#359 | The New Weapons of AG 49-B
This article assumes a base level of knowledge about Indexed UL illustrations, the previous forms of AG 49, the impact of using engineered indices with fixed interest bonuses and the basic mechanics of the recent revisions to AG 49-A, colloquially referred to as AG 49-B. If you’re not up to speed, read this article, originally published in Aspire Magazine, and these articles published in The Life Product Review: #342, #329, and #300.
Quick Take
Now that AG 49-B is effective as of 5/1, there is no question that it does what it set out to do. Engineered indices with low Hedge Budgets illustrate worse than S&P 500 strategies and significantly worse if they also incorporated a fixed interest bonus. But as usual, life insurers have immediately found ways to regain lost ground. Some increased Hedge Budgets on engineered index accounts in order to match the S&P 500. Some are strategically and creatively using fixed interest bonuses to juice illustrated loan arbitrage. But by far the most powerful strategy is to aggressively set rates for a hypothetical BIA. That free and simple change pumps oxygen into the lungs of engineered indices, allowing for illustrated rates and performance that is well above comparable S&P 500 accounts and not so far off of what existed before AG 49-B. It’s not what regulators intended. The irony is that regulators viewed AG 49-B as a “quick fix,” but the reality is that it only delivered on half of that equation – it was quick, but not a fix. What comes next? More regulation. But until then, life insurers will undoubtedly avail themselves of the weapons they have available and the illustration war in Indexed UL will continue unabated.
Full Article
The progression of Indexed UL regulation from AG 49 to AG 49-A to AG 49-B is, in my view, not going from aggressive to conservative or from realistic to unrealistic or even from simple to complex. Say what you will about AG 49 – and I’ve said plenty – but it was internally consistent and represented the principles-based view of Indexed UL illustrations held by life insurers selling the product at the time.
There are essentially three principles that underpin AG 49. First, the existence of a “risk premium” for Indexed UL, meaning that Indexed UL should outperform Universal Life, all else being equal, because of its options-based exposure to equity indices. Second, that a reasonable approach for estimating the risk premium is to use a hypothetical historical lookback methodology, which applies the currently declared cap and participation rate to historical index data. Third, that it is reasonable to use the resulting returns in an illustration using level annual rates of return. AG 49 standardizes, canonizes and legalizes these three core principles, with a few clarifications and guardrails thrown in.
The problem with AG 49 was and is that those three core principles created and promulgated by the insurers selling Indexed UL are fundamentally flawed. There is no third party empirical research supporting the existence of a “risk premium” in call options over the long run. Even if the “risk premium” in call options does in fact exist, there is no empirical evidence supporting the fact that a hypothetical historical lookback, which was created by insurers for indexed products and found nowhere else in the world of options, is the proper way to estimate it. And it is inherently misleading to illustrate a “risk premium” using level annual rates of return that appear to be riskless in an illustration that is meant to be a demonstration of product mechanics, not a projection of future expected performance*.
The practical outcome of relying on fundamentally flawed core principles is that they usually lead to some pretty bizarre and uncomfortable places. After AG 49 was implemented, we saw the proliferation of index return multipliers, which are completely consistent with the three core principles and therefore adhere to the letter and the spirit of AG 49. But they were too big. Too aggressive. Too egregious. In response, regulators created AG 49-A to limit the application of the three core principles to index upside funded exclusively by the Hedge Budget. Any index upside from additional policy charges or in excess of the carrier’s earned rate to buy a multiplier or higher cap was illustrated as net-neutral with no benefit. In other words, regulators abandoned the principles-based approach and instead opted for a rules-based approach to achieve the goal of eliminating illustrated benefits of buy-up caps and index return multipliers.
In response, life insurers started using engineered indices which, again, are perfectly consistent with both the letter and spirit of the original AG 49. Engineered indices show huge “risk premiums” on the order of 2 to 3 times what the S&P 500 shows. How is that possible? Because they are optimized to show performance in the industry’s chosen hypothetical historical lookback methodology for estimating risk premium. They are built with the core principles in mind, which is exactly why they’re so incredibly effective on the illustration. They aren’t aberrations from the core principles, they are a creature of them. But again, they got to be too big, too aggressive, too egregious.
