The primary concern cited by Mr. Cautious’ investment advisor was that the benefits projected in the Policy illustration were not “guaranteed.” Inherent within this criticism, however, is the suggestion that only results that are guaranteed can be reasonably expected to occur. Moreover, the investment advisor’s focus on the guaranteed assumptions (and the fact that the Policy would lapse after 30 years under those circumstances) left Mr. Cautious with the impression that this dire scenario had some reasonable likelihood of occurring. But is that really accurate?
Analysis Of Perceived Risks
As noted above: Over the past 89 rolling 10-year periods with a 1 percent and 11 percent collar on the Index, the very worst ones produced an average compound return of 5.0 percent (4.89 percent after volatility is taken into account)—a return that is nearly five times greater than the guaranteed return of 1 percent. With current charges and a 4.89 percent annual return, not only would the Policy never lapse, but it would have a cash surrender value that exceeds the amount of premiums paid by the end of the 7th year, and have a cash surrender value IRR of 2.19 percent after 10 years. Would it be possible to realize worse results than this? It would—but for that to happen, some combination of the following conditions would need to occur:
i. the 10-year compound return on the collared Index would have to fall below 4.89 percent—something that has never happened over the past 85 rolling 10-year periods, despite several that incorporated the stock market crash of 2008 and many others that spanned The Great Depression;
ii. the insurance carrier would need to dramatically increase policy charges from their current level; and
iii. the insurance carrier would need to lower the adjustable 11 percent cap on the collared Index.
While conditions (ii) and (iii), discussed in more detail below, are subject to carrier discretion and therefore more difficult to predict, it seems fair to project that the chances of seeing condition (i) are—at least statistically—extraordinarily remote.
When you look at 30-year rolling averages with a 1 percent and 11 percent collar, the statistics are even more compelling. If the average return on the collared Index over the next 30 years is equal to the worst rolling 30-year period since 1920 (which, as noted in the chart, was 6.0 percent), the cash surrender value IRR at the end of year 30 will be 5.86 percent rather than the 6.68 percent that is projected on the Policy illustration assuming a 6.75 percent Index return.
Subjective Risks Associated With Indexed Universal Life
In contrast to the objective, statistical analysis applied above to concerns about worse-than-projected market performance, a different sort of analysis must be conducted with respect to concerns about an adverse exercise of insurance carrier discretion.
Increase in Policy Charges. While many life insurance policies provide that the insurance carrier may increase policy charges under specified circumstances (generally defined broadly by reference to the company’s expectations regarding future mortality, investment, expense and persistency experience), this discretion is very rarely exercised. In fact, there are a number of insurance carriers who state proudly that they have never in their entire history increased policy charges after a policy has been issued. Even under circumstances where an increase in charges could be justified, there are two compelling reasons why an insurance carrier might still be reluctant to do so:
• Adverse Selection. If an increase in policy charges causes a policy to be noticeably less favorable, economically, than other competing products, insureds who are healthy enough to obtain similar coverage elsewhere would very likely decide to surrender or replace their policies. This would leave the carrier with an insurance pool that is made up largely of those insureds who are too unhealthy to obtain alternate coverage elsewhere. Premium receipts would decrease dramatically, giving the carrier fewer resources to pay death benefits to a pool of insureds that now has a considerably shorter average life expectancy.
• Reputation. A carrier who increases policy charges without adequate justification would put itself at a competitive disadvantage when it comes to issuing new policies. Although all carriers retain the ability to increase policy charges, they universally downplay the likelihood that this will ever occur. A policy increase that is not followed (some might say, validated) by other carriers in the industry would call into question the trustworthiness of the offending carrier and cause many consumers to avoid that carrier’s products. A sharp decline in a carrier’s reputation could also cause a reduction in the carrier’s credit rating if analysts believe that the new perception will adversely impact future business.
Reduction of Index Cap. When analyzing the risk associated with most indexed UL policies, a potential reduction of the Index cap should arguably be listed as the primary concern. In our 1 percent and 11 percent collar example, each percentage point subtracted from the cap reduces all of the rolling average yields by anywhere from 0.45 percent to 0.60 percent per year. Unlike policy charge increases which rarely, if ever, occur, most carriers tend to adjust Index caps periodically—upward as well as downward. Because most indexed UL policies have relatively low guaranteed cap levels (in nearly all cases, 4 percent or lower), a decision to lower the Index cap to the minimum guaranteed level could significantly impair the performance of the policy. Still, as described above with respect to an increase in policy charges, an insurance carrier who lowers its Index cap to the point where policies become economically unattractive would risk a swift departure of all healthy members of its risk pool, and risk substantial damage to its reputation.