Indexed Universal Life (IUL) Considerations
The following are common considerations when purchasing an IUL policy:
1. Index crediting levers may not be guaranteed.
2. Index returns do not include dividends.
3. Underlying IUL insurance charges may be higher than traditional UL.
4. Required rate of return on index call option package – aggressive or sustainable?
5. Comparing historical IUL crediting rates to a traditional UL current crediting rate offered today may not be appropriate.
6. What is an appropriate IUL crediting rate assumption?
Index Crediting Levers May Not be Guaranteed - It is true that the current cap and participation rates may not
be guaranteed and therefore may be changed by the insurer at the end of each segment term. However, both are
also subject to a guaranteed minimum. As an example, the current cap may be 12% with a guaranteed minimum of
3%, and the current participation rate may be 110% with a guaranteed minimum of 100%. Most IUL products with
current cap rates that are not guaranteed provide a current participation rate of 100% that is guaranteed. If an IUL
product does not contain a cap, then the current participation rate is typically not guaranteed. The current floor is typically guaranteed. As an example, the floor is 0% on a current and guaranteed basis. Both current and guaranteed index levers should be noted and considered when reviewing and comparing IUL products. However, the non-guaranteed nature of IUL crediting levers should be put in perspective. Traditional UL current crediting rates and whole life (WL) dividend interest rates are also not guaranteed and subject to a guaranteed minimum. As an example, traditional UL current crediting rates today typically range from 4%-5% with a guaranteed minimum crediting rate in the range of 2%-3%. Some current UL crediting rates may be guaranteed for one year but otherwise current rates may be changed by the insurer at any time. UL crediting rates and WL dividend rates are supported by a portfolio of bonds and mortgages; therefore, as interest rates have declined over the past 25+ years so have UL and WL rates. This same dynamic will also impact IUL crediting levers where a decrease in interest rates may reduce the cap or participation rate as more funds are needed to support the floor. This leaves less funds to purchase the index call options (and vice versa if interest rates increase).
The other dynamic with the pricing of IUL crediting levers is the cost of call options. If the cost increases then the levers may need to be reduced (and vice versa if the call option cost decreases). The cost of index call options will rise with increased equity market volatility (and vice versa).
In summary, IUL crediting levers may indeed be non-guaranteed components. However, they are subject to guaranteed minimums and are based on disciplined pricing, which is similar to a traditional UL crediting rate and a WL dividend interest rate.
Index Returns Do Not Include Dividends - It is true that IUL index returns typically do not include dividends. This is significant as dividends have historically provided an additional 1% to 4% annual return to the S&P 500 index. The main reason for excluding dividends is that most publicly available and recognized index data is reported without dividends; therefore, the IUL index return is aligned with public data. It would be possible for insurers to price IUL index returns with dividends (a Total Return index), but the cost of the call option package would increase. Because there is disciplined pricing, the increased cost of the call option would then need to be offset with reduced index crediting levers (such as a lower cap) in order for the insurer to maintain its profit target.
Underlying IUL Insurance Charges May Be Higher Than Traditional UL - From a theoretical pricing standpoint there is no reason for IUL insurance charges to be higher than UL insurance charges. However, the reality is that many IUL products do indeed have higher insurance charges. Because the underlying pricing factors of mortality, expenses, and investment yields are very similar (if not exactly the same) between the two products, the insurance charges should also be very similar. But prospective buyers appear to focus more on the index crediting levers, which leads insurers to price with more favorable index levers (for marketing purposes) but offset with higher insurance charges. Prospective buyers should review and compare both the crediting rates and insurance charges for various IUL offerings (as seen in the illustrated values).
Required Rate of Return on Index Call Option Package – Aggressive or Sustainable? - Articles have criticized IUL by stating that aggressive index call option returns are required for the IUL crediting rate to exceed a UL 5 crediting rate. One example stated that a call option return of approximately 60% is needed to support an 8% IUL crediting rate—approximately 300 basis points (bps) higher than UL crediting rates offered today. The numbers behind this example are indeed basically correct, and therefore the required returns may appear to be aggressive and unsustainable. However, remember from earlier in this Bulletin that call options inherently provide leveraged returns. Let’s look at the numbers behind the following example:
- A conservative portfolio yield assumption of 5%
- As seen in the earlier pricing section, $4.76 will be available to purchase a package of S&P 500 call options based on a $100 net premium and a 12% cap
- An S&P 500 equity index return of 8% yields $8 (8% of 100)
- This translates into a 68% S&P 500 call option return (8 / 4.76 – 1 = 68%)
What is an Appropriate IUL Crediting Rate Assumption? - Illustration systems provide a default IUL crediting rate, which may or may not be appropriate for a crediting rate assumption. The default IUL crediting rates can vary significantly from product to product and should not be considered as similar to a UL current crediting rate. The UL 7 current crediting rate is based on the underlying general account portfolio yield comprised primarily of investment grade bonds and mortgages. The portfolio yield is relatively stable and is primarily impacted by changes in new money rates as the portfolio assets mature and new assets are purchased. IUL does not support a current crediting rate as the historical and likely future IUL crediting rates will be quite volatile due to the link to an equity index. Therefore IUL requires the potential buyer to determine an appropriate crediting rate assumption when running illustrations.
