indices to products that illustrate massive lookback-based returns at very low option costs. This allowed life insurers to essentially have a lower option budget to get the same lookback illustrated rate as the BIA limit and then redeploy the savings into a fixed interest bonus that could be added to the lookback illustrated rate and, crucially, the illustrated loan arbitrage. The net effect is that these sorts of strategies can boost illustrated income, the operative metric for Indexed UL benchmarking, by as much as 65%. How is that possible? It all comes back to the assumption of option profits.

AG 49-B cuts the legs out from under this strategy in a one-two punch. First, it calculates the option profit for the BIA account, which is equal to the lookback rate divided by the Hedge Budget. Current BIA illustrated option profits are in the neighborhood of 25%, which you can estimate by dividing the maximum AG 49-A illustrated rate for a 10% cap (6.2%) by the cost to hedge a 10% Cap in the IUL Benchmark Index (about 5%).

Second, AG 49-B applies that ratio to all other indexed accounts, meaning that the maximum illustrated rate for any non-BIA account is equal to the Hedge Budget multiplied by the option profit ratio for the BIA. Voila. This very simple, very straightforward, very logical modification to AG 49-A closes the loophole. From this point forward, any strategy that has the same Hedge Budget as the BIA will illustrate the same as the BIA. Any strategy that has a lower Hedge Budget than the BIA, which under AG 49-A would allow for a fixed interest bonus and increased illustrated performance, will now illustrate worse than the BIA. It is a total regime change from what we are seeing in the market right now. And that is a very, very good thing.

In stark contrast to AG 49 and AG 49-A, my view is that the immediate impact of AG 49-B will not be a slate of new features designed to exploit a loophole and augment illustrated performance for the simple reason that there is no clear and obvious loophole in AG 49-B. For AG 49, there was a broad understanding – at least amongst those of us who were intimately involved in the process – that Equitable’s last minute haggling to allow illustrated benefits for buy-up caps could potentially lead to all-out illustration warfare with buy-up caps and multipliers, which is exactly what happened. For AG 49-A, everyone understood that companies could and were already gaming the regulation by using engineered indices and fixed interest bonuses but for reasons that remain mysterious to me, regulators forged ahead regardless and even made some last-minute accommodations that made the loophole more powerful, more defined and easier to exploit. None of that happened with AG 49-B. No obvious loopholes have been identified. There was no last-minute haggling. This was a clean and straightforward process that delivered what regulators seemed to originally be looking for.

However, that doesn’t mean the regulation is perfect. The way the regulators framed this debate was a bit odd in that all of the proposals that were submitted had to be a “quick fix” but the regulators gave various and changing definitions of what constituted a “quick fix.” One criteria, it seemed, was simply that a quick fix meant fewer changes to the guideline. This is a bit like saying that the quickest way over a mountain is the shortest route on a map – straight up the cliffs and over the top.

In an attempt to draw the shortest line between two points, AG 49-B adds a single bullet to Section 4 of AG 49-A, which sets the maximum illustrated rate. It does not eliminate language elsewhere in Section 4 which seems to directly contradict or is at least rendered irrelevant in light of the new AG 49-B language. It does address Section 5, which deals with actuarial supportability testing, which potentially leaves the door hanging wide open for some, uhh, “creative” interpretations or “innovative” features that play on the fringes of what might be reasonable.

Crucially, AG 49-B also does not add language requiring disclosure of the Hedge Budget, despite the fact that the maximum illustrated rate for all non-BIA indexed accounts, which for some products is every single account available in the product, will be dependent on the Hedge Budget. You can kiss the days of being able to explain where maximum illustrated rates come from goodbye. The reality of AG 49-B is that regulators got a solution that looks very clean on the map but, in the real world, could end up being quite a bit messier.

However, I think it’s important to note that the result could have been much worse. Until a month ago, the prevailing wisdom in the industry was that the Securian proposal wouldn’t fly for the simple reason that some of the largest Indexed UL writers – all of whom were actively exploiting the loophole in AG 49-A to great effect – banded together to craft their own proposal, which was called the Group of 6* Proposal, and had the political heft to make it happen. I’ll bite my tongue a bit on this proposal and simply say that it was an almost comically self-serving, tone-deaf and ill-conceived attempt to preserve the loophole while giving regulators nothing more than some token concessions. It received very little attention, virtually no discussion and zero votes. Regulators weren’t messing around this time and, somehow, these Indexed UL writers didn’t get the memo. Times have changed since 2014.

