Indexed Universal Life Policies: Watch These Risks
May 20, 2015 by Justin Keupper
Universal Life insurance policies come in many different flavors, ranging from low-risk fixed rate to higher risk variable models. Of course, the trade-off is that fixed rate models have lower returns and variable models involve the potential for a decline in value. A new rapidly growing type of policy promises to offer the benefits of both worlds — equity-like returns without the risk.
According to LIMRA Insurance Research, indexed universal life insurance policy premiums increased 23% in 2014, representing the majority of all universal life premiums at 52% and 20% of all individual life premiums. Financial advisors and individuals considering such plans should take note of several risks, however, when considering indexed universal life policies that may not be immediately obvious on the surface.
In this article, we’ll take a look at some risks associated with indexed universal life when being considered by both financial advisors and individuals.
Understanding IUL Policies
Indexed universal life insurance policies give policyholders the option to allocating all or a portion of their net premiums (after expenses) to a fixed or indexed account. While the fixed accounts works by crediting interest at a stated interest rate, the index accounts credits interest based on the performance of an underlying index with a floor of 0% return and a cap rate and/or participation cap on the return.
The dynamics of indexed universal life policies begin to get a bit murkier when looking at how the index exposure is built. Rather than purchasing equities outright, the insurance company typically enters into options contracts using some portion of the policy premium, which enables them to pass on the upside gains without the downside losses — but at the cost of an additional counterparty risk.
Many insurance companies provide minimum cap rates of between 1% and 4% and participation rates of around 50%, although some provide non-guaranteed cap rates of around 10% to 14% and participation rates in excess of 100% in sales materials, according to a The Bishop Company LLC report. If an underlying index returns 20%, a policyholder may only realize a 10% to 12% return with these caps in place.
Potential Hidden Dangers
Indexed universal life insurance policies are subject to unique dynamics given their use of stock options. Under the Black-Scholes model, stock options are priced based on, among other things, interest rates and the volatility of an underlying index. Option prices increase when market volatility rises, which could leave less money to purchase options and result in higher fees or less-attractive caps.
The use of stock options also eliminates dividends from any index return calculation, which usually account for 2% to 4% of total market return. Without these returns, policyholders may generate a lower return than the benchmark indexes, which is an important consideration over the long run, where compounding returns on small percentages makes a big difference.
Finally, the performance of financial assets depends largely on market timing. For example, someone establishing an IUL during the economic recovery may have realized their full cap returns over the ensuing five years, but those establishing the policy in 2007 may have realized no returns for the first several years of their policy, which can be quite costly relative to guaranteed fixed rate ULs.
Higher Costs & Expectations
Most indexed universal life insurance policies have considerably higher expenses, since they must develop and maintain complex derivative portfolios. In a study evaluating 15 different carriers over a 45 year period, the cumulative policy charges per $1 million of net amount at risk was 45% higher in IUL policies relative to UL policies — costs that are usually passed on to consumers.
Often times, these higher costs may not be fully reflected in aggressive assumptions that are often presented in the sales literature. The fact that many policies are sold based on accumulating cash value rather than guaranteeing benefits — presumably the point of life insurance — signals the height of the disconnect and lofty expectations when convincing individuals to purchase IULs
Financial advisors and individuals should be keenly aware of these costs and expectations when evaluating their options.
Redeeming Qualities
Indexed universal life insurance policies may have many ‘gotchas’ and concerns, but there are still some reasons to consider them. When using in the right situation with reasonable expectations, some clients could benefit from the potential for greater returns if they aren’t relying as much on the guaranteed income. The greater flexibility also has numerous timing-related benefits.
Some IULs also come with guaranteed contractual benefits through riders, which can actually provide guaranteed benefits that are comparable to general account products. The key is carefully reading through the literature and using the right calculations to determine exactly what the assumptions are, if they match the advisor’s assumptions, and what those mean for the client.
The Bottom Line
There are many risks that financial advisors and individuals should consider before purchasing an IUL — including some sneaky risk factors that may be difficult to identify. By properly vetting these policies beforehand, these parties can avoid entering into contracts that could prove costly over the long run.
Wink’s Note: for accurate descriptions and expectations please see Life Insurance 101 at: https://www.winkintel.com/insurance-basics/life-insurance/
