A clear and present danger facing cash value life insurance policyholders and those considering a cash value policy is index universal life.

These policies are sold with promised crediting rates (the interest paid on a policy’s cash value) that do not appear sustainable. They are, however, the industry’s current response to changing market and regulatory conditions.

An overview of the life insurance industry’s evolution explains how we got here. It also adds context to the suggestions I have for the different types of cash value policies.

Participating Whole Life and Universal Life (1977–1992)

The dates are not exact, but 1977 approximately marks the period when national high interest rates started showing up in participating whole life (PWL) dividend values and when mutual companies started providing a “dividend interest rate” figure. (Dividends are the insurer’s surplus amount available for distribution.) Prior to this approximate date, companies just referred to it as the “1975 scale.”

Once interest rates reached double digits around 1983, they remained that way until about 1993. The primary policies sold until the early 1980s were participating whole life, sold by the mutual companies, and whole life, sold by stock companies. Participating whole life premiums were higher than whole life premiums, but would be enhanced by future dividends. Conversely, the whole life story was for buyers to side-fund the premium difference and it would exceed the future value of dividends. For the first time, spreadsheets were prepared by stock company agents to show this. By 1979 interest rates were so high, pulling dividends with them, that companies offering whole life policies (with no dividends) had to come out with new policy series about every few months to appear competitive. This signaled the death of whole life.

I rarely see whole life still in force. Participating whole life has provided superior policy value. Northwestern Mutual and Guardian are to be especially admired for giving the same treatment via dividends to all policies no matter when purchased. The other mutual companies have not been as good at this.

Early in the 1980s, universal life was introduced to be able to offer buyers double-digit interest crediting rates (new money rates) that were higher than participating whole life’s portfolio rates. Agents used these illustrated higher rates to replace as much participating whole life as they could. Most (if not all) of these first-generation universal life policies have a policy maturity age of 95. This presents a serious problem now that adults age 90 or older are the fastest-growing demographic, and insureds are outliving their policies. This is an issue I frequently deal with.

Universal life policies purchased throughout the 1980s and 1990s are uniformly underfunded and today are in great risk of terminating well before insureds’ life expectancies. This is because they were sold with much higher crediting rates that have all fallen dramatically. Plus, no one has reviewed the policies and adjusted the premiums higher to maintain universal life solvency. This is a huge problem.

Variable Universal Life (1993–2003)

Participating whole life dividends and universal life crediting rates began to gradually decline starting in 1993 as lower interest rates dug in.

During the era of historically high interest rates, mutual insurance companies came upon the idea to promote their participating whole life policies with vanishing premiums. With computing power in every agent’s office, illustrations (hypothetical assumptions) based on high dividends could be presented showing a limited number of years to pay premiums, with the policy becoming self-sustaining afterward. This vanish point was often 10 years or less. Companies were playing a game of “Name That Tune,” or which company could show the fewest number of payment years before the policy was self-sustaining. Some companies started using actuarial steroids to outperform their competitors. (It got so bad that new regulations were enacted to hold this cheating in check, but it hasn’t been particularly successful).

Of course dividends then started their decline, and the number of years for payments increased over and over. All mutual companies faced class action suits, and all but a couple settled. The settlement terms for the policyholders were quite good.

With dividends declining, many agents turned to variable universal life (VUL) policies, which have various stock and bond sub-accounts that policyowners can choose from for investing their premiums and cash values. This allowed agents to illustrate investment returns of up to 16% for all years. (It is now lower.)

With this kind of compound interest firepower, many participating whole life and universal life policies were replaced by variable universal life polices because the latter illustrated so well. In fact, variable universal life policies are a toxic insurance asset because of the extreme investment volatility that destroys policyowner confidence when the inevitable investment crashes occur.

Variable universal life policies need reviewing and management if a policyowner decides to continue with them. (See my previous articles at www.aaii.com/authors/peter-katt for more about variable universal life policies.)

Guaranteed Universal Life (2004–Present)

In reaction to insurance companies being burned by promising vanishing premiums at a time of historically high dividends and interest crediting rates that significantly declined, most companies designed a new policy type: guaranteed universal life (ULG). Premiums and death benefits were no longer subject to future interest rates.

The most aggressive companies offered eye-popping premiums that they then had to drop on subsequent policy iterations in order to make sales. With only the one moving part, the lowest premium, companies weren’t in the game without it.

The excellent guarantees were possible because guaranteed universal life policies have low to zero cash values. When a policy lapses because premiums have been missed, the policyowner does not receive the policy’s asset share (typically the cash value in participating whole life). Instead, guaranteed universal life companies make a profit that benefits persisting policies and has made the low pricing possible. So far these companies have remained solvent.

Always fighting the last war, agents have pounced on participating whole life and universal life policies, replacing as many as possible with guaranteed universal life policies. Whether this is in a policyowner’s best interest is a case-by-case matter, a factor not considered by most agents.

Index Universal Life (IUL)

Around 2009, another new policy type became popular with agents: index universal life (IUL). Index universal life promises that its interest crediting rates are determined by referencing to the S&P 500 stock index with no losses. I have seen illustrated rates as high as 9.0% that also included a 0.5% bonus rate starting in the 11th policy year for illustration purposes.

The problem is that index universal life premiums collected are not being invested in the S&P 500 by the selling companies. Something on the order of 95% of their premiums are invested in fixed-income instruments. The insurance companies claim they can make up the difference by using various hedging techniques to cover promised crediting rates that are much larger than their investment portfolios produce. Even if companies have actually designed hedging formulas, such exotic strategies are notoriously inaccurate. It is a mystery that index universal life isn’t in obvious violation of even the tepid illustration regulations from the 1990s.

I think it is very likely that index universal life will turn out to be just a marketing gimmick, using stock returns to justify illustrating much higher interest crediting rates than a company’s investments can possibly attain. Sales pitches using 8% and 9% crediting rates are backed up by such contract language as: “the annual index growth that will be recognized in the calculation of the index earnings for an equity indexed segment on a segment anniversary. We will determine in advance the participation rate applicable to each equity indexed segment for each 12-month period and will communicate it to you in an annual report or in notices to you.”

This means the insurance company can credit whatever they want. I see no reason why they will provide better actual performance than universal life or participating whole life. The problem for buyers is raised expectations of performance measured either by lower premiums or higher cash values than would otherwise be expected or in fact delivered.

And of course agents are using index universal life to replace all the participating whole life and universal life they can with what I believe are false comparisons. Unlike guaranteed universal life that does have a place, index universal life should be avoided.

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