Higher reserves for universal life insurance will make it more expensive.
As financial planning professionals, our clients
look to us for advice about the benefits and drawbacks of products on
the market. One product that has attracted special attention from the
insurance industry and the press lately is the universal life with
secondary guarantee policy (ULSG), sometimes called the "no-lapse"
We think the ULSG policy often can be a good product for the consumer, but a change is being proposed that would raise the technical actuarial reserves (which will likely raise prices) on this popular product. It's worth taking a skeptical look at whether the proposal to raise reserves has any real merit while examining a positive movement to modernize reserving practices and the implications for our clients of such a movement.
What are ULSG policies? A universal life with secondary guarantee policy takes the old universal life insurance concept and gives it a twist by introducing the concept of "secondary guarantees," i.e., a guaranteed death benefit for a specified period of time, often for life. Generally, the ULSG generates very low cash surrender values. However, many consumers want permanent life insurance and could care less about cash values. Still others would like to replace old, poorly performing cash value policies and move to these contracts.
The ULSG product is attractive to consumers because of its low premiums and high degree of flexibility in the payment of the premiums. ULSG products allow consumer flexibility in choosing not only the premium payment period, but also different levels or patterns of premiums to fund future guaranteed death benefits.
ULSG products are not helpful when the client needs cash value or is trying to meet a short-term insurance need. In appropriate situations, however, the ULSG products can prove a valuable tool for the financial planner. The ULSG was initially used in estate planning, when planners determined it was more important to produce a guaranteed lifetime death benefit for a low premium than to create cash values. The ULSG concept soon moved to single life UL policies, often having an added benefit of a waiver of all policy charges when the insured attains age 100. ULSG products, probably justifiably, have been touted as the "right product at the right time to respond proactively to the changing needs of an evolving life insurance marketplace." (For more information, read Robert Dehais' article, UL: An Overlooked Choice For Older Americans, The National Underwriter Company, July 21, 2003).
The advantages of universal life, and in particular ULSG, have not been lost on the marketplace. A LIMRA International study shows that universal life has steadily gained in the market share of U.S. individual life annualized new premiums. Universal life market share skyrocketed from 19% in 1999 to 37% in 2004. Market share for whole life insurance products, on the other hand, declined during the same time period to 25%.
Unfortunately, a recent brouhaha in the life insurance industry may decrease the availability of the ULSG product. Critics of ULSG (primarily companies that choose not to sell the ULSG product) charge that the reserves for the ULSG product should be increased so that companies would hold similar reserve amounts for ULSG policies as is required for whole life policies. ("Reserves" in insurance refers, in general, to a sum of money set aside by an insurance company, in an amount calculated to be sufficient to meet the liabilities on the policies.) Since whole life offers a cash value and is covered by different regulations, reserves required for whole life policies are higher than those currently required for ULSG. If the critics of ULSG have their way, the ULSG product will almost certainly become pricier.
The critics who advocate higher reserves on ULSG policies have proposed a change in Actuarial Guideline 38 (AG 38), an interpretation of the regulation that governs reserving for ULSG products. The detractors maintain that the current formulas can lead to inadequate reserving for certain ULSG products. They argue that actuaries at an insurance company may be pressured to design products that technically meet the formulas but produce reserves too low to meet the liabilities of the policy. Therefore, they argue, the AG 38 formulas must be changed, and reserves must be increased.
Many regulators and companies on the other side of the debate point out that current AG 38 already prohibits under-reserving because it explicitly requires that companies must abide by the "spirit and intent" of AG 38, and that the intent of AG 38 is clear: Reserves need to be established for the guarantees provided by a policy. If the reserves calculated by the formula are too low, current AG 38 requires that an insurance company must increase the reserves so that they are adequate to meet the guarantees provided by the policy.
