Very Tricky Policies: Anti-Consumer Features of Some Indexed Universal Life Insurance Policies
The Multi-Year Indexed Strategy Trap
Many indexed universal life policies offer the consumer the option of allocating some of the premiums to indexed strategies that credit interest to the policy according to the performance of the specified index over not one year but periods of two, three, or five years. If a consumer designates premium dollars to an indexed strategy (as opposed to a fixed interest strategy), the money is allocated to what insurers often call a “block” or “segment,” which begins on the date the money is allocated to the particular indexed strategy and ends on the “maturity date” of the block. Early indexed universal life policies began with one- year maturity periods, but many companies now offer consumers the option to put money into longer blocks, with maturity dates up to five years out. Selecting these longer periods creates a substantial hazard for consumers who find themselves later wanting to surrender the policy because upon surrender they will forfeit any interest that may have accrued since the beginning of the block. Under the interest crediting method used with most IUL policies, interest is credited only upon the maturity date of a block.
This means that a consumer who allocates $10,000 to a five-year indexed strategy in 2019 will not receive any interest on that money until 2024. If the index averaged an 8% gain over the five-year period, the consumer would receive $4,000 in interest credits when the $10,000 block matured in 2024. But the consumer would receive no interest credits if he or she surrendered the policy in, for example, 2023. The same forfeiture of interest may occur if the consumer did not voluntarily surrender the policy, but the accumulated value of the policy fell below the amount of the surrender charge, since most insurers write their policies so that the surrender charge is automatically applied if the accumulated cash value falls below the amount of the surrender charge. (For example, lets assume that a policy has a surrender charge of $50,000; if the policy has an accumulated cash value of $51,000 but then a $1,500 cost of insurance charge is deducted, reducing the accumulated cash value to $49,500, then most insurers will impose the $50,000 surrender charge as well, thus wiping out all the policy’s value and causing it to lapse.)
Consumers who allocate their money only to one-year indexed strategies also forfeit any accrued but uncredited interest if they surrender before the end of a policy anniversary. But losing a partial year’s worth of interest is far preferable to forfeiting multiple years’ worth of interest.
Many consumers pay attention to surrender charges in evaluating a policy for purchase and/or when considering whether to surrender a policy that has already been purchased. But because the forfeiture of interest described above is a consequence of the way in which indexed credits are calculated and applied, the forfeiture is generally not described by insurers as a surrender charge, so even a consumer who is paying attention to surrender charges may not understand that the cost to the consumer of surrendering the policy includes not just the charge identified in the illustration or policy as a “surrender charge” but also the forfeiture of interest.
Potential Public Policy Responses:
Disclosure of Interest Forfeiture as a Surrender Charge
Insurers offering indexed universal life insurance policies should be required to disclose the forfeiture of interest as a surrender charge, to be described in the same place in the illustration or policy where the insurer describes surrender charges. That way, a consumer who wanted to know the consequences of surrendering the policy would understand that substantial losses could be incurred if the policy is surrendered before the maturity date of the segments or blocks in which the consumers’ money is invested. Descriptions of multi-year indexed strategies also should describe this disadvantage to the consumer of selecting a multi-year strategy over a one-year strategy.
Require Insurers to Pay Prorated Interest:
Insurers also could be required to pay interest prorated to the most recent segment anniversary. Insurers may complain that such a requirement would interfere with the options that they purchase to cover their exposure to risk stemming from their obligations to credit interest based on the performance of the specified index. That may be true, but in that case the insurer could simply cease offering indexed strategies of more than one year. (We are not proposing payment of prorated interest for periods of less than one year, but only disclosure of the interest forfeiture.) If there is some marginal benefit to consumers in being able to choose a multi-year indexed strategy, we expect that benefit is outweighed by the risk of interest forfeiture as well as the increased complexity of the purchase decision and the need to explain to consumers the risks of selecting a multi-year strategy.
Impose a ”Best Interest” or Similar Standard on Agents
Imposing a fiduciary or “best interest” standard on agents might solve the problem of multi-year indexed strategies because an agent who was obligated to make only recommendations that are in the best interest of the consumer would be unlikely to recommend a multi-year indexed strategy, at least not without clearly explaining the significant potential downside of selecting such a strategy over a one-year strategy.
