Indexed Universal Life – Mission Impossible, follow up

My earlier post on IUL, referencing a letter I sent to a consulting client asking for my advice, clearly touched on something.  The post has garnered about 20 times more impressions than usual and almost ten times as many as my previous maximum.  It also generated a conversation that doesn’t often result.  I’m still trying to determine exactly why.

The post’s point was the agent’s approach, tactics, and rationale in replacing a policy he had placed ten years prior.  My analysis concluded there was no possible way to replace the existing VUL policy with the proposed IUL in the client’s best interest, and the agent was using easily provable misrepresentations and inaccuracies.  Whether he knew it or not is up for debate.

Among other things, the ensuing conversation included a question about an IUL policy with loans projected to perform better than the same policy without loans.

With IUL policies, one can choose a standard loan or an alternate loan, sometimes called a participating loan, variable loan, indexed loan, etc.  With a standard loan, the loan rate is relatively low and fixed, and the cash value that is collateralizing the loan is removed from the index and put into a fixed account that credits slightly less than or equal to the loan rate.  This is often referred to as a ‘wash loan’ and related as a push, though it’s not really at all because the total loan interest rate is applied, but due to policy charges and expenses, not all of the crediting is effectively applied.

Alternate Loans

With alternate loans, the cash value collateralizing the loan is kept in the indexing account, which gives it the possibility of higher crediting, but the loan interest is meaningfully greater.  Per AG49, the collateralizing cash value crediting can exceed the loan rate.  (AG49-B reduced the maximum positive crediting spread to .5%.) If an alternate loan is chosen, the cash value collateralizing the loan will earn whatever it would have earned sans the loan.  If a given product has a 5% participating loan interest rate (as opposed to maybe a 2.5% fixed loan rate), the regs allow the carrier projections to assume up to a 5.5% crediting rate on that loan amount.

The actual gross policy crediting may be greater or lower in any given year.  Assuming the cap rate for this contract is 8%, the gross crediting could be 8%, with the loan accumulating at 5%, an effective positive arbitrage.  However, if the policy crediting for the segment is 0%, the loan rate is still 5%.  Also, the 0% would be the gross crediting.  The cash value would be reduced due to policy expenses and charges.  If the policy has optional kickers and bonuses, the costs increase, possibly up to multiple hundreds of basis points of additional charges, making the “policy crediting” quite negative.  The loan doesn’t care about that and marches forward, growing at 5%.  Too often, I channel my inner Inigo Montoya from The Princess Bride and say, “I don’t think the 0% floor means what you think it means.”

The issue is that the illustration systems, per the regs, can assume perpetual positive arbitrage between the policy crediting and the loan rate, which won’t happen.  We know that.  Will positive arbitrage in the big picture over multiple years play out?  Maybe, maybe not.  It’s also not as easy as looking at the 300 basis point spread referenced.  The potential 8% is the gross crediting, not net.  Policy expenses and charges can reduce gross crediting by a meaningful amount, and at least some of the potential positive spread can be quickly lost.

Loan Surprises

Virtually every premium financing case I review assumes alternate or participating loans for the reasons discussed below.  It’s the only way for most of them to look appealing on paper, regardless of the potential chance of it playing out in real life.  Most policy owners have no understanding of what’s going on.  Many are shocked to learn there is a loan at all.  They realize there is a commercial loan from the bank initially, but most also “understand” the loan to be paid off with cash value at some point.  They don’t realize that one loan is often paid off by another.  This is a potential two-fold problem.

First, they had no idea their policy would have an indefinitely ongoing loan that’s commonly assumed to be paid off by the eventual death benefit.  Second, the entire model isn’t built off assumptions as conservative and reasonable as they believe and aren’t likely to pan out.  Reasonable people can disagree on this, but that’s my stand.

They’re generally appalled when I point out the loan balance later in life.  Sometimes, these loans have accumulated to tens or hundreds of millions of dollars.  Sometimes there’s not enough room on the ledgers to show all the numbers, and they resort to “numbers below are represented by the thousands” as in, it’s not really a $30 million dollar loan, it’s $300 million, or even in the billions.  Yes, I’ve seen it.

“I never would have done this had I known that!!!” is not an uncommon response.

How the Numbers Shake Out

I opened one insurance carrier’s software and plugged some numbers in.  They are pulled out of the air, and no attempt is made to make them look good or bad.  The assumption is built on a 30-year-old healthy male making a $100,000 annual premium per year for 30 years and then modeling a couple of loan scenarios assuming both standard and alternative loans.

This piece will not dive deep into analysis but simply relate some numbers to illustrate a point.  Yes, there are innumerable ways to tweak this, but not today.  The first table is a baseline with no loans.

