Guaranteed universal life insurance has always been a somewhat boring topic to me from a daily professional life point of view. It doesn't fit all that well into my usual paradigm of life insurance plan design, and as a result is often skipped over (rightfully so) by me. However, purely from a thought exercise point of view, guaranteed universal life insurance is quite possibly one of the most fascinating products the industry has ever dreamed up.
A Really Quick Primer
Guaranteed universal life insurance is simply universal life insurance with a small contractual twist. A provision that states so long as a certain premium is paid on time the cash surrender value of the contract will not determine the product's ability to remain in force. You'll remember from earlier posts about universal life insurance that unlike whole life insurance the life insurer does not assume the risk of the policy's reserve, and if the cash surrender value reaches zero the policy will lapse if no measure is made by the policy owner to place ample money into the contract to keep it in force.
So, this provision that cash surrender value no longer matter regarding the policy's ability to remain in force is quite strange. But, really all that one needs to understand (or so many agents once thought) was that the owner/insured needed to know what the premium was that kept the contract in force (for those who like details, it's referred to the as the secondary guarantee premium).
And once you knew that premium and paid it on time, the contract could not lapse. Term to age 100, was the common descriptor (age 100 because at its original inception we were using the 1980 CSO table and that's when policies ended because that was the age at which that CSO considered everyone to be dead).
But how does a level premium insurance product completely ignore the economics (and even more importantly the legally requirements) to build a reserve?
That was always my thought regarding guaranteed universal life insurance. But I'm weird and of course I'd ask that question. For a while, we (i.e. insurance agents) ignored that question, and the party rolled on.
The Answer Hides in the Shadows
No this isn't another post about my lamenting the obtuseness of the insurance industry. I'm being serious and truthful about the answer hiding in the shadows. In fact, that's even what the industry called it.
The Shadow Account
Before we can explain the idea of a shadow account, we have to ensure at least a rudimentary understanding a policy reserves. Simply put, the reserve is the money associated with the policy that (in effect) acts as a self insuring mechanism.
It's the excess premium paid when the cost of insurance is much lower than the actual premium, and this extra money is used to cover the cost of the eventual higher than level premium paid at inception–I say self insuring because the increase in the reserve also decreases the net amount at risk (i.e. the pure insurance).
The shadow account is a reserve built with the money collected in access of the pure cost of insurance and used to achieve a yield credited to this money, generally higher than the interest paid on the cash surrender value. So, even though insurance companies do have access to the real reserve, guaranteed universal life insurance does violate the laws regarding level premium life insurance because it does have a mechanism to do what is required of all level premium life insurance policies. And some pretty simple math can be employed to work backwards on the money needed from you the policy holder in order to provide adequate reserves. Seems simple enough, no one could possible mess that up…or so we thought.
Manipulating the Shadow Account
Unfortunately the people in upper management in the life insurance industry are people, too. And they fall victim to the same vices that wreak havoc on other industries.
In this specific case, the desire to beat out the competition and post big gains on incoming premium. And how does one do that with a product like guaranteed universal life insurance?
Well, the pieces have all been put on the table, now we just have to reconstruct the model.
Since the secondary guaranteed premium is based off the assumption about incoming money and the yield on that money (to build a reserve) there is an inverse relationship between the secondary premium and:
- The assumed premium paid
- Yield on the shadow account
So, if one wants to reduce the premium required under the secondary guarantee provisions, he or she need go no further than to assume two things:
- That the insured will pay higher premiums than required
2. That earnings on shadow account (i.e. the reserve) will be higher
Number one seems like a bad assumption, but it actually took place. It's sort of like sending the insurance company an extra check at the end of the year for your 20 year term insurance, but someone somewhere convinced him/herself and others that it might possibly happen.
The assumed yield was even more wild (and more interesting). This statement comes with reinforcement from conversations with actuaries (let me clarify–these are people who actually designed these things) that in some cases, shadow accounts assumed yields were creeping up into the double digits (sounds like 1980's current assumption universal life fun!).
Needless to say, bad assumptions were made about what realistically was going to be handed over by the policy holder and what the insurance company was going to earn on it. And for the most part, they knew it.
The whole AG 38 adjusting reserve requirements debacle is not something that someone suddenly noticed last year. The Society of Actuaries and the National Association of Insurance Commissioners' Life Actuary Task Force has public discussions going back to the early half of the last decade about the inadequate reserving practices of universal life contracts issued with secondary guarantees.
So What Happened?
As is usual in the United States bureaucracy got in the way. It took a while, but the beginning came when the NAIC drafted and adopted new reserving guidelines under Regulation 30 (you'll see referenced most often, and through the rest of this article as Reg XXX).
Among several things, Reg XXX spoke to reserving requirements of level premium life insurance products, and had a specific impact on products less well known for reserving requirements (level term and guaranteed universal life insurance).
Now, to be clear, Reg XXX's initial adoption came at a time prior to a lot of the buzz regarding guaranteed universal life reserving adequacy, but it certainly called it deeper into question.
The NAIC followed up with Actuarial Guideline 38 (AG 38), which further explained reserving requirements for guaranteed universal life insurance. For a while, many insurers, who did not keep the money on hand to cover reserves, met their requirements through letters of credit, which is simply a deal with a lending institution (think bank) to access a line of credit at your discretion (much like home equity lines of credit work only without so much pledging of collateral).
This seemed okay, until 2008 rolled around and this little event took place where several banks failed and were becoming more and more insolvent by the day, forced the banking industry to freeze much of the liquidity market and basically tell the life insurers they needed to look elsewhere when their LOC's were up for renewal.
2012 Adopted Revisions
After further squawking, the NAIC adopted revisions to AG 38 that further stipulated more stringent reserving requirements on level premium life insurance contracts. The biggest impact was on level term insurance beyond 10 years and guaranteed universal life insurance.
As a result of this adoption, we've seen several carriers decide to close or suspend indefinitely their 30 year level term products, and an industry wide price increase to guaranteed universal life insurance premiums.
It's hard to say if AG 38's newest set of guidelines solves the reserving questions raised by many. We do know that many life insurers have realized lapse rates on their guaranteed universal life insurance contracts that are much lower than anticipated (that's a problem) as it turns out that not only do people not tend to pay you more than they have to for what equates to little more than term life insurance, they also tend not to let it go if you let them keep it at the same premium for the rest of their life.
The reserving requirements are causing frustration among insurers regarding the tie up of money. And the new pricing necessitated by higher reserve requirements has certainly caused a lot of frustration among agents (ah shucks…).
But all is not lost for those who like to live life by the seat of their pants, last year the NAIC approved the Principal Based Reserves (PBR) Handbook, which could reduce the reserving requirements for all products including guaranteed universal life insurance.
We do know that AG 38 is here to stay, and I have a sneaking suspicion that barring an adoption of PBR its existence might profoundly effect the survival prospects of guaranteed universal life insurance.