Managing Client Risks And Expectations With Indexed UL
September 2, 2011 by David Hayward
September 2011 Issue
Since the introduction of indexed universal life, sales of this product line have been rapidly growing while many other types of life insurance products have fallen or remained stable.
Why is there such an interest in this type of product? The thought of upside potential with downside risk protection sounds good. The illustrations that can be produced can look very impressive, and in some instances unbelievable!
Projections can show that with an illustrated rate of 8.3 percent (not guaranteed) a healthy 30-year-old female can pay $5,000 per year for 20 years and have an initial death benefit around $290,000 that grows along with the cash value. At a projected retirement age of 65, she can receive $80,000 of annual income for the next 35 years and still have a $2.1 million death benefit remaining at age 100. In all, total premiums of $100,000 can illustrate more than $2.8 million of income with an additional $2.1 million of death benefit.
While math and illustration projections can show that tremendous growth can occur, how realistic are they? There are many factors involved and subtle changes may have a dramatic impact. Bottom line, a properly designed life insurance policy can help clients with a variety of their financial needs, but it is important to show realistic expectations rather than the absolute best assuming nothing goes wrong.
Let’s look at some of the main features to be considered in designing a case.
• The first decision that must be made is the amount of death benefit protection. If your client’s goal is to have a product with the most cash value that can be accessed later in life, you want to suggest the smallest policy for the greatest premium. However, most clients have the greatest need for life insurance protection currently and it may decrease as they get older. Mortgage loans decrease with each principle payment, children get through school and become independent, and the income replacement need shrinks as one gets closer to retirement. These two thought processes appear to conflict with each other.
Is it best to have one larger policy that is not funded with the maximum premium, or a smaller policy with maximum premiums and supplement the death benefit need with term insurance? The best policy design may vary between clients, so different options should be explored.
• Once the death benefit and premium amount are decided, the next decision is to determine the crediting strategy and interest rate that is suitable for future projections. There are a variety of index options available; some are simple and straightforward, while others are complex and very difficult to explain.
Since the most popular index that carriers benchmark the interest rate to is the S&P 500, that will be the focus of this study. The maximum illustrated rates are typically based on a 15- through 30-year historical look-back period at the carrier’s current cap and participation rates.
The current maximum illustrated interest rates vary somewhere between 7 and 9.5 percent, depending on the company and product chosen. Current cap rates are between 10 and 16 percent for a 100 percent participation strategy.
Using a cap rate of 13.5 percent and a 100 percent participation rate, which is close to the current industry average, what interest rates should one expect to earn in a policy?
If we look back at historical performance, this can help in trying to determine an acceptable interest rate assumption. It won’t actually determine the next interest rate—all we know is that it can be anywhere between zero and 13.5 percent. Table 1 summarizes the one-year percentage change in the S&P 500 valuated on day 21 of every month from January 1980 to June 2011. There were 378 different one-year time periods.
For 91 months, clients would not have earned any interest in the index strategy. For 158 months or 41.8 percent of the time, they would have hit the cap at 13.5 percent. The remaining 129 times or 34.1 percent, they would have earned somewhere between zero and 13.5 percent. The geometric average of this set of data is 8.214 percent. So is that a suitable rate to project going forward?
There are several items that need to be considered. First is how many premiums are being paid in. An annual premium only has one chance to earn interest over the year, whereas monthly premiums have 12 chances. The more times that are evaluated, the lower the volatility, so clients have a greater chance to expect long term results closer to the average.
Annual premiums may lower the net amount at risk and produce lower cost of insurance charges over the year, but then there is only one chance to earn interest for the period. A spike in the index value on the final evaluation date can eliminate any gain that might otherwise have been made, but it can also produce a higher return.
If monthly payments were made, there are 12 chances to earn interest, so unusual movement in the index will affect only one of the months. If the index goes up and down throughout the year, some of the months may capture the gain, while others may be protected by the index floor and not earn interest. Overall, there is a greater chance for some interest to be earned and your clients are not relying on one day of the year to determine if they earn interest or not.
If the carrier offers dollar cost averaging, clients can benefit from the lower net amount at risk with an annual premium and have it deposited throughout the year in the index strategies to lower the volatility. However, dollar cost averaging does not guarantee a profit.
• The next thing to consider is the holding period. Is your client younger and expecting to make contributions for many years, or older with fewer years to be paying premiums? Economic movements often last several months, if not years. An upward or downward trend in the economy impacts the short term expected interest earning potential in any index strategy. Over longer holding periods, the up and down movements tend to counteract each other, making the return closer to the overall average.
If a client purchases an index UL policy just before a recession, he may not earn interest for the first year or two, but eventually the crediting strategies will capture the gains when the recession ends.
