A lot of investors, seeking a reprieve from the ups and downs of the stock market, have turned to a life insurance product called “indexed universal life insurance.” This type of life insurance is permanent life insurance, which builds cash values based on the upward movement of a stock market index. Premiums are paid, cost of insurance and other policy charges are deducted from the premium and accumulated cash value, and then the remainder of the premium and cash value is used to buy a mix of bonds and index options.
The insurance company caps earnings using either a hard cap rate or a participation rate. The cap, participation rates, and the bond holdings limit risk and provide the insurer a way to offer guarantees to the policyholder. Sounds good. What’s the problem? There are several, really:
Indexed universal life in inherently riskier than both term insurance and whole life when used for death benefit protection. There are no two ways around this. The insurer needs to buy index call options to power the contract. Policy fees can overwhelm the index credits. In some cases, administrative risk makes indexed universal life difficult to manage over the long-term. Administrative risk refers to how policies are serviced by the insurance company after the sale. Specifically, degraded policy servicing can make it difficult to get premiums processed properly, to receive inforce policy illustrations in a timely manner, and get changes to the policy done in an orderly fashion.
Degraded policy servicing can also happen when the insurance company sells off their block of business to another company that doesn’t really care about customer service, “forgets” return your phone calls, delays paperwork processing, or in really egregious cases, “forgets” to apply your premium properly and you end up with rising premiums or a lapsed policy. It happens. Policyholders of old Aviva policies and, more recently, Voya, know all about this. Both insurance companies were big players in the indexed UL space, sold massive amounts of indexed universal life policies, but later decided the product was not profitable, thus sold the book of business to companies who “gutted” the book and degraded service to policyholders.
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This rarely happens to whole life insurance sold by mutual life insurance companies due to the inherent structure of mutuals and how whole life insurance works.
Some advisors have suggested that overfunding a UL policy prevents all (or most) problems. Overfunded ULs can still collapse or underperform. There is a trend now with newer indexed universal life policies to overfund the policy to the maximum allowable under current IRS rules for life insurance. By doing this, agents hope to avoid some of the problems that plagued older policies. Specifically, they hope that policy charges will remain relatively low and that interest earnings will cover those charges and net the policyholder some sweet gains on cash value. But, IUL is usually very expensive and contains expense charges which consume a large portion of the policy premiums for many years. It’s certainly possible for interest earnings to exceed policy charges, however the opposite is also true and I don’t think many agents give that side of things much serious thought. Additionally, indexed life hinges on the ability of insurance companies to keep cap rates and participation rates high enough for interest credits to overpower policy charges. However, the trend is for cap rates to come down, not up or even level.
For example, right now, life insurers can afford to offer policyholders a 5.3% cap rate (or 42% participation rate) on IUL. Many of them, however, advertise a much higher caps than that, and are relying on mean reversion pricing or are subsidizing higher caps in other ways. Those higher caps are obviously unsustainable and will have to come down. When, and how, those rates come down remains to be seen, but if an insurer has to “overcompensate” for holding their cap rates artificially high for too long, then you can bet it won’t turn out well for policyholders.
Bottom line: when you go with whole life insurance for death benefit and estate planning purposes, you often pay more, but get more. That’s what people don’t like. They don’t like paying the higher premium and so they go with the lower premium universal life policies. Can’t say I blame them. It’s less money out of pocket. When you buy whole life insurance for cash value, you get an inherent guarantee on cash values. No such guarantee exists for indexed universal life, since its an assumption-driven life insurance product. When you buy universal life insurance, you are hoping to get more out of your policy than whole life insurance, but pay less. This is the assumption — an assumption which has not paid off for many policyholders over long periods of time.
Author Bio
David C Lewis, RFC is an independent life insurance agent, a Registered Financial Consultant, and the founder of Monegenix®. For more information about his unique approach to life insurance and financial planning, go to www.monegenix.com.