Assumptions

  • 30 year old male, preferred non-smoker
  • $100,000 premium for thirty years
  • Loan at age 60

No Loans

 Age 80Age 100
Cash Surrender Value$11,587,000$27,388,000
Net Death Benefit$16,000,000$27,662,000
Loan$0$0
Policy Credits$616,446$1,288,000
Policy Charges$124,000$66,000
Loan Interest$0$0

For loan comparisons, I’ll start with a $1 million loan at age 60, the first year after premiums are terminated.  Following are the numbers at age 80 and age 100.

$1 Million Standard Loan

 Age 80Age 100
Cash Surrender Value$8,648,000$8,688,000
Net Death Benefit$14,404,000$13,510,000
Loan$1,596,000$2,490,000
Policy Credits$514,000$499,000
Policy Charges$155,000$1,353,000
Loan Interest$35,000$54,000

Here is the same with a $1 Million Alternate Loan.

 Age 80Age 100
Cash Surrender Value$9,117,000$21,544,000
Net Death Benefit$13,529,000$21,817,000
Loan$2,470,000$5,844,000
Policy Credits$616,000$1,288,000
Policy Charges$124,000$66,000
Loan Interest$104,000$246,000

It’s easy to see that these numbers are very different in some cells.  But that, in and of itself, doesn’t mean either is inherently better or worse than the other.  To address the comment that the policy performs better with a larger loan, I’ll present two more tables with the same assumptions and a $2 million loan.

$2 Million Standard Loan

 Age 80Age 100
Cash Surrender Value$5,708,000$-
Net Death Benefit$12,808,000$-
Loan$3,191,000$-
Policy Credits$411,000$-
Policy Charges$186,000$-
Loan Interest$70,000$-

$2 Million Alternate Loan

 Age 80Age 100
Cash Surrender Value$6,647,000$15,699,000
Net Death Benefit$11,059,000$15,973,000
Loan$4,940,000$11,689,000
Policy Credits$616,000$1,288,000
Policy Charges$124,000$66,000
Loan Interest$208,000$492,000

You might first notice the lack of data in the age 100 column for the standard loan.  That’s because the policy projects to lapse at age 94.

To note a few more things, the interest rate on the standard loan is 2.25%, and 4.4% for an alternate loan.  This stays the same regardless of the size of the loan or the year you look at it.  You’ll notice that the $514,000 of credits at age 80 on the $1 million standard loan are reduced to $411,000 for the $2 million standard loan.  With a larger loan, more of the cash value is in the fixed account and not getting the higher projected crediting of the indexed account.  This results in a more slowly growing cash value and a more significant lingering net amount at risk, resulting in greater mortality charges.  For the alternate loan, the policy credits stay the same regardless of the loan size and are the same as the ledger with no loan.  The cash surrender value for the $1 million standard loan is very similar at age 80 and age 100, though there’s a much more significant difference during other years.  For the alternate loan, you can see that the cash values differ dramatically from 80 to 100.  It’s the same story for death benefit.

Loan interest is greater at age 100 and age 80 in any of the situations, as you would expect with a growing loan.  As opposed to the lower credits at age 100 than at age 80 for the $1 million standard loan, for the alternate loan, the credits are much higher at age 100 than they are at age 80.

At a glance, the most significant disparity in numbers is regarding policy charges.  For the alternate loan projection, policy charges go down from age 80 to age 100; however, the policy charges for the standard loan increase from $155,000 to $1,353,000.  By the way, this is the reason the policy with the $2 million standard loan lapses.  The charges get huge, and the cash value cannot support them.

Why?  Because the spread between the cash value and the death benefit is larger for the policy with a standard loan because the cash value is projected to grow at a slower rate.  As a larger and larger portion of the cash value is allocated to the fixed account for collateral purposes, more and more of the cash value is being credited at a lower rate, which keeps the cash value from growing and maintains a larger net amount at risk resulting in dramatically higher mortality charges that are unsupportable.

Yes, I know the policy could be built differently to mitigate this, but that’s not the point of this comparison.

The standard and alternate loan projection comparisons are from the same insurance product with the same insurance company.  The cash value is allocated to the same index account.  The insured individual is the same, the premium is the same and the loan amounts are the same… however, the projections assuming standard loans are less favorable, while the numbers for the alternate loan, even though the interest rate is higher, soar over time.

I could spend thousands of words explaining this, but not today.  I’m leaving it at this for now.  You can probably now easily see why alternate loans are utilized rather than standard loans.  Everything simply looks better.  Would you expect anything different?  The illustration I took these numbers from is 54 pages long.  It’s a rhetorical question to ask how many policy owners you think review the ledgers and details.  That being said, right in the middle of the 54 pages is this statement: “This causes alternate loans to be significantly more volatile than standard loans.”