There certainly is no definitive answer for an appropriate IUL crediting rate assumption. It may be suggested that the
assumption be based on a long-term return expectation but decreased for conservatism. While historical returns are
no guarantee of future performance, they can provide a basis for developing an expected future return assumption.
Many IUL illustration systems offer hypothetical historical crediting rates based on the IUL product’s current index
crediting levers. Some insurers also offer a historical rate calculator, which provides hypothetical historical IUL
crediting rates based on user defined crediting rate levers. This allows for comparisons between different index
strategies.
For the IUL example (S&P 500 without dividends, 100% participation rate, 12% cap, 0% floor), the hypothetical 20- year historical cumulative annual crediting rate is 8.2% (October 1990 to October 2010). Some rate calculators are more thorough, providing a longer historical time period and a rolling start date by month. Confidence intervals and an average return may also be provided.
Another consideration for determining an appropriate IUL crediting rate is the current interest rate environment and expectations for the direction of future interest rates. As reviewed in the pricing section of this Bulletin, general account portfolio yields will impact index crediting levers (typically the cap rate). Portfolio yields are currently experiencing downward pressure; therefore, current index cap rates should also be exposed to downward forces. But over the long term there may be expectations for increasing interest rates as today’s rates are at historical lows. Increasing interest rates would provide upward pressure for index cap rates.
To put the possibility of a changing cap rate into perspective, below are historical hypothetical index crediting rate results based on varying cap rates. The hypothetical historical IUL crediting rates change by approximately 50 bps per 1% change in the cap rate. For the conservative buyer, funding a policy with a 6% IUL crediting rate assumption may be appropriate. A 6% crediting rate is higher than most current UL crediting rates and would appear to provide a cushion even if the cap rate is reduced to 10% based on hypothetical historical results.
20-Year Historical Hypothetical Cumulative Index Crediting Rates:
October 1990 – October 2010
S&P 500 Index (without Dividends), 0% Floor, 100% Participation Rate
As with UL and VUL, IUL requires active in-force management. Illustrated values are not guaranteed and assumptions and performance will change over time. This is particularly true for an IUL product where crediting rates will vary significantly. Policy reviews should be conducted to ensure that the policy remains on target. Inforce illustrations are critical in determining a policy’s status relative to the financial objective. Additional premium funding or a face amount reduction may be considered when actual policy performance falls behind schedule. Reducing premium funding or taking distributions may be considered when actual policy performance is ahead of schedule. A policy replacement, under certain circumstances, may also be an option.
Summary
IUL offers the potential for an enhanced crediting rate that is tied to an equity index (typically without dividends) and guarantees a minimum return. As with UL crediting rates, an IUL crediting rate is not guaranteed and will vary over time. However, IUL pricing is disciplined where the general account portfolio yield and call option pricing will determine the current crediting levers (participation rate, floor, and cap). Call options allow the insurer to transfer the equity index risk to a third party and provide leveraged returns. In many instances IUL insurance charges will be higher than UL insurance charges, and therefore IUL will require an enhanced crediting rate. Based on hypothetical historical results, IUL has provided an enhanced yield of 100 to 150 bps as compared to UL crediting rates.
A critical assumption when illustrating IUL is the crediting rate. Hypothetical historical crediting rates may be used as a basis for setting a crediting rate assumption (even though they do not provide a guarantee for future returns). Hypothetical rates calculated with current IUL crediting levers may be considered conservative as historical levers would likely have been more favorable due to higher historical general account portfolio yields. It may be suggested that a margin be deducted (such as 100 bps, at a minimum) or a 90% confidence factor be considered in order to provide a policy performance cushion.
Many valid considerations have been raised regarding IUL and they should not be ignored. IUL product education will provide the basis for a balanced review. IUL considerations should be reviewed in the context of the risk/return trade-offs and relative to the considerations of other life insurance products such as WL, UL, and VUL.
With an educated review, and a thorough assessment of objectives, it may be determined that IUL is an appropriate product choice for the life insurance buyer.
