In 2015, the National Association of Insurance Commissioners's (NAIC) Life Actuarial Task Force (LATF) codified new rules for life insurance illustrations with indexing features. Actuarial Guideline 49 (AG49) placed certain restrictions on interest rate assumptions companies can make when projecting policy values inside their indexed universal life insurance policies (or any life insurance policy that has an indexing feature).
The major changes in 2015 prevented “backcasting” that used current index cap rates, floor rates, participation rates, and spreads plugged into historical index data to arrive at a maximum illustratable interest rate for the life insurance illustration.
The argument against this backcasting in 2015 was all of the components that affect the parameters life insurers place on index accounts (i.e. cap rates, floor rates, participation rates, and spreads) are specific to the economic circumstances at that time. It was therefore unfair to take current parameters and pretend like they would be the same each and every single year for 30 or so years prior.
AG49 more closely tied index interest rate assumptions to the investment results life insurers actually achieve on the assets held in the General Account. The regulation did leave a contingency for the enhanced returns achievable through the hedging strategy used to produce the actual index credit.
Additionally, AG49 significantly reduced the spread life insurers assumed between policy loan interest rates and the index credit achieved through so-called “arbitrage” loans, which are non-direct recognition-like loans for indexed universal life insurance policies.
Not surprisingly, these changes to illustration rules greatly subdued the projected values produced in indexed universal life insurance sales illustrations. But life insurers are crafty and they came up with a way to–sort of–get around the new rules.
Index Credit Enhancements
While features that pay bonus interest to universal life insurance are far from a new innovation, several life insurers focused on the sale of indexed universal life insurance continue to roll out more substantial bonuses almost by the day.
The bonuses became so prevalent they appear to now have their own special colloquialism, interest credit enhancements or ICE's.
The concept is fairly universal, but the precise functionality varies quite considerably across life insurers. Some entail fairly straightforward calculations that enhance policy performance while some use obtuse language an appear nearly impossible to reconcile.
Regardless the approach, the universal truism concerning ICE's is their purported ability to augment returns people realize on their life insurance policy cash value.
This is great in many respects, but it comes with a subtle consequence to indexed universal life insurance illustrations that might leave expectations a tad inflated.
AG49 predates the prominent use of index credit enhancements, so there's very little guidance regarding their proper use in terms of projecting cash values in a sales illustrations. Perhaps not surprisingly, several life insurers use liberal interpretations of the rules vis-à-vis ICE's and AG49 that put the indexed life product in the best possible light. In other words, ICE's became a way around the restrictions AG49 put in place to subdue projected values.
Specialized Uncapped Indices
Index life insurance products follow an index (usually a stock index, but indices can include other securities like bonds) to arrive at an interest payment made on the policy's cash value. Traditionally, these index options include the following four features:
- Cap Rate: The maximum interest payment the insurer will make in a given period of time regardless of the index performance
- Floor Rate: The minimum guaranteed amount of interest paid on the cash value in a given time (usually 0, but in some cases 1%).
- Participation Rate: This is an adjustment expressed as a percentage of the index appreciation within the time period. So if the participation rate is 70% and the index is up 10%, then the interest paid is 7%.
- Spread: This is an additional adjustment usually expressed in basis points or as a percentage adjustment. If, for example, the spread is 4%, and the index is up 10% for the time period, then the interest payment to policy cash value is 6%.
Traditionally indexed universal life insurance policies didn't focus much on participation rates and spreads (i.e. the participation rates were often 100% and spreads zero). This left cap rates the most important consideration and biggest variable among insurance options.
After the implementation of AG49 a lot of insurers rolled out ever more clever index options to help max out illustratable interest. While the index might not perform as well in practice as the allowable interest rate suggests, it helped companies project higher cash values versus their competitors.
Forthcoming Amendments to AG49 to Address Loopholes
Just a few days ago, the NAIC's LATF convened to address several topics in a regularly scheduled meeting. Among the topics for discussion was amending AG49 to address the use of index credit enhancements as well as unique indexing options that exist largely to bump max allowable illustrated interest rate.
The proposed amendments appear to eliminate illustrating interest enhancement credits altogether and will place greater restrictions on max allowable interest on indices without cap rates that some criticize as a tool to boost interest rate assumptions in illustrations.
Additionally, the amendments seek to clear up confusion that currently exists concerning the 100 basis point spread rule regarding arbitrage loans originally established by AG49.
The 100 basis point rule eliminated the ability to assume a loan spread that is higher than 100 basis points. A loan spread is the difference between the loan interest rate and the assumed interest generated by the indexing feature of the policy.
For example, if you assumed your indexed universal life insurance policy would produce a 6.5% interest rate year-over-year on a policy that assumed a 4% loan interest rate, AG49 required any arbitrage loans illustrated to adjust the interest assumption down to 5% at a maximum in years that policy loans were outstanding.
With the development and prevalence of interest credit enhancements, confusion existed regarding if that 100 basis point maximum was inclusive of the ICE bonus or any other bonus paid if applicable. The new amendments clear up the confusion by establishing that the 100 basis point rule is the net allowable spread in an illustration.
New Rules Likely Apply to In Force Business
Originally AG49 illustration rules applied to future and in force life insurance policies. The implication is that in force illustrations are subject to a new set of rules that didn't exist when the policy was originally purchased. This means that in force illustrations can no longer make assumptions at the same level the original illustration did.
This face might cause some confusion and/or concern among policyholders when/if they request an in force illustration and discover that the projected values now differ from what they saw originally. This change isn't due to anything structural to the policy, but due to new regulations that subdue projected policy values. This can be especially problematic for agents who opted to use default maximum illustrated rates when selling indexed universal life insurance.
Illustration Rules do not Affect Actual Policy Performance
It's extremely important to understand that while these rules reduce the projected values produced by a life insurance company illustration, they do not affect the actual policies ability to produce benefits.
This means that indexed universal life insurance policies could very well perform better than illustrated, but that showing that scenarios isn't permissible due to AG49 changes.
Final Thoughts
Indexed universal life insurance entails a degree of complexity due to its wide variability in terms of results. Because the indexing feature creates varied interest earnings and because the sequence of those interest payments matters a lot over time, agents owe their clients a higher level of care to make reasonable projections of policy values.
Regretfully, the implications of the above paragraph often goes beyond the skill level of a large population of the agent salesforce and many policy sales hinge on questionable assumptions. This is why we have an AG49 in the first place.
Clearing up the confusion on the 100 basis point rule is good for business. The spirit of the rule was to address a very unrealistic scenario regarding massive spreads between what policyholders paid insurers in loan interest and what they earned on cash value backing those loans. The mathematical implications of those assumptions were often way beyond the grasp of the people selling and buying the product.
Eliminating interest credit enhancements likely puts indexed universal life insurance at an unfair disadvantage when it comes to projected policy values versus alternative life insurance policies. Because some of the ICE features use more complicated calculations, it will be difficult to truly understand the net benefit from the feature.
Addressing index options that exist more or less to allow insurers to illustrate higher interest rates is long overdue. It's a problem that predates the establishment of AG49. But I believe it's a rather complex element to index universal life insurance that is extremely difficult to solve merely through regulation.
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