Understand what you're selling: The truth behind variable loan rate caps

By jkonopik

AMZ Financial Insurance Services, LLC


From time to time, life insurance companies come out with policy benefits that can significantly reduce an individual client’s risk by spreading that risk over all their customers. This isn’t one of those times!

Indexed universal life (IUL) has the potential to add significant value to clients who have a desire to harvest the taxation benefits of permanent life insurance while utilizing a crediting mechanism that is extremely appealing. Since most IUL sales have some sort of an income component in the illustration, the provisions used to provide that income are very important.

There are basically two different structures that are being used to illustrate income on an IUL: 1) withdrawal to basis/fixed loans and 2) variable loans. The latter is the primary structure that is currently being used by most agents. As an actuary, I have done a significant amount of analysis on both the risks and benefits of variable loans and have a high degree of confidence in that option, provided that the proper product is being used.

The benefit of variable loans is simple — arbitrage. Since the values in the policy continue to grow at the indexed crediting rate and the outstanding loans grow at a floating rate, there is the potential for the policy to grow at a higher rate than those of the outstanding loans. As an example, if the average crediting rate is 7 percent and the average loan rate is 5 percent, then it is equivalent to taking a loan from a bank at an interest rate of 5 percent and investing those funds in a vehicle that is earning 7 percent — you would do that all day long.
This benefit, however, comes with a risk. You could potentially have a crediting rate of 5 percent and a loan rate of 7 percent, which would obviously decrease the performance of that product rather significantly. In an effort to relieve this concern, carriers have started coming out with policy provisions that alter the “floating rate” aspect of variable loans. Several carriers have placed static caps on their variable loan rates that are promoted to reduce the risk of negative arbitrage. On the surface, these variable loan rate caps seem very valuable to clients. Be careful, however, because the “value” you are selling will likely not lead to a better performing product for your clients.

For example, assume a carrier puts a 5 percent cap on their variable loan rates. Today, the 5 percent cap is worthless because variable loan rates are around 4 percent. But assume that 20 years from now, when clients are heavily utilizing, the current rate that carriers are charging is 8 percent. In that environment, the carrier will be forced to loan money at a rate of 5 percent even though the current rate is 8 percent. In this scenario, they would be losing 3 percent on every single loan they make.

IUL is a non-guaranteed product, and as an actuary who has worked with the pricing actuaries at many carriers, I can guarantee you one thing: Insurance companies won’t lose money on a non-guaranteed product. What this means is that this carrier will make up for the losses they are incurring on their variable loan portfolio. Most likely, the profits will be recouped by lowering cap rates on their indexed crediting strategies. In this scenario, the carrier will have substantially lower cap rates than carriers that do not have variable loan rate caps. This will significantly reduce, and likely eliminate, the perceived benefits of having the variable loan rate cap in the first place.

How valuable would that variable loan rate cap be if indexed cap rates are so low that there is little room for any positive arbitrage? From time to time, life insurance companies come out with policy benefits that can significantly reduce an individual client’s risk by spreading that risk over all their customers. This isn’t one of those times! In today’s environment it is more important than ever that agents truly understand what they are selling. Otherwise, you will be making promises to your clients that will never be realized.