For Institutional Investor or Investment Professional use only. Article copyright 2014 by Nease, Lagana, Eden, & Culley, Inc. (NLEC). Reprinted with permission. NLEC is an independent company and not affiliated with Fidelity Investments. Listing NLEC does not suggest a recommendation or endorsement by Fidelity Investments. The information and opinions expressed in this presentation are solely those of the author and in no way represent the advice, opinions, or recommendations of Fidelity Investments or any of its affiliates. Fidelity Investments does not provide advice of any kind. There is no assurance that the information is accurate, complete or timely. You should conduct your own analysis, review and due diligence based on your specific situation. The third party products and services mentioned herein are the property of their respective owners. The information provided is general in nature and should not be considered legal or tax advice. Consult with an attorney or tax professional regarding your client's specific legal or tax situation. Fidelity Family Office Services is a division of Fidelity Brokerage Services LLC. Member NYSE, SIPC. Fidelity Family Office Services 200 Seaport Boulevard Z2N Boston, MA 02210 681585.1.0
For the IUL example (S&P 500 without dividends, 100% participation rate, 12% cap, 0% floor), the hypothetical 20- year historical cumulative annual crediting rate is 8.2% (October 1990 to October 2010). Some rate calculators are more thorough, providing a longer historical time period and a rolling start date by month. Confidence intervals and an average return may also be provided.
Another consideration for determining an appropriate IUL crediting rate is the current interest rate environment and expectations for the direction of future interest rates. As reviewed in the pricing section of this Bulletin, general account portfolio yields will impact index crediting levers (typically the cap rate). Portfolio yields are currently experiencing downward pressure; therefore, current index cap rates should also be exposed to downward forces. But over the long term there may be expectations for increasing interest rates as today’s rates are at historical lows. Increasing interest rates would provide upward pressure for index cap rates.
To put the possibility of a changing cap rate into perspective, below are historical hypothetical index crediting rate results based on varying cap rates. The hypothetical historical IUL crediting rates change by approximately 50 bps per 1% change in the cap rate. For the conservative buyer, funding a policy with a 6% IUL crediting rate assumption may be appropriate. A 6% crediting rate is higher than most current UL crediting rates and would appear to provide a cushion even if the cap rate is reduced to 10% based on hypothetical historical results.
20-Year Historical Hypothetical Cumulative Index Crediting Rates:
October 1990 – October 2010
S&P 500 Index (without Dividends), 0% Floor, 100% Participation Rate
As with UL and VUL, IUL requires active in-force management. Illustrated values are not guaranteed and assumptions and performance will change over time. This is particularly true for an IUL product where crediting rates will vary significantly. Policy reviews should be conducted to ensure that the policy remains on target. Inforce illustrations are critical in determining a policy’s status relative to the financial objective. Additional premium funding or a face amount reduction may be considered when actual policy performance falls behind schedule. Reducing premium funding or taking distributions may be considered when actual policy performance is ahead of schedule. A policy replacement, under certain circumstances, may also be an option.
Summary
IUL offers the potential for an enhanced crediting rate that is tied to an equity index (typically without dividends) and guarantees a minimum return. As with UL crediting rates, an IUL crediting rate is not guaranteed and will vary over time. However, IUL pricing is disciplined where the general account portfolio yield and call option pricing will determine the current crediting levers (participation rate, floor, and cap). Call options allow the insurer to transfer the equity index risk to a third party and provide leveraged returns. In many instances IUL insurance charges will be higher than UL insurance charges, and therefore IUL will require an enhanced crediting rate. Based on hypothetical historical results, IUL has provided an enhanced yield of 100 to 150 bps as compared to UL crediting rates.
A critical assumption when illustrating IUL is the crediting rate. Hypothetical historical crediting rates may be used as a basis for setting a crediting rate assumption (even though they do not provide a guarantee for future returns). Hypothetical rates calculated with current IUL crediting levers may be considered conservative as historical levers would likely have been more favorable due to higher historical general account portfolio yields. It may be suggested that a margin be deducted (such as 100 bps, at a minimum) or a 90% confidence factor be considered in order to provide a policy performance cushion.
Many valid considerations have been raised regarding IUL and they should not be ignored. IUL product education will provide the basis for a balanced review. IUL considerations should be reviewed in the context of the risk/return trade-offs and relative to the considerations of other life insurance products such as WL, UL, and VUL.
With an educated review, and a thorough assessment of objectives, it may be determined that IUL is an appropriate product choice for the life insurance buyer.
For Institutional Investor or Investment Professional use only. Article copyright 2014 by Nease, Lagana, Eden, & Culley, Inc. (NLEC). Reprinted with permission. NLEC is an independent company and not affiliated with Fidelity Investments. Listing NLEC does not suggest a recommendation or endorsement by Fidelity Investments. The information and opinions expressed in this presentation are solely those of the author and in no way represent the advice, opinions, or recommendations of Fidelity Investments or any of its affiliates. Fidelity Investments does not provide advice of any kind. There is no assurance that the information is accurate, complete or timely. You should conduct your own analysis, review and due diligence based on your specific situation. The third party products and services mentioned herein are the property of their respective owners. The information provided is general in nature and should not be considered legal or tax advice. Consult with an attorney or tax professional regarding your client's specific legal or tax situation. Fidelity Family Office Services is a division of Fidelity Brokerage Services LLC. Member NYSE, SIPC. Fidelity Family Office Services 200 Seaport Boulevard Z2N Boston, MA 02210 681585.1.0
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