And now, we have AG 49-B (technically referred to as an update to AG 49-A), which tightens the screws on the application of the three core principles even further. Under AG 49-B, the three core principles are essentially constrained only to the Benchmark Index Account**. The ratio of the Hedge Budget to the maximum illustrated rate based on the hypothetical historical lookback methodology, which remains unchanged from the original AG 49, is then applied to the Hedge Budgets of all of the other indexed accounts in order to determine the maximum illustrated rate for each account.
The net result is that the ratio between the maximum illustrated rate and the Hedge Budget, which doesn’t have its own term in the guideline but we’ll call the “BIA Ratio” for simplicity’s sake, is now the dominant driver of illustrated performance for every indexed account. In other words, regulators are essentially saying that they still believe in the three core principles – but only for the S&P 500-based Benchmark Index Account. The only time the hypothetical historical lookback comes into play for non-BIA accounts is if the result is lower than the Hedge Budget for the account multiplied by the BIA Ratio.
From my vantage point, the correct interpretation of the progression of Indexed UL regulation is from principles-based to outcome-based. The application of three core principles – presence of a structural “risk premium,” using the lookback to calculate the risk premium and applying the risk premium in the context of a level rate illustration – has been steadily chipped away with each iteration of the guideline in order to address problematic designs. Because regulators can’t throw the three principles out completely without raising the ire of the industry, they’ve resorted to a sub-optimal solution: outcome-based regulation that relies on the specific language of highly technical rules and definitions.
Outcome-based regulation is like squeezing a balloon. Constrain a part of it with a new rule and a bubble immediately pops up somewhere else. That’s what we’ve seen consistently with Indexed UL and, unfortunately, AG 49-B is no different.
Reduction in Illustrated Performance for Engineered Indices
This is the intended consequence of AG 49-B, the bubble that regulators set out to clamp. This part of AG 49-B was undeniably successful. Almost every company selling engineered indices was priced under the idea that the engineered index can have a lower Hedge Budget but still produce the same illustrated rate as the BIA thanks to higher lookback performance in the engineered index. AG 49-B laid that strategy to waste.
Because the Hedge Budget is now the dominant driver of the illustrated rate for non-BIA accounts, any engineered index with a Hedge Budget lower than the BIA now illustrates far worse than it used to and far worse than the BIA. AG 49-B essentially returns the S&P 500 account back to supremacy in terms of illustrated performance.
Case in point – North American Builder Plus 3 IUL. Prior to AG 49-B, this product sported a huge 2.65% bonus on its Fidelity Multi-Factor Yield index account and some of the highest illustrated income in the industry. I ran a benchmark on the product a few months ago and illustrated around $250k in income for that particular cell using a 6.24% illustrated rate for the engineered index, which was 60% higher than the S&P 500 index. Now, that same index illustrates at just 3.58% (which implies a Hedge Budget of around 2.8%) and the illustrated income is just a shade above $100k, a reduction of 60% from what it showed under AG 49-A a few months ago and 40% lower than the current S&P 500 illustrated income. It’s carnage.
Other companies have been similarly affected. Allianz has dropped the illustrated rate on its Classic Accounts, which have a 0.9% bonus, from 7.08% down to 5.74%. Lincoln’s bonused Fidelity account fell from 6.09% to 4.58%. John Hancock’s bonused Barclays account fell from 6.10% to 4.44%. In each of these situations, the hit to illustrated income is in the neighborhood of 30% to 50% and brings the illustrated income for these accounts below the S&P 500. And that’s exactly what was intended by the regulation.