These regulators and companies say one good thing about the industry is that it will continue to evolve. If there is a calculation problem, they think that patching up outdated formulas is only a temporary fix. Formulas will always become outdated as long as companies continue to be innovative. If any change to AG 38 is needed, they argue, it should tend toward a more progressive approach to insurance reserving.
The companies wanting the increase in reserves for ULSG at first argued that their concern was about the solvency of the issuing insurance companies. But, several months and much rhetoric later, no evidence of a solvency issue has been produced. Some of even the most ardent proponents of changing AG 38 have had to concede that the reserves currently being held by companies selling ULSG were probably sound.
Those who want to see an increase in ULSG reserves have also argued that the law required a formulaic approach to reserving for the ULSG. However, respected lawyers with national reputations have weighed in, pointing out that the law does not require a purely formula-based approach to reserving. They state flatly that reserves can be legally calculated using other, more progressive approaches, such as "asset adequacy analysis." Asset adequacy analysis involves testing the reserves using realistic assumptions with a margin for adverse deviation, and can involve scenario testing of various assumptions, such as interest rates and lapses. The lawyers state that these approaches are within the parameters of the reserving laws. The asset adequacy approach would allow more flexibility in reserving and could allow ULSG products to stay more attractively priced.
Most recently, however, the proponents for an increase in ULSG reserves have emphasized what is likely the real reason for advocating higher reserves for ULSG products: The whole life product simply has not been able to compete with the ULSG. By raising reserves on the ULSG product, the "playing field" would be leveled-and prices will almost certainly be higher. That result is not in the best interests of our clients.
At the heart of the national debate about AG 38 is the broader issue of reserve redundancy. Of course, it is in the interest of all parties to have conservative, adequate reserves. However, redundant reserves are reserves in excess of a conservative economic estimate of what is required to meet the liabilities of the policy. Reserve levels, for almost a century, have been based on extremely conservative formulas and tables that produce reserves significantly higher than the risk represented by the policies. While the effects of reserve inadequacy are obvious, the industry has been slow to recognize the negative impact of excessive reserves. Redundant reserves artificially inflate prices, making insurance less affordable to many consumers. This reduces the number of choices for our clients.
It should be pointed out that redundant reserve requirements are often addressed through reinsurance or, more recently, capital market solutions that transfer the reserve requirement to a third party. While this is perfectly lawful, it adds costs to the manufacturing process, which are ultimately borne by the consumer. Some companies, especially large companies with economies of scale, are more easily able to access reinsurance or capital markets solutions to redundant reserves, so in fact they may have a competitive advantage over other companies.
But smaller companies or new entrants into the market may not be able to access these solutions. With fewer companies offering ULSG because they cannot utilize complicated solutions to redundant reserves, our clients again would suffer from lack of choice of issuers. Additionally, these arrangements make for financial statements that are more complicated, thus making the regulators' jobs more difficult. Why add costs and increase the regulatory headache?
One positive development in all of this is that at least the problem of redundant reserving is being publicly discussed. At the 2004 meeting of the National Association of Insurance Commissioners in New Orleans and again at the Salt Lake City NAIC meeting in March 2005, a group of insurance commissioners from various states expressed significant concern that the current valuation system often results in unnecessarily redundant reserves. They acknowledged the negative effect on consumers, and then emphasized that consumer interests must take priority over "level playing field" concerns. The commissioners directed the regulatory actuaries reporting to them to utilize an asset adequacy-based approach to tackle not only AG 38 but reserve valuation requirements in general, to come up with a long-term solution to the problem of redundant reserving.
These were courageous steps for the commissioners, and we applaud them. With such forward-thinking leadership at the state regulatory level of the insurance industry, perhaps this reserving tug-of-war between companies will result in a win for consumers. And a win for our clients is a win for their planners.
Charles Haines is president and CEO
of Charles D. Haines LLC, a family office advisory firm based in
Birmingham, Ala. Cecil D. Bykerk is president of CDBykerk Consulting
LLC and a former executive vice president and chief actuary for Mutual
of Omaha Insurance Co.