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:
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:
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.