Stress Testing Indexed Universal Life Insurance

Indexed universal life insurance policies use a stock market index to set the interest payable on the policy's cash value.  This feature has a limit (the industry official calls it a cap) above which the market index returns will not affect the interest payable by the insurance company.  This indexing feature plays a crucial role in many arguments for and againts IUL policies.

On the one side, agents and marketing organizations that that favor these policies claim that they can unlock access to high market-driven returns without subjecting the policy owner to losses associated with the stock market during a correction, recession, or depression.

Detractors argue alternatively that these products leave too much to the whim of the insurance company to manipulate in its favor.  Stacking the deck against the unsuspecting buyer who must simply accept changes doled out by the life insurance company.  The indexing feature, and more specifically its cap rate aspect, fuel the fire of this argument.  This same crowd also tends to use historical blemishes in universal life insurance record to further cast doubt on the viability of the product.

We wanted to evaluate the impact downward changes have on the failure likelihood of indexed universal life insurance, so we set out to run a product through an array of stress tests to determine where–if ever–it falls apart.

Setting Appropriate Indexing Assumptions for Indexed Universal Life Insurance

Much debate took place over the past decade regarding the appropriateness of various assumptions used to project IUL cash values.  The industry originally left insurers much latitude to self-regulate and set the parameters for reasonable forecasting.  This, not surprisingly, led to some instances of lofty cash accumulation projections.  Though incredibly optimistic, insurers argued that these projections had substantiation from historical backcasting–simply the process of laying an indexing account's floor and cap rates over several previous years' actual market returns to compute an average result used as the ley variable in calculating future values.

We argued against this approach for a number of reasons, but the key reason was that it too simplistically arrived at a coefficient used for making projections.  Sadly, the industry was largely committing the same intellectual dishonesty as the investment industry when claiming the results of an arithmetic mean calculation could serve as an accurate way to project results for a geometric mean scenario.

We developed our own process for arriving at what we felt were reasonable expectations when speculating future IUL values and talked about it numerous times on this blog.  We continue to use this methodology today when presenting and analyzing indexed universal life insurance policies.

We started our analysis with a normal IUL policy designed with a minimum non-modified endowment contract death benefit, using an increasing death benefit, and qualifying as life insurance under the guideline premium test.

Our current methodology says that the specific product in question should reasonably assume a 5% average indexing credit.  As you'd expect, using that 5% assumption, the policy's values grow just fine over time eventually coming to something close to 5% compounding per year.

Dropping the Assumption to 3%

Let me start by saying that the circumstances that warrant we assume this same indexed universal life policy will only ever achieve an average indexing credit of 3% are quite drastic.  But, since we are looking to evaluate how things unfold under much more dire circumstances, it makes perfect sense to run this scenario.  Here is what it looks like:

IUL Lower Cap Rate IUL lower interest assumption Indexed Universal Life Insurance Lower Cap Rate

Despite this drastic reduction in policy performance, we do not realize a catastrophic failure of the policy.  Sure the policyholder would have been much happier had the policy performed at a higher average assumed indexing credit, the important take away is that we do not experience outright failure.

Reducing the Assumption to 1%

If we drop the assumed indexing credit to 1%, which happens to be this product's absolute minimum guarantee, the policy will eventually fair.  Failure means that the policy expenses will cause cash value to drop to zero and a lapse occurs prior to age 121.  So if we truly assumed that the product would never perform higher than its guaranteed 1% interest rate, we are headed to a conclusion of premature policy termination due to catastrophic failure.  The policyholder would lose all his money contributed and have no death benefit remaining at this point.

More Realistic Stress Test Scenario

If 1% were the assumption we planned to make about the interest rate on an IUL policy in all years, I'd argue that we'd best look elsewhere for a place to save our money.  The good news is, we'd know to skip this option before getting into it.  But what happens if things change?