2. Illusory Guarantees
Most indexed universal life policies sold today have a 0% floor on index earnings, so that if the relevant index (for example, the S&P 500) has a negative return in a given policy year, index credits are zero but not negative. In addition, many policies provide a guaranteed minimum interest rate, typically of 1%, 2%, or 2.5% per annum. That sounds like a valuable feature, which is presented separately from the 0% annual floor that applies to index earnings. However, many companies do not apply the minimum interest rate annually but instead on a “retrospective” (i.e. “backward-looking”) average basis. As explained below, when guaranteed minimum interest is calculated on a retrospective basis, the guaranteed minimum interest is an effectively illusory benefit.
To see why, take the case of an indexed universal life policy that is indexed to the S&P 500 and has a 2% guaranteed minimum interest rate. With an annual guarantee, guaranteed interest would be provided in any year in which the S&P 500 gained less than 2%. But a guarantee that is applied retrospectively would not be applied year by year but only upon termination of the policy (or, for some policies, after termination of a specified period such as five years), at which point guaranteed interest would be credited only if the average gain over the life of the policy (or, for some policies, over the specified period) was less than 2%. Assume hypothetically that the policy was surrendered after five years, during which the S&P 500 gained 0% in each of the first four years and 10% in the fifth year. With an annual guarantee, the policy would be credited 2% in each of the first four years and 10% in the fifth year, for a total of 18%. With a retrospective guarantee, no guaranteed interest would be provided because the average gain of the S&P 500 over the five years was 2%. No guaranteed interest would be credited, and the total interest would be only the 10% credited for year five.
Our hypothetical presents an extreme case where the S&P 500 gained 0% in four of five years. But an annual guarantee, unlike a retrospective guarantee, would provide up to 2% interest in any year in which the S&P 500 gained less than 2%, which happens in approximately one year out of every three. Since the S&P 500 index began in 1957, the index (without dividends, which is the way that most insurers index their policies) has gained less than 2% in 21 out of 62 years. However, there are no five-year periods since 1957 (on a calendar year basis) in which the average gain of the S&P 500 has been less than 2%, which means that the minimum interest guarantee would never have been triggered if calculated on a retrospective basis. In contrast, the cumulative interest that would have been credited with a 2% guarantee applied annually totals 37%
While a retrospective guarantee might be triggered if a policy lapses in a very short period of time such as one or two years, some companies do not credit guaranteed interest upon lapse, and any policy that persists for only one or two years is inevitably a disastrous purchase for the policyholder in any event.
Insurers might argue that even if retrospective guarantees have little or no value, where’s the harm? The harm is that they are used to help sell policies because they seem valuable, and many consumers do not understand that in fact they have effectively no value.
The market for indexed universal life insurance would function better if these guarantees were eliminated, as they have no real value but they risk confusing consumers. Consumers are generally not familiar with retroactive average interest rates, which are unlike the interest rates they encounter with credit cards, home and auto loans, and CD’s or deposit accounts. Retroactive average rates are also unlike the other kinds of rates consumers encounter in illustrations and policies (such as policy loan interest rates, indexed strategy caps, and the interest rates that are used to project non-guaranteed values in illustrations). A few consumers may figure out how these minimum interest rate guarantees work and may see that they lack value, but no consumer should have to expend the effort to figure it out, especially when there are many other complex aspects of the transaction to attend to.
Potential Public Policy Response:
We do not propose a ban on such guarantees because a retrospective guarantee could have value if the percentage guarantee were high enough. Nevertheless, clear disclosure must be made to consumers. We therefore propose that if an illustration or policy references a minimum interest rate or minimum credit guarantee that is not applied on an annual basis (e.g., if applied retrospectively as discussed above), the illustration or policy must state “THIS GUARANTEE IS NOT AN ANNUAL GUARANTEE.” Further, the illustration or policy must include a numerical example such as the one discussed above, that illustrates how the calculation of the guarantee differs from the calculation of an annual guarantee.
3. Use of Multipliers to Boost Illustrated Values and Evade Actuarial Guideline 49
Although Actuarial Guideline 49 was adopted in 2015 to reduce maximum illustrated index crediting rates and make them more comparable across companies, some companies are offering riders or features by which the consumer can buy a multiplier to the index credits that would otherwise accrue, allowing the insurer to illustrate policy values that are far higher than what AG49 would otherwise allow. In some instances, rather than illustrating a high crediting rate (e.g. 9%) certain insurers are now illustrating what appears to be a more reasonable rate (below 6%), but when taking into account optional multipliers, they are in reality illustrating at crediting rates that may be at least twice that rate.
