Rules governing indexed universal life insurance may not go far enough

New rules designed to curb overly rosy policy return illustrations, the primary sales tool used to sell indexed universal life insurance, seem to be having their desired effect, but they may not go far enough.

The rules, Actuarial Guideline 49, provided more uniformity around the policy-return illustrations used by brokers and insurance agents to sell indexed universal life products, in a play at tamping down on some of the unrealistically high returns being presented to clients. The average maximum rates shown in policy illustrations have come down since the rules were issued in March 2016.

The bad news, though, according to some: AG 49 didn’t address some persistent problems with illustrations.

“The bigger issue, to me, is not the cap on a hypothetical return, but more a realistic expectation of what is possible,” said Barry Flagg, president and founder of Veralytic Inc., a life insurance research and ratings provider. “If you put a cap on something unrealistic, it makes it more realistic, but it doesn’t necessarily make it realistic.”

Indexed universal life insurance has been a hot-selling insurance product. Last year marked the product’s best sales year on record, notching about $1.9 billion in annual premiums, according to Wink Inc., a market research firm.

The product, a type of cash-value life insurance, is similar in construction and marketing to indexed annuities, both promising “downside protection with upside potential.”

Insurers invest the vast majority of a policyholder’s premium dollars into fixed-income securities such as high-grade bonds to achieve a guaranteed interest floor (often 0%, sometimes higher). The remainder of the premium is invested in options contracts linked to a market index such as the S&P 500.

The latter is what delivers the potential upside, which is limited by the insurer through mechanisms such as caps, participation rates and spreads.

In March 2015, before the National Association of Insurance Commissioners issued AG 49, the average assumed illustrated policy return was 7.46%, according to Wink. Fast-forward two years, and that rate fell to 6.33%.

“A lot of times what the sales process boils down to is [that] the best illustration wins,” said Scott Witt, owner of Witt Actuarial Services, a fee-only insurance advisory firm. “The one that looks best on paper is the one that’s chosen.”

An illustration is a hypothetical calculation of a policyholder’s future return. It’s a point-in-time snapshot based on factors such as historical market-index returns, a company’s current cost of insurance and expenses, and a policy’s cap, spread or participation rate.

While illustrations for indexed universal life policies are now more reasonable following AG 49, they still don’t take into account a few key factors, leaving room for potentially misleading sales, observers say.

For example, insurers are able to tweak caps, spread and participation rates — on an annual or other basis stipulated by the policy — if economic conditions change, making items such as derivatives and hedges more expensive for the insurer to purchase, Mr. Witt said.

However, the potential for those tweaks isn’t reflected in illustrations.

“That totally changes what the policyholder gets,” Mr. Flagg said.

Plus, any variability in the rate of interest charged for a policy loan isn’t reflected either — only the rate at that point in time, Mr. Witt said. A prudent broker would discuss these risks with clients, and show some hypotheticals around what happens if illustrated rates don’t come to fruition, he said.

Further, illustrated returns on an indexed universal life policy don’t include dividends from a market index, because a policyholder isn’t invested directly in the index.

So, if a policy is linked to the S&P 500, an illustration would be compared with the S&P 500’s capital return (or, the return minus dividends) rather than its total return.

That puts a broker trying to help an investor understand indexed universal life returns with respect to other common types of investments at a disadvantage, said Mark Whitelaw, president of Valley View Consultants Inc.

In one example, the illustrated rates of one “major indexed universal life issuer” for 2017 are 35.21% to 49.53% lower than the equivalent S&P 500 total return, according to calculations made by Valley View Consultants.

“That’s the issue for the securities licensed rep: They’re not provided the starting point consistent with the information they have if they’re providing info on IRAs, 401(k)s, variable annuities, taxable brokerage account investing,” Mr. Whitelaw said. “Consumers don’t buy products based on capital return.”

“As a registered rep, I’ve always taken the perspective that I need to figure out how to translate AG 49 into the S&P 500 total return so I can be compliant with Finra [rules],” he added.

Such shortfalls aren’t necessarily shortfalls in AG 49, but are indicative of other improvements that could be made to the illustrations used by brokers and consumers, observers said.