AG 49-B Article – Aspire Magazine

I wrote this article for Aspire Magazine, but I thought I would reprint it here on The Life Product Review because it’s a concise description of the history of Indexed UL illustration regulation and the forthcoming revisions to AG 49-A, which I refer to as AG 49-B for simplicity’s sake. The original can be found here: Aspire Magazine

Since Indexed UL hit the market in 1997, the question of how to illustrate the product appropriately has been a hot-button topic. The problem was and still is that Indexed UL doesn’t fit cleanly into the Illustration Model Regulation that governs the illustration regime for fixed insurance products. The problem is that the key non-guaranteed element in Indexed UL is the level of exposure to an external index rather than a declared crediting rate, as in Universal Life. What’s that exposure to an external index worth for illustrative purposes? Therein lies the rub.

Actuarial Guideline 49 was adopted in 2015 to answer that question. The Guideline prescribes a way to value a certain level of non-guaranteed exposure, such as a Cap, Participation Rate or Spread, to an index by applying the current non-guaranteed level of exposure to the historical index return data. This is what is commonly referred to as a hypothetical historical lookback. AG 49 didn’t come up with this methodology, but it did standardize it for all life insurers and their products. In that respect, AG 49 was an unmitigated benefit for producers, consumers and even life insurers. The rules of the game had finally been codified.

But before the ink was even dry on AG 49, life insurers began to add charge-funded multipliers and buy-up caps to their Indexed UL policies. These features augmented illustrated performance beyond what was originally intended by the guideline. This led to AG 49-A, a highly targeted revision of AG 49 that was designed to specifically charge-funded multiplier and buy-up cap designs, which by then had become common in Indexed UL products and comprised the bulk of Indexed UL sales. AG 49-A was supposed to be the end.

It wasn’t. Life insurers had another tool on hand – engineered indices. These indices are created by banks and asset managers specifically for use in indexed insurance products. They tend to have three primary attributes. First, they have exceedingly high lookback performance, typically much higher on a risk-adjusted basis than established indices that have been in market for decades. Second, they are very cheap to hedge. This allows life insurers to offer, for example, more than 100% participation in the index performance without a Cap even with a modest hedge budget. And third, in order to achieve the first two, the indices are usually extremely complex and opaque.

In an Indexed UL product under AG 49-A, engineered indices provide life insurers the ability to perform a sleight of hand in order to increase illustrated performance. The idea is relatively simple. The maximum illustrated rate for any Indexed UL product is set by the S&P 500 illustrated rate. Let’s say it’s 6.25%. To provide exposure to the S&P 500, the life insurer buys options. Let’s say it costs 5% in order to buy enough exposure to the S&P 500 to illustrate at 6.25% based on the lookback methodology.

Engineered indices provide a more efficient solution. They offer more illustrated rate bang for the hedge cost buck. To illustrate the same 6.25% rate based on a lookback, a life insurer might only have to spend 3.5% in hedge budget rather than 5% for the S&P 500. This allows the life insurer to divert the 1.5% in savings into a fixed interest bonus which, thanks to some last minute negotiations by life insurers, can be added to the illustrated performance of the product. Voila. Now a life insurer can illustrate a total rate of 7.75% for the engineered index, a substantially higher rate than the S&P 500.

In the wake of AG 49-A, life insurers have embraced this strategy with abandon. Virtually every major Indexed UL writer has implemented this strategy in their Indexed UL product. The fastest growing life insurers are the ones who have begun to rely on engineered indices – and the more they aggressively they use this strategy, the more quickly their sales have grown. It is an exceedingly effective tactic. And because it doesn’t cost the life insurer a dime to do it, either.

In response, regulators have drafted a slight revision to AG 49-A – which I’m preemptively referring to as AG 49-B – to specifically address this issue. At the heart of these revisions is a very simple concept. The relationship between the illustrated rate on the Benchmark S&P 500 account and the cost to hedge the account establishes a ratio. In the example above, the ratio between the 6.25% illustrated rate and the 5% hedge budget is exactly 25%. The revisions to AG 49-A apply this ratio to all indexed accounts available in a product. Take a look at how it plays out for a series of indexed accounts in a hypothetical product:

Indexed AccountHedge BudgetLookback RateRatioIllustrated RateTotal Illustrated Rate
Benchmark S&P 5005%6.25%25%6.25%6.25%
Engineered Index5%9.00%25%6.25%6.25%
Engineered Index + 1.5% Bonus3.5%6.30%25%4.38%5.88%

The upshot of AG 49-B is that all indexed accounts with identical hedge budgets will illustrate identical maximum illustrated rates. Accounts with higher hedge budgets will illustrate the same as the Benchmark S&P 500. Accounts with lower hedge budgets than the Benchmark S&P 500 will illustrate at lower rates, including those with fixed interest bonuses. In this respect, the revisions to AG 49-A are very effective.

However, there are some real wrinkles to the world created by AG 49-B. Everything above applies within the same productbut, crucially, not from product to product. Despite the fact that all illustrated rates in the industry will now hinge on the hedge budget of each product, AG 49-B does not require life insurers to actually disclose their hedge budget or even ensure that all life insurers are viewing their hedge budget the same way. This is a real problem because every life insurer has its own way of looking at hedge budgets.

It is possible for 15 life insurers who have the same non-guaranteed exposure to index performance to have 15 different hedge budgets and, therefore, 15 different ratios that will be applied to their non-Benchmark S&P 500 accounts. That’s a real problem and it flies in the face of the original intent of AG 49 to standardize illustrated rates across the industry. AG 49-A creates a situation where standardization is impossible – at least not without more clarifications and substantive changes to the guideline itself.

And there are other issues, too. AG 49-B does not eliminate the ability for life insurers to apply fixed interest bonuses to illustrated loan arbitrage. Already, there are life insurers in market with features that artificially inflate the illustrated performance of taking policy loans in ways that may not be impacted by AG 49-B. The revisions also do not address the increasingly prevalent practice of life insurers carving off particularly attractive assets to support their new business Indexed UL policies in order to push up their illustrated rates, creating an increasing disconnect between new business products and in-force products.

So where does AG 49-B leave us? Certainly in a better place than under AG 49 and AG 49-A. This is probably the closest that Indexed UL illustrations have come to the original intent of AG 49. That’s a good thing. But there are still many issues left to resolve, not the least of which is the central question that has been bedeviling Indexed UL from the beginning – what is the proper way to illustrate this product? That question remains unanswered and, unfortunately, AG 49-B brings us no closer to it.