Comparing Indexed Ul To Other Investments
So how might Mr. Cautious’ investment advisor have provided him with more objective, constructive analysis? He might have started by noting the cash surrender value IRRs that the Policy is projected to yield (4.26 percent after 10 years; 5.60 percent after 15 years; and 6.16 percent after 20 years). He might then have explained that these projections are based on two assumptions: (i) that the collared return on the Index will average 6.75 percent per year, and (ii) that Policy charges will be kept at their current levels. Finally, he could have identified and discussed the three risk factors that would prevent the two assumptions from holding true [(i) worse than projected market performance; (ii) an exercise of carrier discretion to lower the Index cap; and (iii) an exercise of carrier discretion to increase charges] in a manner similar to the analysis provided above.
So is the Policy a particularly “risky” place for Mr. Cautious to put his money? Most people, after walking through the analysis, would probably decide that it is not. While there are likely some people who are inherently distrustful of insurance companies, and who might be skeptical of the notion that business considerations should be enough to deter a carrier from unilaterally altering the economics of the policy to the detriment of the policyholder, many of these same people don’t think twice about relying on a corporation to continue fully discretionary dividend practices. Moreover, the risk of being harmed by an adverse exercise of the insurance carrier’s discretion is mitigated over time by the fact that an increase in policy charges or a decrease in the Index cap would be prospective only—and neither of these changes would have any immediate impact on policy value. Unlike the holder of equities in a crashing stock market, or the holder of long-term bonds following a rise in interest rates, the owner of an indexed UL policy can generally liquidate their investment after the occurrence of an adverse event (i.e., an announcement that the Index cap is being reduced) for the exact same value they could have received before the event had occurred. Surrender charges impose a cost to exiting the policy within the early years, but once the cash surrender value of the policy climbs above the total amount of premiums paid (which, in the case of the Policy, is projected to occur at the end of the 4th year), the policyholder should be able to get out without experiencing a loss. (While surrendering the policy under these circumstances might prevent a loss of the premium dollars that had been paid into the policy, the health of the insured, and the income tax consequences associated with surrendering the policy, are other factors that should be taken into account before a policy is surrendered.) Unfortunately, the same cannot be said for the shareholder or bondholder.
Jordan Smith, J.D., LL.M., is vice president of advanced design at Schechter.