It’s also important to note that the result could have also been much better. The proposal put forth by the Coalition of Concerned Insurance Professionals, a band of independent insurance folks such as Sheryl Moore, Dick Weber, Larry Rybka and yours truly took a very different tack. Like the Group of 6 and Securian proposals, we also put forth the idea of using the Hedge Budget as the basis for setting maximum illustrated rates. But unlike those proposals, we took it a step further by eliminating the lookback for determining ledger values while retaining the lookback for the return tables in the narrative summary of the illustration.

Sound familiar? It should. This is the same proposal I’ve been advocating for since 2014 when I was at MetLife and we formed the first Coalition with New York Life and Northwestern Mutual. The reason why I like it so much is because it works. There are no loopholes. It is a once-and-done solution. Had it been the approach used in 2014, there would not be an AG 49-A or an AG 49-B. But it wasn’t. Why not? Because Indexed UL writers hated it and successfully lobbied regulators for more industry-friendly solutions that maintained the lookback. As consumer advocate Birny Birnbaum phrased it on a recent NAIC call, the regulators essentially let the bank robbers design the safe. He’s exactly right.

This time around, regulators were much colder to the industry. They ignored the Group of 6 proposal. Of the 10 votes cast by the IUL Illustration Subgroup, 4 – yes, 4 – went for the Coalition proposal, with some modifications. The fact that the Coalition proposal was one vote off of equal footing with an industry written and supported proposal is momentous. Unthinkable. But it happened and, in my view, it’s an indication that regulators are starting to look at Indexed UL very differently than they have in the past.

Where do we go from here? In terms of regulation, the path forward for the Securian proposal is clear. It will get approved in a couple of weeks and probably set for implementation in March. At that point, every account with an engineered index that illustrates better than the BIA will suddenly illustrate worse than the BIA. The result will be reductions in illustrated income for those accounts to the tune of as much as 50%. It’s difficult to overstate the impact of this reduction. One reason why Indexed UL sales are actually up this year is because these types of strategies have managed to produce huge illustrated performance even as S&P 500 caps broadly fell and remain depressed. Companies that began to offer these strategies the last 12 months are up significantly more than companies that haven’t, with just one and maybe two notable exceptions. Without these strategies, the appeal of Indexed UL is going to drop considerably, especially when you consider the adverse current environment for premium financing.

However, the regulatory inquiry isn’t close to being over. In order to address Indexed UL illustrations, regulators requested the “quick fix” that is to become AG 49-B, but they also opened the door to making modifications to the Illustration Model Regulation (#582) to address Indexed UL on a more long-term basis. #582 is something of a third rail for the life insurance industry. Illustrations have become integral to the sales process. Any change to illustrations will upend the way that life insurers build and sell their products. For all of the justified complaints about illustration warfare in life insurance, companies begrudgingly accept the current illustration framework. It has suited them fairly well. And they know that any effort to change #582 will be a very thorny, very fraught political process that will take a very long time and result in something they may like a lot less than what they currently have.

But I think it’s the right thing to do in this case. In my view, Indexed UL has never fit #582. AG 49/A/B is a clunky way to make Indexed UL fit, like using a flathead screwdriver on a Phillips head screw. The Model Reg needs to be adjusted to actually make the fit. For example, Indexed UL products have annually varying returns like Variable UL and life insurers should be able to illustrate that, but they can’t under the current rule. The model reg is also built on the framework of the disciplined current scale (DCS). A big part of determining the DCS relies on “recent historical” yields for assets that “support” the block of business. The prevailing practice, as outlined in ASOP #24, is to treat the options that support the indexed crediting feature of an IUL product as “supporting” the policy and allowing for gargantuan option profits on those assets. But is that what #582 really intended? I don’t think so. These sorts of things need to be clarified – despite the fact that it’s going to be a long and painful process to do it.

