New rules for indexed universal life insurance underscore due diligence concerns

New rules that go into effect for indexed universal life insurance products next month demonstrate the need for going beyond illustrations when determining a policy's value for a client. The National Association of Insurance Commissioners adopted Actuarial Guideline 49 last June, which, for the first time, sets uniform standards governing the illustrations insurers use in the sale of indexed universal life insurance policies. The first phase of AG 49 went into effect last September, with a March 1 implementation date for the second phase. Based on projections, AG 49 is expected to keep maximum illustrated interest rates below 7% annually. “Even today, with these rules, I think there's still an over-promised risk with the product,” said Larry Rybka, president and chief executive of ValMark Securities Inc., an independent broker-dealer. Similar to fixed indexed annuities, growth is limited on the upside through features such as caps and participation rates, but there's also a buffer to the downside. IUL sales have grown markedly over the past several years, swelling 148% to $2 billion in annualized premiums from 2010 to 2014, according to Limra, an industry group. IUL represented 54% of overall universal life premiums sold through the third quarter of 2015. NEW GUIDELINES AG 49's first phase was meant to address what were seen as unrealistically high assumptions in illustrations of the maximum rate of return on an IUL contract. As a type of universal life insurance, IUL policies have a tax-advantaged investment or cash value component and a death benefit component. In an IUL policy, insurers credit interest to a client's policy based on the performance of a market index such as the S&P 500. The guidelines "simply created a more uniform and lower cap on what they could illustrate,” Mr. Rybka said. Prior to the guidelines, two companies using the same index and crediting method could illustrate two different rates, according to NAIC. For example, insurers using the S&P 500 in an illustration could have a 300-basis-point variation in their projections, “and you would expect them to be similar,” Mr. Rybka said. The second phase of the guidelines, going into effect next month, standardizes policy loan illustrations. If, for example, an investor were to borrow money from an IUL policy at an interest rate of 4% and the insurer projects a contract return of 8%, the investor may think there was a positive loan arbitrage, whereby he or she could actually make money even after taking the loan. This doesn't always reflect reality, though. In poorly performing markets, if growth weren't to eclipse the amount owed in interest payments, that loan could wipe out cash value and ultimately cause an investor to lapse a policy, Mr. Rybka said. AG 49 will limit this spread: Index crediting can't be illustrated at more than 100 basis points above the cost of borrowing. The new phase will be a “bigger deal in the application of indexed universal life for quasi-retirement plans,” whereby investors put money into the contract and borrow it tax-free, said Barry Flagg, president and founder of Veralytic Inc., a life insurance research and ratings provider. It will be less of an issue for those using or considering IUL for more traditional insurance needs or death-benefit protection, he said. 'GETTING BURNED' “AG 49 is a reminder that you should be looking at not the hypothetical values but the internal cost, like you are with mutual funds and for just about every other asset other than life insurance on clients' balance sheets,” Mr. Flagg said. Advisers are “getting burned by” policy illustrations, he said, which are insurers' “principal sales tool." “They're not a good due diligence tool for advisers," Mr. Flagg said. Illustrations typically contain three sets of assumptions: the maximum, the worst-case scenario (or, the minimum contract guarantee) and something falling in between. Pearce Landry-Wegener, wealth management adviser at Summit Place Financial Advisors, recommends advisers demonstrate the worst-case scenario to clients, especially if the primary use for the insurance is death-benefit protection rather than investment accumulation. “I would never show the [maximum]. I don't think it's a realistic expectation,” Mr. Landry-Wegener said. “I recommend giving people the base, whatever's guaranteed, and showing them that first. If this is about protection, this is what you can bank on.” “Those projections are guesses,” he said. “When I'm selling something, I want to know what I'm selling them.” Similarly, Mr. Rybka helps clients assess the risks of IUL contracts by discussing what a few consecutive years of negative market returns would mean for a policy, and what it would mean if insurers were to change the index caps or the cost of insurance. Some insurers recently raised the cost of insurance on in-force universal life policies, largely due to persistently low interest rates. Raising the cost of insurance "is not just hypothetical," Mr. Rybka said. “We should be skeptical.”