Non-bonused accounts that use engineered indices also felt the heat. As I’ve written before – and specifically regarding the Nationwide New Heights product – life insurers used engineered indices not only to fuel fixed interest bonuses but also to rerout profit margin back into profitability or rates offered on the S&P 500 account, which is more expensive to hedge. That strategy no longer works under AG 49-B. Accounts with lower Hedge Budgets have lower illustrated rates. Period. The effect isn’t as pronounced as when there’s a fixed interest bonus present, but it’s still there and it still has teeth.
Rate Increase to Equalize Illustrated Performance with S&P 500 Account
However, life insurers have immediately started to claw those losses back. A small subset of insurers have offset the decrease in illustrated performance of strategies using engineered indices with increases to the participation rates offered on those strategies. In other words, they bumped up the Hedge Budget in order to get the total illustrated performance to match the S&P 500 account.
Nationwide is the most obvious example, boosting participation rates in its JP Morgan Mercury accounts by 40% and its BNP Paribas Global H-Factor accounts by 50% so that the total illustrated rate for the non-bonused accounts equals the S&P 500 and the total illustrated rate for the bonused accounts is just 0.1% lower than the S&P 500 account. In short, although illustrated performance is certainly down for the bonused accounts after AG 49-B, there is now equivalency in performance across all of the accounts in the product thanks to the rate increases.
Corebridge followed a similar path, raising rates such that its Merrill Lynch Strategic Balance (MLSB) account with a 0.65% bonus illustrates identically to its S&P 500 cap account with a 0.1% bonus. So did Pacific Life when it increased the participation rates in its Blackrock Endura accounts by 30% for the bonused account and 35% for the non-bonused account, bringing both in-line with the core S&P 500 account. And, finally, the same goes for Symetra, which implemented a 40% par rate increase and a 0.25% increase in the bonus for its Putnam Dynamic Low Volatility index account and a 31.25% par rate increase for the non-bonused account.
Rate actions concurrent with the new regulation raise a simple question – how did they do that? AG 49-B didn’t improve the fundamental economics of these products. If anything, it probably made the economics worse because the carriers can no longer hide the extra profit margin from the engineered indices. So how is it possible that some insurers raised rates, which is a clear and unmitigated benefit to the policyholder?
It is possible, but not likely, that these insurers cut into their profit margins – but I don’t think that’s what happened. I think this is a reflection of companies optimizing their portfolios in the current higher rate environment. Corebridge has long maintained that it uses new money pricing early in the life of the contract and then blends into portfolio rates later. Symetra has said that it is using a new portfolio segment for its Ascent products that were introduced last year. PacLife has also said that it is using a new portfolio for its Horizon products. And although I haven’t heard Nationwide say anything about a new portfolio for currently marketed products, considering that the changes to rates only applied to currently marketed products and the changes to in-force were token at best, I’d argue that they are effectively using one whether they say it or not.
All four companies are now sitting at or near the top of the benchmarks for both their S&P 500 and engineered index accounts. The only non-new portfolio companies that can compete on illustrated performance are F&G and Allianz, both of which have seen swelling sales in the last few years and were in a prime position to ride the wave of rising interest rates. The competitive pressure for other companies to follow suit is huge – despite the fact that companies using new portfolios are essentially depriving in-force policyholders of the benefit of new premium flows and, over the next decade or so, all of these portfolios will converge to the same yields. This is illustration warfare at its purest because, in the long run, these new portfolios have no effect on actual policy performance. And we’re going to be in for a lot of it.
Illustrated Loan Arbitrage
In positioning AG 49-B to the regulators, life insurers made the argument that it was a true “quick fix” because the changes to AG 49-A only affected one section dealing with the maximum illustrated rate, as discussed previously. However, that approach left a lot of loopholes still open – primarily, illustrated loan arbitrage.
In reading the previous section, you would be forgiven for thinking that when I wrote that S&P 500 and engineered index performance would be equivalent between accounts for companies that made rate changes, I was referring to both the cash value performance and the illustrated income amounts. Theoretically, the two should always run together, especially considering that AG 49-B caps illustrated loan arbitrage at 0.5%. But that’s not the case.