What will life insurers do in the meantime, with their most recent illustration tool taken away from them while they await the fate of #582? I fear the inevitable – they’re going to switch to new money crediting. From what I’ve heard, at least two companies are already set up and running with new money crediting, they just haven’t updated their rates yet. Many other companies are actively working to create new money portfolios. Those that aren’t, are contemplating it. As soon as the first shoe drops, the whole competitive landscape in Indexed UL changes. Companies will be releasing products with S&P 500 Caps in the 12% to 14% range with illustrated rates well north of 7%. The illustration game will shift away from specific product features to, as I’ve written about recently, illustrated performance being driven by (likely temporary) new money investment yields.

There is nothing that AG 49-B can do to stop this sort of thing because the problem is in the Model Reg itself. The Model Reg illustrates values forward at the current scale. It doesn’t draw a distinction between a current scale that is based on portfolio rates or new money rates. The beauty of the design is that it forces life insurers to only illustrate what they can support today. The fatal flaw, though, is that even if today looks nothing like yesterday or tomorrow, life insurers can still illustrate it for the next 50+ years until policy maturity. In a rising rate environment, this means that temporary new money rate advantages look permanent even though they are unequivocally, mathematically not. They’re just a momentary dislocation. The irony of the #582 inquiry for Indexed UL is that it is very likely going to turn to the issue of how to handle illustrating new money rates because that is going to be the pressing issue in 3 months, 6 months or a year – however long it takes.

In the meantime, AG 49-B has the unfortunate effect of amplifying the disconnect between portfolio and new money rates. AG 49-B fundamentally operates off of the ratio between the lookback on the BIA and the Hedge Budget. Once that ratio has been established, it’s applied to all other accounts. Let’s say the ratio is 25%, which is close to where it is today. If Hedge Budgets are 3%, which is where they were trending last year, then a 25% boost brings the illustrated rate to 3.75%. If you apply that to a stream of cash values – forgetting policy charges – then the boost in illustrated values after 40 years is 32%.

But if Hedge Budgets are 6%, which is where they should be for new money crediting right now, then the same 25% boost pushes the illustrated rate to 7.5% and increases illustrated values after 40 years by a whopping 73%. The effect of AG 49-B essentially scales with Hedge Budgets. AG 49-B is like flying a helicopter over a blazing California wildfire and dumping gas instead of water. This effect of AG 49-B is not a loophole, per se, but it’s going to look, feel and act like one if and when new money crediting starts to proliferate.

And that’s why, in my view, there’s going to be an AG 49-C and it’s going to look a whole heck of a lot like the Coalition proposal that lost by a single vote. New money Indexed UL illustrations are going to so look so outlandish that regulators are going to have to do something. Changing #582 is going to take too long to deal with the issue. They’ll need another “quick fix” and they’ll have one ready at their disposal. Eliminating the lookback from ledger values won’t fix the problem of illustrating new money rates across the industry, but it will prevent Indexed UL from being an outsized beneficiary of them. How long will that take? However long it takes for life insurers to switch to new money crediting.

Life insurers stand, I think, at the same sort of diverging paths that they stood at after AG 49 and AG 49-A. They have a choice of pursuing the strategy of mutually assured destruction or disarmament. In this case, the path of mutually assured destruction is new money crediting, essentially sacrificing in-force policyholders for the benefit of new sales. The path of disarmament is to stick to portfolio crediting, even when the going gets rough, because it’s the long-term, principled approach that ultimately benefits all policyholders. But disarmament only works if everyone does it – and the fear is that they won’t. That’s why life insurers usually feel as though they have no choice but mutually assured destruction. And I don’t see a reason to think that they won’t choose this path just like they’ve done in every previous round.

Producers also have a choice. You have the choice to decide whether to play into these wargames at the life insurers or not. You have a choice to not sell the best illustrating product because you know it’s a ruse, or a temporary blip or a gimmick. You have the choice to educate your clients about the principles and drivers of real long-term value in insurance rather than illustrated performance, which means literally nothing. You have the choice to not work with companies who continuously weaponize illustrations for their benefit – not your benefit or the benefit of their policyholders. You have the choice to stand up for what you think is right. Exercise it. Life insurers will lay down their arms when producers tell them that the war is over. And we are long, long overdue for that.

*The Group of 6 is Allianz, National Life, Lincoln, John Hancock, Pacific Life, Sammons (North American/ Midland). Nationwide joined for the final comment letter.