Updated 2/5/2020, Originally posted 11/29/18
In the 1980s when current assumption universal life (CAUL) hit the market, sales illustrations were created showing cash value returns of 10% and more every year – for a product that was invested in fixed instruments. When equity markets soared and variable universal life (VUL) became the rage, many sales illustrations projected 12% returns – again, every year.
Life insurance illustrations are at best a guide – they do not guarantee the future, they are based on hoped-for returns which do not occur as projected. All else equal, in a universal life chassis without secondary guarantees, the higher the rate of return assumption, the lower the premium that has to be shown in a sales illustration to carry the policy to maturity (or some other goal).
The premium shown in a sales illustration is not the cost of the policy – costs are shown on the expense page of the illustration. An unreasonably high return assumption can easily hide higher policy charges. Why? Because over the lifetime of the policy, the highest expense is typically the monthly deduction for the cost of insurance – the mortality charges. Those charges are based not on the death benefit, but on the net amount at risk, which is the difference between the death benefit and the cash value. (For a more detailed explanation of net amount at risk, go to Chapter 6 of the TOLI Handbook, available as a free download here.) As the cash value climbs, the net amount at risk drops and the actual charges deducted drop. A high assumed rate of return creates a double-edged cycle – a higher return creates higher cash value which lowers costs which creates higher cash values. A perfect situation – for a disaster.
The CAUL policies issued in the 80s and into the 90s with unreasonable returns crashed and burned with policy lapses that fueled the rise the rise of secondary death benefit policies, guaranteed universal life (GUL). The 12% returns of VUL policies did not hold up either and after the market crash of 2007-08, many people fled to equity indexed universal life (EIUL). These were considered more “conservative” because while the returns were tied to an equity index, an interest rate floor – typically 0%, limited the downside – “you could not lose money” with this product. (Note that even though the investment component may not be negative, policy charges still accrue so cash value does drop.)
The policy also has a limit on the upside, called the cap, set by the carrier. A policy with a cap of 10%, which is typical, means that any returns over 10% will be lost. This is one reason that the rate of return assumption in EIUL policies is tricky to project. When we first started seeing these policies, the assumed crediting rate in sales illustrations was well above 7%, often approaching 8%. Now with regulation AG 49 in force, sales (and in-force) illustrations are limited to a maximum return of around 7%. One carrier has created an online tool that translates the actual return in an index, like the S&P 500, into the crediting rate applied to the policy. For example, assuming a 10% cap and 0% floor, to credit a policy with a 7% rate, the actual return in the S&P 500 would have to be between 10 and 11 percent.
However, there is more. Regulation AG 49 capped the rate of return that could be shown in the policy, but it did not stop the use of various interest bonuses and multipliers that might not be seen or understood in an illustration. We are in the midst of an illustration war with carriers determined to create products that illustrate better in a sales situation. According to one life insurance expert, these AG 49 compliant illustrations can take a “6.75% illustrated rate” and “generate a 9% illustrated internal rate of return on cash value.” (1) The industry is turning lead into gold.
Unfortunately for the TOLI trustee taking in a new policy, this creates issues. As a fiduciary, you must make sure that the assumptions on the asset in the trust are reasonable. As a business person, you must make sure your clients are not disappointed by policy performance – when the policy crashes, it will be your problem.
So what is the answer? First, have skilled life insurance professionals on staff. An untrained administrator will not be able to decipher today’s sophisticated products. If you do not have skilled staff – find them or outsource the service.
Second, do not accept policies with assumptions you deem unreasonable. Hopefully the current crediting rates on new current assumption policies and dividends on whole life policies are bottoming out, and rates will be rising – a plus.
For variable universal life policies, review the asset allocation and develop a conservative assumption for the expected returns. If you think 8% is reasonable in an equity-rich allocation, also show the outcome at 5.5% or 6%. If a more balanced allocation generates an assumed return of 7%, also show 4.5% or 5%. Show the clients the downside funding needs, you will be glad you did.
For equity index UL policies, get an illustration assuming a crediting rate of 5% along with the 6-7% return that is usually shown. And make sure you (and your grantors) understand the bells and whistles of the policy. (See Chapter 10 of the TOLI Handbook for a thorough discussion of the equity index UL policy.)
Document the higher carrying costs that come with a lower return assumption and have the client sign a document acknowledging those additional costs and make that a part of your trust file.
Generate a report annually that shows the current condition of the policy and any premium changes that should occur to keep the policy on track.
Do not assume the aggressive assumptions made by salespeople to lower the projected premium and increase the chance of a sale will actually occur. Your job is not to sell a policy – it is to deliver a death benefit.
Be careful out there.
- Voya ICAR & The Indexed UL Illustration War, Bobby Samuelson, The Life Product Review, October 11, 2018