In their haste, regulators continued to allow life insurers to add fixed interest bonuses to illustrated loan arbitrage despite the fact that that was at the heart of the problems that led to AG 49-B in the first place. As a result, if a company illustrates the same maximum rate as the S&P 500 account but uses a fixed interest bonus, then the income will exceed what is shown on the S&P 500 account. Corebridge, for example, shows a 5% benefit of using the MLSB account over the S&P 500 account despite the fact that the total illustrated rate for both accounts is the same 7.07%. Why? Because illustrated loan arbitrage is 0.6% for the S&P 500 account (0.5% AG 49-B limit plus a 0.1% bonus) and 1.15% for the MLSB account. Voila.
There is no doubt in my mind that companies will “innovate” around how to increase illustrated loan arbitrage. Illustrated income has become the benchmark metric in accumulation-oriented sales in the same way that premium is the benchmark metric for protection-oriented sales. That’s a shame. Illustrated income is easily manipulated in ways that make certain products appear more competitive in certain situations when, in the real world, they wouldn’t be. The proper metric for accumulation-oriented sales should be cash value IRR because it is less easily manipulated. There are only so many games a company can play to boost actual cash value IRR – but there is plenty of latitude for illustrated income.
The prime example is North American. I wrote a previous article about North American’s Fixed Participating loan provision that has an embedded 2% bonus in the loan itself. In that article, I said that if North American keeps that bonus, it will fundamentally upend AG 49-B because it provides a path for life insurers to use loan-specific bonuses to augment illustrated performance. Well, they kept it and it is quite effective. Using the S&P 500 account, the illustrated income jumps by a whopping 35% from a standard indexed loan (0.5% illustrated arbitrage) to the Fixed Participating option (2.5% illustrated arbitrage). It takes North American from being near the bottom of the benchmark to sniffing the top 5. Other insurers will surely feel the pressure to follow suit – if they can get around the illustration actuary testing issues – so they’re not caught flat footed.
Hypothetical Benchmark Index Accounts
One of the quirks of AG 49 that stayed for AG 49-A and now AG 49-B is the ability for life insurers who don’t offer a Benchmark Index Account to instead run their maximum illustrated rate using a hypothetical Benchmark Index Account that is not actually available for allocation. The theory was that regulators didn’t want to prescribe the use of a BIA and wanted to give latitude for companies that didn’t offer one. But some companies saw a different angle – purposely not offering a traditional BIA so that they could take advantage of a hypothetical BIA.
The benefit of a hypothetical BIA is that the carrier doesn’t have to follow the same ratesetting process for the hypothetical BIA as they would for a BIA offered for policyholder allocation. The carrier can set the hypothetical BIA at the absolute limit of actuarial supportability, using a Hedge Budget with a 0% profit margin. I would even argue that AG 49-A goes further than that by allowing life insurers to aggregate indexed accounts for actuarial supportability testing, meaning that a life insurer could theoretically fail illustration actuary testing for the hypothetical BIA as long as margin elsewhere can make it up.
The company that initially figured out how to use a hypothetical BIA most effectively is John Hancock. In its Accumulation IUL 21 product, the hypothetical BIA yields a maximum illustrated rate of 6.10%. However, the closest thing to the BIA is the Select Capped account which isn’t a BIA only because it has a 5% guaranteed multiplier. The maximum illustrated rate for that account is 5.49% including the multiplier, nowhere near the hypothetical BIA.
If you want to get an illustrated rate all the way up to the hypothetical BIA, you have to select the Capped Account, which has a 1.98% asset-based charge and a guaranteed 45% multiplier. It’s a remnant of the days after AG 49 when index return multipliers were prevalent. The illustrated rate for the Capped account is 5.57% courtesy of an 8.75% cap, which is 0.75% higher than in the Select Capped account. But if you add in the 45% multiplier and subtract the 1.98% asset charge, you get exactly 6.10%, the same as the hypothetical BIA. In short, John Hancock figured out how to still get some juice out of charge-funded multipliers even after AG 49-A through clever use of a hypothetical BIA.