I don’t believe many people read that far.  Even if they did, they’d likely not understand it.  Just because something looks more favorable doesn’t mean that it’s better.

There’s also something in the numbers that doesn’t make sense if you are familiar with AG49B.  The regs limit the spread between the crediting rate and the loan interest rate to 50 basis points. However, the crediting rate for this ledger is 4.93% and the loan rate is 4.40%.  This is 53 basis points.  So why is the crediting the same for the scenarios with and without a loan?

The crediting is the same because they bump the loan rate up to allow the maximum crediting rate.  Is this how it works in real life?

A Few Observations

It’s frustrating how far you have to dig into the ledger to find gross cash values and loan balances.  There’s an Accumulated Cash Value and a Cash Surrender Value column on the primary ledger, but they’re always the same number.  Why not have the Accumulation Value be the gross value and the Surrender Value be net of loans and surrender charges, as has historically been done?  When there are loans, the Accumulated Value column is then labeled the Net Accumulated Value column, but at the same time, the Death Benefit column is not referred to as the Net Death Benefit column.

Most confusing is the fact that the ledgers with standard loans do not have any page in the entire ledger showing the policy loans.  However, the ledgers assuming alternate loans do.  Why show the loan in one scenario and hide it in another?

In my earlier post, I mentioned that some agents advocate for loans by stating that the policy performs better with a larger loan… because the AG49B regs allow carriers to illustrate a 50 basis point positive arbitrage indefinitely, though it may not be realistic.  The ellipsis indicates the end of the sentence in most situations and the next part of the sentence with the ‘why’ isn’t often voiced.  When you look at the numbers above, the credits and charges are the same whether we’re looking at the ledger with no loans or a $1 million or $2 million alternate loan.  Also, the cash value and death benefit are lower with $2,000,000 borrowed out than with $1 million borrowed out, and the $1 million loan has a lower cash value and death benefit than the projection with no loan at all.  How does this indicate more loans result in the policy performing better?  Most numbers in the $2 million loan cells look worse than the $1 million loan cells. 

We do have the $1 million or $2 million in hand to do something else with, but I think it’s easier to see when we take the loan and put it right back in as a premium.

 No Loan

 Age 80Age 100
Cash Surrender Value$11,588,000$27,338,000
Net Death Benefit$16,000,000$27,662,000
Loan$0$0

$1 Million Standard Loan and Premium at Age 60

 Age 80Age 100
Cash Surrender Value$11,909,000$29,392,000
Net Death Benefit$14,404,000$29,710,000
Loan$1,595,000$2,490,000

$2 Million Standard Loan and Premium at Age 60

 Age 80Age 100
Cash Surrender Value$12,226,000$30,293,000
Net Death Benefit$12,997,000$30,646,000
Loan$3,191,000$4,980,000

$1 Million Alternate Loan and Premium at Age 60

 Age 80Age 100
Cash Surrender Value$12,379,000$31,283,000
Net Death Benefit$13,530,000$31,654,000
Loan$2,470,000$5,844,000

$2 Million Alternate Loan and Premium at Age 60

 Age 80Age 100
Cash Surrender Value$13,081,000$33,327,000
Net Death Benefit$13,982,000$33,777,000
Loan$4,940,000$11,688,000

We can see that it doesn’t matter if it’s a Standard Loan or an Alternate Loan; they project to perform better than no loan at all regarding cash value at any point and death benefit at the longer durations.  With both types of loans, borrowing more outperforms borrowing less, and Alternate Loans outperform Standard Loans.  Also, the “improved performance” is in lock step with the increasing size of the loan.  Remember that the alternate loan interest rate can increase.  It’s easy to foresee a time where the loan interest is $500,000 in a given year when the policy is being credited with 0% less policy expenses and mortality charges. What if cap rates are low at the same time?  What if cap rates are lower than the loan interest rates?

Please don’t be tempted to blow this off.  In the premium finance world now, all the variables moved in the wrong direction at the same time and the policy owners are often underwater millions of dollars.

At another time, I’ll show how this plays out in a supplemental income model where the difference is accentuated.

Whether or not it’s a focus of discussion, there’s an elevated risk with Alternate Loans, as highlighted in the carrier ledger.  It’s exceedingly important to pay attention to risk and reward, but these numbers aim to show a plain vanilla side-by-side comparison.  Unfortunately, the process is often based on nothing but these plain vanilla side-by-side comparisons.

Next

There’s much more to cover, but let’s leave it here.  Until next time…

Bill Boersma is a CLU, AEP and licensed insurance counselor. More information can be found at www.OC-LIC.com,  www.BillBoersmaOnLifeInsurance.info, www.XpertLifeInsAdvice.com, via email at bill@oc-lic.com or call 616-456-1000.

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