What You (as Trustee) Need to Know About Equity Indexed Universal Life

Lately, ITM has seen an upsurge in the use of Equity Indexed Universal Life (EIUL) policies. Agents are touting the product’s “upside potential” with sales illustrations projecting higher rates of return than Current Assumption Universal Life (CAUL) products. These agents also highlight the “downside protection” that makes the product attractive to those fleeing the volatility of Variable Universal Life (VUL) policies.  Once again, the insurance industry has seemingly come up with the perfect vehicle for the times.

An EIUL policy is designed to track the returns of an Index such as the S&P 500 Index, but without including dividends. The policy will generate upside returns, while limiting the downside with an investment floor, typically 0% or 2%.

The policy promoters tout the fact that EIUL “limits your risk” because of the investment floor feature. However, the risk that you, as trustee, takes on is the risk that the policy will not perform as illustrated. To understand that risk you must look under the hood of an EIUL policy.

While Indexed UL is most often compared to VUL, it operates more like a CAUL policy.  Premium paid into the policy is placed into the general account of the carrier where it earns the current rate of return, much like CAUL. But here is where the products differ.  The carrier will typically use the majority of the credited interest earned to purchase call option contracts which gives the carrier the right to specified returns generated by the Index chosen in the policy. If the market goes up, the policy is credited with the positive returns, subject to some limitations. If the market goes down, the contract expires and the policy is credited only with the guaranteed floor.

The upside gain is limited to a cap rate which represents the highest rate of return that can be credited to the policy. The returns can also be affected by the participation rate, the percentage of actual Index gain that will be credited to the policy.  So, for example, if a policy had a 10% cap, 100% participation rate and a floor of 0%, actual returns to the policy would look like this:

The call option costs to the carrier rise as the rate cap increases.  A call option contract with a 12% cap and 0% floor will be more costly than one with a 10% cap and a 0% floor.  Call option costs can also rise because of market volatility. If call option costs rise, or the crediting rate returns used to buy the options drop, the profitability of the policy will decline for the carrier.  Since the cap and/or participation rates typically are not guaranteed, they can rise or fall as dictated by the carrier. In many EIUL policies, they have.

Remember that the risk to the carrier is not the Index return, but the cost of the hedging, the call options. While the policies with the highest caps tend to illustrate better, they are typically the most expensive policies because of the increased hedging costs.

This brings us to the illustrated rate shown in a policy sales illustration, a completely arbitrary decision. Some carriers, citing back tested models, have default rates in their illustration software that exceed 8%, which many feel is rather aggressive. The most conservative carriers suggest a rate of return 2% higher than current CAUL policies are currently paying, which would suggest a rate in the 5-6% range.  Understand that rates of return shown in the illustration are linear and will not perform as shown as returns in the policy will fluctuate year to year.  No matter what rate of return is shown in the policy, the actual outcome will surely differ. I expect to post a blog to follow up and expand on calculating illustration rates to show.  Keep your eyes open. 

When accepting one of these policies into a trust, I would suggest that you explore and document the following:

• All of the “moving parts” of the policy: Make sure you understand not only the current and guaranteed caps and participation rates, but also the Index the policy is using and the manner in which the Index returns are computed. This can be as simple as yearly point to point changes in the Index, but other alternatives are available. These alternatives may generate potential higher returns, but may come with higher risks.
• The underlying policy costs: As with any Universal Life policy, the actual policy costs incurred will have a dramatic affect on policy performance. Make sure the costs in the policy are in line. Know which costs are based on current assumptions and which are guaranteed.
• Is the death benefit guaranteed?: Some EIUL policies come with guarantees that the policy will pay a death benefit no matter what happens to policy performance as long as the premium is paid in full and on time. Understand the policy guarantees, including all caveats. Know the length of the guarantees and what is required to maintain them.
• Rate of return used on sales illustration: Everything else equal, a higher projected rate of return will predict a better outcome with an EIUL product. Of course, the higher the rate of return projected the less likely the return will be obtained. It is suggested that at least two illustrations be obtained and reviewed, especially if one of the illustrations is aggressive. For example, if an advisor is suggesting a 7.5% return, ask to see the outcome at 5% also, which might be more in line with reality. It is not wrong to fund a policy based on a lower return expectation, knowing that funding in later years can be decreased if a higher return is obtained.  In the past with life insurance sales, the opposite has often occurred, with illustrations designed to show the lowest possible outlay shown. This often resulted in disappointed clients.

When accepting the policy, provide your grantor with a disclaimer statement outlining the disadvantages and caveats of the policy.  Also document the gifting expectations, including possible increases should policy performance lag.

Once the policy is in your trust you should be vigilant in tracking the actual returns of the policy. Periodic updates of policy performance should include premium revisions needed in order for the policy to reach stated goals. These updates should include a review of the “moving parts” discussed earlier. Have the caps or participation rates changed? Is the policy still in the most appropriate Index and crediting scenario? In addition, actual policy costs should periodically be checked against projected costs.

At ITM we do not believe that there is one “best” policy, but that each different policy has its place. Equity Index Universal Life, especially with death benefit guarantees, is a policy that has its place when used in the right situations, with the right design and expectations