For example, Pacific Life’s Discovery Xelerator IUL 2 offers an optional “Enhanced Performance Factor Rider” (“EPFR”) that allows PacLife to illustrate enormous returns prior to expense deductions – externally calculated to average over 14% annually in years 2-20 despite the fact that the maximum illustrated rate of return without the EPFR (and calculated in accord with AG49) is only 5.67%. The higher returns are produced by what Pacific Life refers to as a “dynamic multiplier” that multiplies the actual credited amount by a factor that Pacific Life intends to pay as each indexed segment matures. Pacific Life is not the only carrier to offer multipliers of remarkable magnitude, but it has been the largest seller of IUL products such as Discovery Xelerator 2 since it first introduced this “dynamic multiplier” in 2017. Since then, several other carriers have followed suit with multipliers of their own.
The creation of such multipliers has been driven by insurers’ desire to illustrate significantly higher returns in order to make their illustrations more competitive compared to other IUL products - and therefore make them more marketable to consumers.
Such multipliers pose serious risks for consumers. To begin with, they have rendered largely irrelevant the attempt of regulations such as AG49 to contain unrealistic illustrations.
Second, these multipliers come with a high price tag. PacLife’s dynamic multiplier costs the policyholder as much as 7.5% of the policy’s accumulated cash value every year. Whether the EPFR is a net positive or a net negative depends heavily on how the relevant index (e.g., S&P 500) performs.
To start, he 7.5% asset charge of the “Performance Plus” (Maximum) EPFR is assessed against cash value each year.
Taking a hypothetical example, let’s assume a policy has $1,000,000 in cash value and then assume now that the S&P 500 were to have no gains for the year. In that case the EPFR would contribute no interest credits, but the same $75,000 EPFR charge would still be assessed, thus reducing the accumulated cash value of the policy to $925,000 before counting cost of insurance or other charges that would further reduce the accumulated cash value.
By combining high cost with a multiplier that provides benefits only when the underlying index makes gains (because the rider multiplies the credits generated by the index), the rider causes the policy to perform especially poorly when the underlying index is negative or posts either no gains or only small gains over successive years. This characteristic of EPFR riders amplifies the volatility and lapse risks that we discuss in the Lapse Problem Section.
Third, such multipliers present an unrealistic and often inflated picture of the rider’s performance because illustrations use an average rate of return and apply that rate every year, while real indices like the S&P 500 exhibit volatility (meaning that the performance of the index varies from year to year). Applying an average rate every year can cause illustrated returns to be higher than what the returns would actually be in the real world (with index return volatility) even if the index achieves the same average rate in the real world as was assumed in the illustration. While this can be true even of illustrations without enhancement riders, the riders amplify the degree to which illustration of an average rate of return can diverge from what the policy would earn in the real world with volatile returns. And because the illustrated returns from the riders can be unrealistically high, this may cause the policyholder to underfund the policy, further increasing the risk of lapse.
Finally, the complexity introduced by these riders underscores the need to impose a fiduciary or “best interest” standard on agents selling LIIS policies because consumers cannot be expected to make informed decisions by themselves about whether to buy a policy with such a rider. The riders are complex even when discussed in simplified form, as we have attempted above. For example, for simplicity, we have ignored the fact that the rider has a range of different costs and different performance factors after year 20. See “Enhanced Performance Factor Rider” (“EPFR”). Determining whether the rider will pay for itself is far beyond the capability of an ordinary consumer – and likely even of the capability of an agent. Without sophisticated modeling provided by the insurer or agent, a consumer who buys the rider is simply gambling with no way to know the odds.
Regulators are waking up to the problems posed by these riders, yet some in the industry favor a “buyer beware” approach. See Article from InsuranceNewsNetMagazine.com.
In our view, consumers are poorly served by such an approach, and regulators should undertake an examination of whether multipliers such as those discussed herein violate the letter or spirit of AG49 and whether such multipliers impose risks on consumers that are unreasonable or are unknowable as a practical matter. We see insufficient consumer benefit in these multipliers to justify their risks and believe that regulators who examine them will agree.
Important to note: we are NOT suggesting that Pacific Life or any other carrier is doing anything illegal. These companies play by the rules. It’s just that the rules are complicated and there are clever approaches to following the rules while making your illustrations look better than the other guy’s. We’re also not saying these policies are bad or inappropriate. It’s just that it’s become very difficult to appreciate the amount of risk you’re taking in favor of what appear to be the promised rewards. Unfortunately, many agents are in the same boat. So where are you supposed to gather the information needed to make a smart decision about pursuing one of the LIIS policies – or not?
Potential Public Policy Response:
State insurance regulators should examine, through hearings or otherwise, whether the kinds of multipliers discussed above should be prohibited as violations of AG 49 and, more broadly, whether such multipliers should be prohibited as creating undue risks for consumers.