However, the hypothetical BIA takes on a whole new level of importance with AG 49-B. Because the BIA Ratio is applied to all other indexed accounts, it is essentially the governing factor for illustrated performance for the product. That makes sense theoretically, but the problem is that AG 49-A doesn’t clearly define the Hedge Budget or how to calculate it. Here’s what it says:
Hedge Budget: For each Index Account, the total annualized amount assumed to be used to generate the Indexed Credits of the account, expressed as a percent of the account value in the Index Account. This total annualized amount should be consistent with the hedging program of the company.
This definition is actually an inversion of the way that folks usually think about the Hedge Budget. We think of it as something that a life insurer sets internally and then adjusts caps and participation rates to match. But this definition goes the other direction – it starts with the Indexed Credits and then works backwards to the amount required to hedge the credits. In its purest form, based on this definition, life insurers should calculate the Hedge Budget each month based on the actual cost to hedge their declared caps and participation rates. If they did that, then the BIA Ratio would change every month even if the caps and participation rates stayed the same.
Hence, the reason why this definition uses a pivotal word – “assumed.” The regulators are not prescribing that life insurers use the actual cost to hedge as the Hedge Budget. Instead, they’re given latitude to make assumptions about what it costs to hedge their declared caps and participation rates as long as the Hedge Budget is “consistent with the hedging program of the company.” Regulators are making the assumption insurers aren’t going to incur actual hedge costs that are significantly different from their Hedge Budget over an extended period of time. It’s a guardrail to keep the Hedge Budget from deviating too far from what the carrier is actually doing.
That’s a fair assumption for any real indexed account that is actually offered to clients for allocation. But for a hypothetical BIA, there is no hedging program and there are no hedging losses because there is no Account Value. In that situation, a life insurer might assume that the cost to hedge is based on this month’s cost to hedge, or the average cost to hedge over the previous 12 months, or the average cost to hedge over the past 10 years or maybe even their own internal model of what hedges should cost going forward.
Let me give you a real example – right now, the price to hedge a 10% S&P 500 on year point-to-point cap is around 5.1%, but the 10 year average price is closer to 4.5%. The BIA Ratio using today’s pricing is about 21% (6.21% / 5.10% – 1). The BIA Ratio using historical 10 year pricing is nearly 40%, just below the maximum Ratio allowable under AG 49/A/B of 45%. A carrier could set their actual offered S&P 500 cap based on recent option prices but set their hypothetical BIA cap based on 10 year option prices. Doing so would apply the BIA Ratio of 40% to all accounts and give the carrier a huge amount of latitude to show higher performance in engineered index accounts even while adhering to the letter of AG 49-B.
One example of this sort of thing at work is Symetra Ascent IUL 2.0. The product has a hypothetical BIA with a 6.97% maximum illustrated rate, which equates to an 11.75% Cap. The cap in their Core S&P 500 account, which is effectively a BIA but isn’t technically classified as one, is set at 10.5%. If you take the (extremely attractive) fixed account rate of 5.25% as the Hedge Budget, then it makes sense based on today’s option prices that Symetra would offer a Core S&P 500 cap of around 10.5%. But if you were to look back over the past 10 years of option prices, you’d get closer to the 11.75% cap with the same 5.25% Hedge Budget.
This dramatically increases the BIA Ratio and gives the Putnam engineered indices room to run. The non-bonused Putnam engineered index account matches the hypothetical BIA illustrated rate of 6.97%, as does the Putnam account with a 5.97% illustrated rate and a 1% bonus. The effect on illustrated income is dramatic. Using the Putnam account with a 1% bonus but the same total illustrated rate of 6.97% pushes the illustrated income to 27% above the Core S&P 500 account thanks to the increased illustrated loan arbitrage. It’s a colossal improvement in the world of AG 49-B.