What if IUL looks good today, but conditions worsen for it?  That's a much scarier scenario and probably one that holds a lot more interest to a greater number of people.  To model this situation, I took the same illustration and assumed the following:

  • 5% per year index credit up to year 20
  • 1% per year index credit in all years 21+

This approach models the possibility that while indexed universal life insurance looks good today, circumstances might change in the future.  If circumstances do change, how much trouble will the policyholder find himself in?

One key attribute to universal life insurance is its flexibility/adjustability.  We can alter a great many aspects of the policy to accommodate current and changing needs.  The policy definitely needs an adjustment if such a scenario plays out where some years into the future it can no longer pay interest on cash value higher than its contractual guarantee.  But can we make those adjustments and keep the policy in force.  The answer, it turns out, is yes:

IUL Guaranteed Interest Rate IUL Guaranteed Assumption Index Universal Life Insurance Guaranteed Accumulation

As seen here, once the assumed accumulation rate drops, the rate of return on cash value also declines.  Despite dropping to a 1% index credit, the policyholder always accomplishes something higher than 1% compounding year over year after the decline.  But the other important move here is a reduction in the death benefit.

Reducing the death benefit on a universal life insurance policy is an advanced policy maneuver that preserves cash value due to lower insurance expenses.  The move requires an advanced understanding of life insurance regulations because we do not want to violate the 7702 Test that qualified the contract as life insurance.  You'll notice in the ledger that starting in year 33 and continuing through year 47, money comes out of the policy.  This is a force-out required in order to keep the policy from violating the 7702 Test.  Now, practically speaking, the way I'd really handle the death benefit reduction is different from how I handled it here.  I'd take much more time to make incremental reductions that greatly minimized or eliminated the force out.  That takes considerable time to sort out and so much more time than I'm willing to dedicate to a blog post I made available for free to the public.  The important lesson here is that this move is possible with the asterisk point that in real life, we use a much higher level of care and precision when executing it.

There are two important observations that come from this.

First, the policy does not fail.  While it produces far less cash than originally assumed, it does not fail.  This speaks to universal life insurance's resiliency.  It's not as fragile as some people like to suggest.  Now it is possible that insurance expenses could be adjusted upward and that would greatly increase the risk of policy failure.  I can't model a cost of insurance increase so I cannot say what the impact ultimately is.  I'm willing to bet that at the maximum contractual expense, the policy fails.  But we have to also understand that either a reduction in cap rates such we assume such an interest rate or an increase in policy expenses comes only after serious macro-economic shifts that force the insurance company's hand.  These are not arbitrary decisions.

Second, note that in year 20, the policy achieved nearly a 4% annually compounding rate of return on cash value per the amount of premium paid to that point.  This is a reasonably good result for a savings vehicle with such a low risk profile.  As much as we like to think that the decision to buy such a life insurance is a lifetime partnership, that may not ultimately be the case.  If the policy mechanics change such that the new assumed interest credit will be 1%, we have to look at all options on the table.  That includes moving on to a different plan with this money.  The good news is, we achieved a positive rate of return and shielded ourselves from the risk of significant loss in the last 20 years.  We now have roughly three-quarters of a million dollars that we can take somewhere else and benefit from the accumulation of this wealth.  The IUL policy maybe didn't work out entirely as planned, but it's not a complete loss and it worked out as planned up to this point.

IUL is Safe and Versatile

The bottom line here is that indexed universal life insurance policies are a safe place to store cash and provide versatility to handle a number of changing situations.  The product is not a fragile insurance product ripe for losses due to arbitrary changes made to maximize insurance company profits.  What's more, IUL can withstand a number of stresses that many people suggest would result in painful losses for policyholders.

10 thoughts on “Stress Testing Indexed Universal Life Insurance”

  1. This does show you can keep IULs in force despite low crediting. It’s a fairly robust product.

    It also shows it takes a lot of work to keep it in force (changing the death benefit, draining cash value out of it, and actively monitoring it each year to optimize results), and the force-out on the cash value drains the policy considerably.

    In your podcast on this subject, you say it’s just a different way to accumulate cash value in a life insurance policy.

    This seems to suggest that IUL does in fact involve more risk than whole life and it’s not “just another method”.

