Back in July of this year, Forbes published an article that sought to “Sound the Alarm on Indexed Universal Life Insurance.” Here's the article if you wish to reference it. The article, like all the others that came before it, makes multiple misstatements and peddles a lot of half-truths about universal life insurance. We're going to address the accuracy of the author's claims, which are largely false.
Indexed Universal Life Insurance is the Industry's Most Profitable Product
Right off the bat, the article claims that indexed universal life insurance (IUL) has been one of the life insurance industry's most profitable products. It doesn't provide a source for this claim. I'm pretty well versed in life insurance sales data and I don't know that I would make this claim. I know that IUL is often reported as being one of–if not the–fastest growing life insurance products as expressed by premiums written. But we showed over two years ago this data might overstate the success of IUL while discounting the fact that it's substituting what had formerly been regular universal life insurance sales.
Complexity and Obfuscation through Exotic Indicies
Indexed universal life insurance pays an interest rate on cash value determined by the movement in an index. This is often an index like the S&P500 Value Index. But some insurance companies have introduced alternative indices to follow in an attempt to bring diverse options to market. The article attempts to paint this practice as bad because unwitting consumers may be placing their policies' money into more “esoteric” options like “the Heng Seng, Gold, and Emerging Markets.”
I've known about the Heng Seng since I was roughly 14 years old. It's a major Asian market and is often followed by investors to gauge the health of the global economy. There's nothing esoteric about it. Gold and Emerging Markets are also market categories I wouldn't identify as esoteric. I don't know exactly how many IUL products make non-S&P 500 indices available, but I do know it's a few. I've seen some people do really well with these non-S&P500 indices so I'm not sure where the problem is. I think this is more about stating something that might sound bad and hoping no one will make you explain why it's bad, because ultimately it's not.
IUL Lets you Play the Options Market?
A long-standing fear tactic used against indexed insurance products focuses on the use of options (e.g. puts and calls) to create the interest payable on these products. As a general rule, the investment industry views trading options as risky. This can be true in the case of buying options contracts instead of stocks in the hopes that the movement in a stock would create a return in the options contract magnified vs. the return achieved by owning the stock. The ultimate downside is that the options contract expires before the movement you were hoping for materializes. This results in a 100% loss.
But trading options involves more strategies than simply buying the put or call and hoping the move happens before the contract expiry date. Many people use options to hedge risk. In fact, it's the original intention of options contracts. There are many ways to use options as a hedge for your specific stock strategy, and there are multiple ways professional investors employ options to mitigate the risk of loss in a portfolio–this is precisely what life insurers are doing.
The article makes this completely erroneous claim:
“These policies are sold by insurance agents as an indirect way to play the options market.”
I've never met an insurance agent, marketing organization, or insurance company that portrayed indexed universal life insurance as a way to play the options market. In fact, I've met quite a few agents who didn't even understand that options were part of the investment strategy that created the features of IUL.
But further, the options strategy employed by insurers with indexed insurance products is far from “playing the options market.” Insurers are prohibited by law from using general account assets (the money held inside your life insurance policy) for speculative investments. Options are only allowed when they specifically hedge against something. This is also why insurers do not make money off the difference between the appreciation in the underlying index and the effective cap rate.
Further showing the author's confusion on the subject, he makes this claim:
“Options allow the holder to buy or sell the underlying index at a certain price at a certain time, which can rise or fall rapidly. If an option is exercised “in the money,” the payoff can be significant. But if the option expires “out of the money,” the entire investment in that option is lost. And this is why IUL is a riskier investment than traditional insurance. Critics say that risk is not properly disclosed and is borne by the policyholder.”
Again, people who own IUL policies do not own any options. The insurer uses options to create the necessary strategy that affords the interest payment on cash value. If the underlying index is negative or flat the options strategy will expire with zero value. This is why indexed universal life insurance can have years where the policyholder earns no interest. But this doesn't result in a loss of cash value in the policy due to the insurer losing the money spent on options. Nor is the insurer using a large percentage of the policyholder's cash value or premium to buy options. It represents, on average, somewhere around 3-5% of the premiums paid by the policyholders.
Indexed Life Insurance is Somehow More Expensive?
The article claims:
“To afford the budget for the money management involved in options trading and compensate the insurer and its agent, IUL policies can include significantly more fees and costs than an average life insurance policy. One insurer charges upwards of 8% of the premiums and cash value in the policy in the first year alone, according to Steven Roth, president of Wealth Management International, an insurance analyst and litigation consultant. That’s more than most hedge funds.”