Table 2 shows hypothetical averaged interest rates over 5, 10 and 20 year holding periods. These assume 12 equal monthly deposits through the year based on a January to December calendar year. The interest rate is the geometric average of every monthly one-year return over the holding period. This is based on the historical changes in the S&P 500, assuming an annual point-to-point strategy with monthly sweeps along with a 13.5 percent cap and a zero percent floor. The best and worst returns are highlighted.
The table shows that the longer the holding period, the higher the worst averaged interest rate and the lower the highest averaged interest rate. You should expect wide fluctuations to the interest rates that will be earned every year, but the longer a policy is in force, the closer it may come to the historical average return. However, past performance will not predict the future; it can only give us insight to help make an informed decision.
Statistically speaking, with a long enough time frame, roughly half the time clients will do better than average, the other half will be worse than average. However, in the earlier example of starting a policy just before a downturn in the market, there is always the risk the index is negative for a period of time. This would cause no interest to be credited to that index option for that time frame.
If your client is conservative, you may want to set his expectations with a rate that is below the historical average and hope that he will be one of those who experience better than average performance.
• The last important item to consider is the methods that can be used to take income from a policy.Policyholders can take withdrawals or loans against their cash value, which will reduce the cash value and death benefit of the policy and, as explained later in this article, could result in lapsing the policy if not managed properly.
With index UL products, loans are often the proposed method, since they won’t trigger the surrender charge that is applied to withdrawals from the cash value during the early years of the policy. Loan interest is charged by the insurance company and interest is credited to the cash value. Loans can be classified as fixed loans (sometimes referred to as wash loans) or as variable loans.
A fixed loan separates the loaned amount from the rest of the account value, and interest is earned at the same interest rate as the loan interest is being charged to the client. This approach is the most conservative, and the policyowner is not allowed to profit or take a loss in value due to the interest credited by the index strategies. The cash value that is not held as collateral for the loan is the only portion where the interest rate is determined by the index strategy.
With a variable loan, the loaned value is not separated from the rest of the account value. The insurance company will charge loan interest to the client and for interest crediting purposes; it is assumed that there is not a loan on the policy. The entire account value will earn interest at the rate the index strategy calculates. In periods when the index strategy returns an interest rate above the loan interest rate, the owner profits from having the loan. In years when the index strategy returns an interest rate below the loan interest rate, the owner experiences a loss in cash value.
Since illustrations usually assume that the index strategies will earn more than the loan rate on borrowed money, projections show that there is always a profit from having a loan against the cash value. When this is projected for 20 or more years in the future, the wonders of compound interest really make the numbers look good. If a client can borrow at a fixed rate of 6 percent and project that he will always earn 8 percent, why wouldn’t he borrow as much as possible?
Variable loans work well when the index strategy produces a larger interest rate, but that does not always happen. The downside to insurance illustrations is that they almost always show that it will always happen.
If the actual interest rates are not as strong as projected, too much of the account value may be taken out as a loan and the policy may lapse if it is allowed to continue. This could also result in a taxable event for the client that he wasn’t anticipating.
When showing clients a projection with variable loans, make sure they understand the risk and let them know that eventually there may not be enough cash value to continue with additional loans.
Most carriers have an over-loan protection rider that will help policyowners in the situation when a loan is going to exceed the available cash value. If clients meet the rules and the rider is activated, no additional loans can be taken and the policy is converted to a small death-benefit-only amount. The rules and requirements to activate this rider vary with the different insurance companies, but typically provide little or no protection in the early years of the policy. Make sure your clients understand the rules if they are being more aggressive with the assumptions used in designing a case.
In all, indexed universal life policies offer policyowners the death benefit protection they desire and the potential to earn an attractive interest rate on their cash value. There are a lot of options and decisions that need to be made in designing the most appropriate policy for a prospect. Illustrations can be designed to look very attractive; however, the better they look, the more potential risk clients may be assuming.
There is nothing we can do to change the future to make sure a policy will deliver the way it is projected, but we can look to minimize the volatility and make reasonable assumptions that match the client’s risk tolerance.
David Hayward, CLU, ChFC, FLMI
CLU, ChFC, FLMI, is an advanced sales consultant for National Life Group. He specializes in the family protection, retirement planning and wealth transfer markets. Hayward received a BSBA from Drake University with a major in insurance. Prior to joining National Life Group in 2008, he had worked with American General Life and Accident Insurance Company’s mature market division and the ING Group’s educational services and advanced marketing departments. Hayward can be reached at National Life Group. Telephone: 802-229-3801. Email: firstname.lastname@example.org.