On the one hand, agents and marketing organizations that favor these policies claim that they can unlock access to high market-driven returns without exposing the policyholder to losses associated with the stock market during a correction, recession, or depression.
Opponents alternatively claim that these products leave too much to the whim of the insurance company to manipulate in its favor. To stack the tire against the unsuspecting buyer who simply has to accept changes handed out by the life insurance company. The indexing function, and more specifically its roof speed aspect, drives the idea of this argument. The same crowd also tends to use historical stains in the universal life insurance register to further question the viability of the product. <! – ->
We wanted to evaluate the impact of downward changes on failure. the probability of indexed universal life insurance, so we started running a product through a series of stress tests to determine where – if ever – it breaks down.
Specifying Appropriate Indexing Assumptions for Indexed Universal Life Insurance
Much debate has taken place over the last decade about the appropriateness of various assumptions used to project IUF cash values. The industry initially left insurers a lot of room to self-regulate and set parameters for a reasonable forecast. This led, not surprisingly, to some cases of high cash accumulation forecasts. Although incredibly optimistic, insurers argued that these projections were substantiated by historical backcasting – simply the process of putting an index account floor and ceiling rates over several previous years' actual market returns to calculate an average result used as a variable when calculating future values. .
We argued against this approach for a number of reasons, but the main reason was that it was too easy to arrive at a coefficient that was used to make projections. Unfortunately, the industry committed largely the same intellectual dishonesty as the investment industry when they claimed the results of an arithmetic mean calculation could serve as an exact way to project results for a geometric means scenario. <! – ->
We developed our own process to reach what we considered to be reasonable expectations when we speculated about future IUF values and talked about it several times on this blog. We continue to use this method today when we present and analyze indexed universal life insurance policies.
We started our analysis with a normal IUF policy designed with a minimal unmodified capital agreement. death benefit, using an increasing death benefit, and qualifies as life insurance according to the guideline premium test.
Our current methodology states that the specific product in question should reasonably take a 5% average indexing credit. As you would expect, with the 5% assumption, policy values grow well over time and eventually come to something close to 5% composition per year.
Losing assumption to 3%
Let me start by saying that the circumstances that justify us assuming that the same indexed universal life policy will only ever achieve an average indexation credit of 3% are quite drastic. But since we want to evaluate how things develop in much more serious circumstances, it makes sense to run this scenario. This is what it looks like:
Despite this drastic decline in policy performance, we do not realize a catastrophic failure in politics. Of course, the policyholder would have been much happier if the insurance had been taken out with a higher average assumed index credit, the important thing is that we do not experience direct failure.
Reducing the assumption to 1%
If we lose the assumed indexing credit to 1%, which happens to be the absolute minimum guarantee for this product, the policy will eventually become fair. Errors mean that insurance costs will cause the cash value to drop to zero and that a maturity occurs before the age of 121. So if we really assumed that the product would never perform higher than the guaranteed interest rate of 1%, we are on our way to a conclusion about early political dismissal due to catastrophic failure. The policyholder would lose all his contributions and had no death benefit left at that time.
More realistic stress test scenario
About 1% was the assumption we planned to change the interest rate on an IUF policy in all years I would argue that we would best look elsewhere for a place to save money. The good news is that we're skipping this option before we go into it. But what happens if things change? <! – ->
What if the IUF looks good today, but conditions are deteriorating for it? It's a very scary scenario and probably one that has a lot more interest in a larger number of people. To model this situation, I took the same illustration and assumed the following:
- 5% per year index credit until year 20
- 1% per year index credit in all years 21+
This method models the possibility that while indexed universal life insurance looks good today, circumstances may change in the future. If circumstances change, how much trouble will the policyholder end up in?
An important attribute of universal life insurance is its flexibility / adjustability. We can change many aspects of the policy to meet current and changing needs. The policy definitely needs to be adjusted if such a scenario emerges where, in the next few years, it can no longer pay interest on the cash value higher than its contractual guarantee. But can we make these adjustments and keep the policy in place. The answer turns out to be yes:
As shown here, when the assumed accumulation rate decreases, the return on cash value also decreases. Despite deteriorating to an index credit of 1%, the policyholder always achieves slightly higher than 1% compound year after year after the decline. But the second important step here is a reduction in the death benefit.
Reducing the death benefit on a universal life insurance is an advanced policy maneuver that preserves the cash value due to lower insurance costs. The move requires an in-depth understanding of the life insurance rules because we do not want to break the 7702 test that qualified the contract as life insurance. You will notice in the general ledger that from year 33 onwards 47 money will come out of the policy. This is a challenge that is required to prevent the policy from violating the 7702 test. In practice, the way I would really handle the reduction of death benefits is different from how I handled this. I would take much more time to make step-by-step reductions that greatly minimized or eliminated the power. It takes a long time to sort out and so much more time than I am willing to spend on a blog post that I have made available to the public for free. The important lesson here is that this move is possible with the asterisk point that we actually use a much higher level of care and precision when we perform it.
There are two important observations derived from this.
First, the policy does not fail. Although it produces much less cash than originally assumed, it does not fail. This speaks to the resilience of universal life insurance. It's not as fragile as some people would like to suggest. It is now possible that insurance costs can be adjusted upwards and this would increase the risk of insurance failure. I can not model a cost for the insurance increase, so I can not say what impact it has. I am willing to bet that the policy will fail at maximum contractual cost. But we must also understand that either a reduction in the ceiling interest rates, we assume such an interest rate or an increase in the insurance costs only after serious macroeconomic shifts that force the insurance company's hand. These are not arbitrary decisions. <! – ->
Second, note that during the year 20, the policy achieved almost 4% annual return on cash value per premium amount 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, so maybe in the end it is not the case. If the policy mechanics are changed so that the new assumed interest credit becomes 1%, we must look at all the alternatives on the table. That includes moving on to another plan with that money. The good news is that we achieved a positive return and protected ourselves against the risk of significant loss over the past 20 years. We now have about three quarters of a million dollars that we can take elsewhere and benefit from the accumulation of this wealth. The IUF policy may not have worked quite as planned, but it is not a complete loss and it worked as planned up to this point.
IUU is safe and versatile
The core here is the indexed universal life insurance is a safe place to store cash and provides versatility to handle a number of changing situations. The product is not a fragile insurance product that is ripe for losses due to arbitrary changes made to maximize the insurance company's profits. In addition, the IUF can withstand a number of strains that many suggest would lead to painful losses for policyholders.