    That risk can be managed, but there are also more moving parts, it requires more “babysitting”, and things can backslide quite a bit.

    If returns are *substantially* higher than whole life, I can see how that added risk might be worth it. If returns are comparable to whole life, I don’t see the benefit of the added risk. I just see more risk for similar results.

    • In my experience, if people buy any cash value product intentionally for its cash value there is risk in the sense of managing it–there’s even risk when they don’t buy it for that purpose. I’ve heard from many people over the years who bought a whole life policy, took a loan (small loan usually), and then found out years later that due to accumulated interest their policy was about to lapse. I’d argue it’s their fault. But the product does allow this to happen nevertheless.

      • The issue isn’t risk. The issue is the type and amount of risk. There is clearly more risk associated with all ULs compared to term or whole life.

        The type of risk is different as well. The thing that powers whole life is income producing assets. And while there is an element of this in IUL in the sense that it’s a general account product, what “powers” IUL are bets place on a stock index through the use of embedded call options. The bet is that call spreads will be profitable.

        This is fundamentally different from the assumptions of whole life. My point here isn’t necessarily to argue in favor of WL over IUL, but to point out that we are talking about different types of risk. And it’s not *just* that they are different. There is measurably more risk in an IUL than other fixed products. These are not “just different products that do about the same thing”.

        • No, the “thing” that powers whole life is the dividend which is the return of your own money was taken from you in excess of what was needed to fund the policy. I am constantly amazed how you whole lifers think. It is if someone stole your wallet and gave it back, you would say you made a profit. Whole life is a joke.

          • David doesn’t really need me to defend him, but I’m going to address this because your wallet analogy is the epitome of the lazy-thinking that goes into much that has negatively been said about life insurance. If you gave your wallet to someone and they gave it back to you with more money than was in it when you gave it to them that would more correctly identify the spirit of whole life insurance.

  2. You mention in your post that 3% crediting is “quite drastic” as an assumption and assume IUL will return higher. You don’t explicitly disclose your methodology for this assumption, but I assume there is some sort of calculation in there.

    It seems like 3% isn’t really *that* drastic for these policies.

    2-3% is exactly where current index options budgets are. This is the “base case” scenario for IUL.

    Every year where returns are assumed to be above the current options budget, there is an implicit assumption of an options profit, usually between 30-50%. What justifies ongoing profits on index call options? These are traditionally hedging products not known for producing consistent profits that accrue to buyers.

    Each year, IUL policyholders are gambling on the outcome of those underlying options contracts, hoping for profitability on the index crediting strategy.

    I’m not saying it can’t work. I am saying the odds are against systematic profits on such a strategy. It could work for periods of time, for example (a decade even). But seems unlikely as a long-term strategy lasting 30-50 years given the inherent nature of options contracts.

    I’ve never seen any convincing evidence that systematically buying call spreads results in reliable profits. The “realistic assumption” for IUL seems to be the guaranteed rate or a return equal to the options budget. Anything over that is “gravy”.

    Do you have evidence showing what kind long term options profitability a policyholder can reasonably expect?

    • I feel like your argument here requires several manufactured negative realities to support your main thesis, which was primarily to take issue with an off-handed comment I made likening IUL simply as an alternative way to accumulate cash value in a whole life policy. I used to build complicated models to justify my thoughts, too. Then I realized that for the most part it rarely mattered.

      Yes, there is a basis for my statement that a reduction to a 3% index credit would require a drastic move for this IUL product. I’m weighing how and where I want to roll out that specific discussion.

  3. Is this a max funded option B increasing Death Benefit IUL with a 0 floor and 10% cap that you are reviewing that take the dividend from the general fund and buys a 12 month point to point call option in the S&P 500 to credit the interest to the cash value as your example. If not could you research create an example following this structure as it is the best way to save money for tax free retirement income and is the best way to structure an IUL for cash value creation.

    • Hi Michael, I’m not completely following you on everything here. There is no dividend with IUL.

      I’m also not really sure what you are asking with your last sentence.


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