This is another claim made with zero evidence to support it. Is indexed universal life insurance more expensive than an average life insurance policy? I've never seen any evidence to suggest it is. In fact, the data I've looked at would suggest the exact opposite.
Regarding the 8% figure. I don't know what this is based on and I'm not sure why–assuming the author felt the evidence he collected was sufficient–he wouldn't specifically name the company/product as an example. This sounds a lot like hearsay to me. And as far as comparing the expenses to a hedge fund goes, it's life insurance. If the insured dies shortly after opening the policy, the life insurance company owes his/her beneficiary a lot more money than it ever received. Of course, there is a cost for that.
Fees, Fees, and More Fees…
Stop me if you've heard this one before…
But apparently indexed universal life insurance has fees 😮
According to the article:
“These fees threaten to drain your policy’s cash value during adverse periods when the market—or whatever index the policy is tied to—plunges. If internal costs cause the policy account value to drop too much, your policy is at risk of lapsing and you’ll have to pay more in premiums just to keep the policy intact.”
While this is mostly factually correct, it's extremely out of practical context. Yes, a zero crediting year could result in policy fees deducting from the cash value and resulting in a net loss year-over-year. The chances that this loss will be significant are very small in most cases. If sustained for a long time, it's also possible that the policyholder would need to pay additional premiums into the policy to keep it, but we're talking about a scenario that has never occurred–sustained market declines spanning 5-10 years.
In fact, the amazing thing about indexed universal life is that it can benefit greatly from a sharp decline in the stock market. The magnitude of a bad market year is inconsequential to IUL. Most products tend to earn zero interest when the index they follow is down. It doesn't matter how much it falls. But when markets fall–especially a lot–they tend to move in the opposite direction in a reasonably large fashion. For example, when the market fell by 38.49% in 2008, it also rallied back in 2009 by 23.45%. In practice, this means the IUL policyholder had a zero year in 2008 and an incredible interest payment in 2009.
The article also casually references a policy example provided by an interviewed expert where the policyholder could pay $367,000 over six years and allegedly have no cash value. The author, however, failed to provide any specific evidence about this supposed policy so what could have been a great opportunity to help steer people away from a bad policy was squandered by poor reporting. I really wish he had specifically named the company/product and provided a ledger. Too bad.
These Policies are Complicated
The article wraps with examples that seek to paint indexed universal life insurance as an overly complicated product. The article quotes the director of a consumer protection agency noting:
“So, it’s no wonder that IULs are complicated. Birnbaum’s Center for Economic Justice obtained a Pacific Life policy that includes 72 pages of legal jargon and many different profit projections—referred to as “illustrations”—making it difficult for the buyer, or even the insurance agent, to understand. Pacific Life did not respond to repeated calls and emails.”
I wonder how much time the Center for Economic Justice has spent lobbying for more disclosure of insurance product details. This seems like a duplicitous argument. On the one hand, insurers don't disclose enough. But when they do attempt to provide us with all the details we ask for, we complain that it's too complicated.
There's also a reference to premium financing IUL policies that suggest this is being recommended to just anyone. That's certainly not the case. In either event, we've made our feelings known about premium financing IUL in an attempt to build cash value.
There's also a reference to one of the interviewed expert's involvement in lawsuits against life insurers for over-complicated billing practices. The author doesn't provide specific cases, but I was able to unearth what is probably the main lawsuit mentioned. It's a case that doesn't involve indexed universal life insurance specifically, but rather universal life insurance in general. It's also a case that only exists because the state of California changed laws in 2013 and the plaintiff is claiming Prudential failed to comply with the new laws.
I'm not going to tell you bad things cannot and have not happened involving indexed universal life insurance–or any other life insurance product. There are examples of dishonest and incompetent agents who harm unwitting consumers. That story is not unique to the insurance industry.
But the sensationalism found in this article is a bit much. If this product was the monster it's portrayed as there ought to be a lot more blood in the streets. The fact simply is this terror doesn't exist.
The author expended a lot of energy telling us why maybe–if we suspend all critical cynicism–bad things might happen. But it failed to provide any specific catastrophic problem where people actually got hurt. If this product is the sales superstar the author started out claiming it is, we have to expect that ownership of IUL is, at the very least, in the tens of thousands–if not more like the hundreds of thousands. If this is true, and if we truly believe there is danger lurking. The 20-ish year timespan this product has existed should have produced ample evidence of its harmful impact on the people who bought it. But no such evidence exists.