Indexed universal life insurance policies use a stock market index to determine the interest payable on the cash value of a policy. This facility has a limit (industry officials call it cap) above which market index returns will not affect the interest payable by the insurance company. This indexing feature plays an important role in many arguments for IUL policies and for re-logic.
On the one hand, agents and marketing organizations favoring these policies claim that they can unlock access to higher market-driven returns without subjecting the policy owner to losses associated with the stock market during reforms, recessions, or depression.
Detractors argue, alternatively, that these products leave too much for the insurance company to manipulate in its favor. Stopping the deck against the uninsured buyer who must accept the changes lost by the life insurance company. The indexing feature, and more specifically its cap rate aspect, fuels the fire of this argument. This same rush also leads to using historical blemishes in universal life insurance records to doubt the viability of the product.
We want downstream changes to be evaluated on the probability of failure of indexed universal life insurance, so we determine to run a product through an array of stress tests to determine where- If sometimes separated.
Establishing appropriate sequencing installations for indexed universal life insurance
There has been much debate over the past decade about the appropriateness of the various assumptions used to project IUL cash values. The industry basically left insurers greater latitude for self-regulation and set the criteria for proper forecasting. This, not surprisingly, was caused by a few instances of lofty cash accumulation. Although incredibly optimistic, insurance companies argued that these estimates were inferred from historical backcasting – just the process of determining floor and cap rates of an indexing account over the past several years, which calculates future values In is to calculate the average result used as a lever variable.
We argued against this approach for several reasons, but the important reason was that it came very simply in the coefficients used to estimate it. Sadly, the industry was largely doing the same intellectual dishonesty as the investment industry when claiming the results of an arithmetic mean calculation could serve as the precise way of project results for a geometric mean scenario Was.
While speculating about future IUL values and talking about it several times on this blog, we developed our own process to arrive at reasonable expectations. We continue to use this method even today when presenting and analyzing indexed universal life insurance policies.
We designed a common IUL policy with a minimum non-revised endowment contract death benefit, using incremental death benefits, and qualifying as life insurance under the guideline premium test.
Our current methodology states that the specific product in question should estimate a 5% average indexing credit. As you expect, using that 5% assumption, the values of the policy recover over time and eventually come close to compounding 5% per year.
3% is assumed
Let me start by saying that the circumstances under which we consider warrants to be the same indexed universal life policy will only receive an average indexing credit of 3% which are fairly stringent. But, since we are trying to evaluate how things unfold in much more difficult situations, it makes perfect sense to run this scenario. Here is what it looks like:
Despite this drastic reduction in policy performance, we do not realize the catastrophic failure of policy. Ensure that the policyholder was happier, with the policy performing an average policy on a higher average assumed credit, the important one being that we do not experience outright failure.
Decrease by 1%
If we leave the assumed indexing credit at 1%, which is the absolute minimum guarantee of this product, the policy will ultimately be justified. Failure means that the policy value will cause the cash value to zero and a lapse occurs before the age of 121. So if we truly believe that the product will never exceed its guaranteed 1% interest rate, then we come to a conclusion. Premature policy termination due to catastrophic failure. The policyholder lost all his money and there is no death benefit remaining at this point.
More realistic stress test scenario
If there was a perception of 1% that we planned to make about the interest rate on an IUL policy in all years, I would argue that we would look elsewhere for a place to save our money the best. The good news is, we know to leave this option before going into it. But what if things change?
What if IUL sounds good today, but conditions worsen for it? This is a very scary scenario and probably one that is of great interest to more and more people. To model this situation, I took the same example and assumed the following:
- 5% per year index credit up to year 20
- 1% credit per year in all years 21+
This approach replicates the possibility that where indexed universal life insurance looks good today, circumstances may change in the future. If circumstances change, how much will the policyholder bother himself?
A major feature of universal life insurance is its flexibility / adjustment. We can change many aspects of policy to accommodate current and changing needs. The policy certainly requires an adjustment if a scenario arises where it cannot pay interest at a cash value in excess of the guarantee of its contract for a few years in the future. But can we make those adjustments and keep the policy in force. The answer, it turns out, is yes:
As seen here, once the accumulation rate falls, the rate of return on the cash value also decreases. Despite leaving for 1% index credit, the policyholder always completes more than 1% compounding year after year after the decline. But another important step here is the reduction in death benefit.
Reducing death benefits on universal life insurance policies is an advanced policy maneuver that preserves the cash value due to lower insurance expenses. This step requires an advanced understanding of life insurance rules because we do not want to violate the 7702 test which qualifies the contract as life insurance. You will see in this book that year starts in year 33 and continues through year 4 money, money comes out of the policy. This is a necessary force-out to maintain the policy from violating the 7702 test. Now, in practice, the way I actually handle death benefit reduction is different from how I handled it here. I take too much time to make incremental cuts that reduce to a minimum or eliminate the force. It takes me a long time to sort out and so much time that I am willing to dedicate a blog post, which I have made available to the public for free. The important lesson here is that this step is possible with an asterisk point that in real life, we use high levels of care and precision when executing it.
There are two important observations that come from this.
First, the policy does not fail. While it originally produces far less cash than Eclipse, it does not fail. It speaks of the decency of universal life insurance. It is not as delicate as some people like to suggest. It is now possible that insurance expenses can be adjusted upward and this will increase the risk of policy failure. I cannot model the cost of insurance increases, so I cannot say what the effect is ultimately. I am willing to bet that at maximum contractual expense, the policy fails. But we also have to understand that either a reduction in cap rates such as we assume such an interest rate, or an increase in policy expenses only after severe macro-economic shifts that force the insurance company’s hand . These are not arbitrary decisions.
Second, note that in year 20, the policy achieved an approximately 4% annual compound rate of return on cash value according to the amount of premium paid at that point. This is a reasonable result for such a low-risk savings vehicle. As much as we like to think that the decision to buy this type of life insurance is a life-long partnership, ultimately it cannot happen. If the policy mechanics change such that the new assumed interest credit will be 1%, then we have to look at all the options on the table. Which involves proceeding with this money on a different plan. The good news is, we have achieved a positive rate of return and shield ourselves from the risk of significant losses over the last 20 years. We now have about three-quarters of a million dollars, which we can take elsewhere and benefit from this wealth accumulation. The IUL policy was probably not fully planned, but it is not a complete loss and worked out as planned until this point.
IUL is safe and versatile
The bottom line is that indexed universal life insurance policies are a safe place to store cash and provide versatility to handle many changing situations. The product is not a fragile insurance product for losses due to arbitrary changes made to maximize the profits of the insurance company. What’s more, IUL can withstand many tensions that many suggest will be a painful loss for policyholders.