The number one question your clients should be asking about IULsArticle added by Katherine Vessenes on March 15, 2013
Katherine Vessenes

Katherine Vessenes

Chanhassen, MN

Joined: August 21, 2010

My Company

Vestment Advisors

IULs can be a great solution for the right client. Unfortunately, they are complicated. As a consequence, we usually do not let a client pull the trigger on this product until we have had at least three meetings to discuss the pros and the cons. With certain clients, we may even discuss it in one or two additional meetings before delivery. We also add it to our agenda for review meetings throughout the year after they have purchased the policy.

Here is the number one question clients should be asking before they invest in an IUL: What could go wrong?

Frankly, this is such a good question, all your clients should be asking it about every investment they have. Here is what I think could go wrong with an IUL and my responses:

First: The insurance company could reduce the caps or participation rates to much lower levels than originally illustrated, making it difficult to average returns that are close to the projected estimates.

My response: Caps and participation rates are mainly a function of the insurance company’s rates of return on their investment portfolios. Although bond yields are low now, they have been much higher just in the last 10 years. Since insurance companies have bonds that might go back even 30 years, in a prolonged downturn in the bond market, their average return on bonds will go down, which will mean the caps/participation rates will also go down. We always explain this to clients.

However, the same is true in reverse; as bond rates go back up, then caps and participation rates should also increase. Potentially lower caps/participation rates are why a good strategy for advisors is to only illustrate these products at a conservative illustrated rate, as opposed to the current illustrated rates. For example, we generally show nothing greater than the 100th percentile return based on historical results.

Second: Another possible problem is the insurance company could raise their expenses or mortality costs to the highest rate allowed by contract.

My response: This is a possibility; however, there is a limit by contract on the amount they can increase their expenses. Each contract is filed by the insurance company with the state insurance department, which must approve it before it is offered to clients. That filing includes both current costs, as well as guaranteed maximum costs. If the company increased expenses above the generally acceptable industry level, policyholders will vote with their feet and move their business to another company.

I also like to look at what insurance companies did during the years following the crash of 2008. That tells you a lot about the character of their management. I noticed that the companies that we use did not adjust their expenses during that time period. Generally speaking, the only time you may experience a carrier raising its rates on a block of business is if they have been taken over by the state as a result of being declared insolvent. Very unlikely to happen!
Third: The insurance company may use a crediting method that relies on an index, such as the S&P 500, that goes out of favor for an extended period of time.

My response: Let’s say the company is using the S&P 500, an index of the 500 largest U.S. companies. We know that since the 1920s, this index has averaged over 9 percent per year. However, during the lost decade from 2000 to 2010, the average annual return was -2.3 percent.1 The beauty of this strategy is the company, by contract, guarantees that the client’s cash value will not go down, even in a down market, excluding expenses.

However, there may be different indices which are more favorable than others over time. Once again, these are not sleepy index accounts that you put in a drawer and forget about. They must be managed. The advisor should be reviewing the different index options each year and making recommendations to the client if any adjustments are needed.

Advisors should choose companies that have a number of different crediting options so they have more flexibility down the road.

Also, some companies have the right to change indices if they find one is going out of favor. One company that we like is currently using the Chinese Hang Seng Index for some of their products. This index has done gangbusters in the last few years because the Chinese market is expanding. What happens if China’s growth levels out and their returns look more like a developed market? The company's top execs assured us that if that happened, they would use another index from another emerging market.

I would also recommend looking at carriers' in-force crediting rates, to understand how well they manage their existing book of business, as opposed to their rates for acquiring new business. Some carriers have an unfortunate reputation of subsidizing their new business crediting rates by reducing their in-force rates to the detriment of their existing customers.

Fourth: What if the bond rates go up, but the insurance company does not raise their caps/participation rates, thereby profiting from the difference?

This is where the marketplace keeps insurance companies honest and ethical. At the time I'm writing this, there are about 60 different insurance companies offering IULs. Their cap rates and participation rates fall within a similar range. If your company’s cap/participation rate was markedly lower than the prevailing range, then we would recommend doing a 1035 exchange into another company who has historically kept their cap rates at higher levels. This works as long as the client is healthy and insurable and there are no significant surrender charges left on the policy. Note: If they were not insurable, then they will be really happy they have the existing policy.

Fifth: What if there is a prolonged market downturn (10 years or longer) and at the same time, the policyholder doesn’t add any new premiums into the policy?

The first place I like to start with this question is the Japanese stock market, because many authorities believe the U.S. stock market might mirror the Japanese in the future.
Since 1990, the Nikkei 225 index, represented by the red line below, has been down a whopping 76.4 percent, as of the beginning of 2013. But it is very important to realize that during those years, it was not down every single year. In fact, their market was actually up 10 times during that timeframe.



The green line represents what we call “protected returns”, using the Nikkei as the standard. When the Nikkei is up, in our example, we credited up to 14 percent. In our hypothetical example above, returns are capped at 14 percent. That means if the investor would have earned 40 percent in the Nikkei, for our purposes, their account would only be credited 14 percent. Any upward movement in their account between 0 percent and 13.99 percent would be credited the full amount of the increase. You will notice, at no time does the green line dip below the previous year’s set point.

As you can see, an investor investing $1,000 in the Nekkei would have had roughly $250 over this time period. Ouch! On the other hand, an investor who had money in a protected strategy that captured up to 14 percenet of the gains, but none of the losses, would have ended up with $2,500.'

Now, our example doesn’t take into consideration the cost of the product, I am just trying to illustrate how the mathematical concept works.

What this graphs shows is that policyholders most likely will benefit, even in a prolonged downward market, as long as there are some years with upside returns. We have seen, even in our own stock market during the lost decade, there were years the market was up, even though the overall trend was down.

To specifically answer the question: In the unlikely event that the markets, and therefore the crediting methods, were down every single year between now and a client’s retirement, and the client couldn’t make any premium payments during the same time period, then there are a couple of possibilities:

Scenario one

If the client had been in the policy long enough and had sufficient cash value, then the insurance company would debit the cash value account for the cost of insurance and other fees. The client may not have to pay in any more funds to justify the death benefit. Note, the operative word here is “may.” This gets back to the policy needs to be managed. We would run an in-force illustration to see where the client stands and what their options are.

Scenario two

If the client is recently in the policy and there is insufficient cash value, then the policyholder has a couple of options: One would be to reduce the death benefit and thereby reduce the cost of insurance. This would make the cash value last longer. Or, we have seen cases where we computed just the cost of the insurance and expenses and had the clients pay that smaller sum to preserve the value of the accumulation account.

From advisor to advisor, this product can be a great way for your clients to position a part of their assets to capture some of the market’s upside while still getting downside protection — all in a tax-advantaged strategy.

1 Yahoo Historical Data: http://finance.yahoo.com/q/hp?s=^GSPC&a=00&b=1&c=2000&d=00&e=1&f=2010&g=d&z=66&y=2508
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