National Life appears to take it even further. On SummitLife, the S&P 500 account illustrates at 5.97%, but the US Pacesetter account illustrates at 6.42% with a 0.75% bonus, bringing the total to a whopping 7.17%. It looks like part of the strategy is a sleight of hand with the S&P 500 account that essentially de-classifies it as a BIA and therefore allows for the use of a hypothetical BIA. If you showed me this rate sheet last year and told me that it was AG 49-B compliant, I would have laughed at you. I thought this sort of thing wouldn’t be possible. But apparently, it is.
This is the classic problem of rules-oriented regulation. There is no underlying principles-based approach for the hypothetical BIA. It’s a regulatory accommodation that has now been weaponized for use in the illustration war. And, of course, it makes no sense to advisors or their clients either. It’s not a real thing. It’s a construct of the specific language in the regulation. And I have no doubt that insurers will defend their use of it by pointing out that S&P 500 option prices are at historic highs and shouldn’t determine long-term illustrated rates, that they think the illustrated “risk premium” is still conservative and that they believe engineered indices will outperform anyway. None of that matters. This is a clear loophole in the regulation that is being exploited for competitive positioning. End of story.
Where AG 49-B Goes From Here
Each iteration of Indexed UL regulation has followed the same path – clamp one part of the balloon and another part bubbles up. What part bubbles up? The latest path of least resistance. In each iteration, life insurers transitioned not to a new strategy created by the guideline but, instead, a strategy that already existed but just wasn’t quite as easy or attractive as the ones that got clamped.
In the past, what made buy-up caps, index return multipliers and engineered indices (with and without fixed interest bonuses) so attractive is that they were free to the life insurer. They increase illustrated performance without changing the economics of the product. As a result, life insurers used them with abandon because there were no tradeoffs and no barriers to entry. These were the path of least resistance.
There are clearly strategies under AG 49-B that have the same attributes. It costs a carrier nothing beyond the usual implementation build to create a new portfolio segment that provides a higher yield at the expense of in-force policyholders. It costs a carrier nothing to rearrange an account to emphasize a fixed interest bonus that will increase illustrated income because of higher illustrated loan arbitrage. And it also costs a carrier nothing – literally, nothing – to use a hyper-aggressive hypothetical BIA with a very high BIA Ratio that gives engineered indices room to run on the illustration. These are the new paths of least resistance.
If you add them all up, they’re meaningful. I don’t think it’s a stretch to say that if a carrier were to avail itself of all of the available tools under AG 49-B, they could figure out how to juice illustrated performance by a 50bps or more and illustrated income by 25-30% and a lot more than that if they follow North American’s lead with a loan-specific bonus.
That is more than enough to get the attention of regulators, especially considering that AG 49-B was positioned as a “quick fix” with a follow up regulation coming later. Until then, I expect to see the illustration war heat up and more and more carriers release products with loan-specific bonuses, new portfolios, hypothetical BIAs – and maybe a few other things that we haven’t seen quite yet.
One final note – some companies were not affected by AG 49-B at all. By my count, those companies are Principal, Mutual of Omaha, Protective, Securian, Transamerica and Ameritas.
*VUL is a different animal. First, it’s a registered product. Second, it can illustrate with variable returns. Third, carriers allow clients to select between a range of illustrated rates that have no relationship to the underlying risk/reward of the investment strategies. The maximum illustrated rate for a money market fund is the same as a small cap equity fund. In other words, the illustration regime doesn’t provide guidance, which is exactly what AG 49 attempts to do for Indexed UL. Anyone buying a VUL knows and understands that the illustrated rate is simply an assumption. But people buying an Indexed UL or sometimes even a Whole Life think that the illustrated rate is an expectation. Those two things are fundamentally different.
**The Benchmark Index Account is a point-to-point S&P 500 account with a 0% Floor, guaranteed 100% Participation Rate and currently declared Cap, without any account-specific multipliers, charges or bonuses.
