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"
policy.
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.