Spotlight Issue 1 - 2013
When I started my career back in 1982, universal life insurance was the new kid on the block among very well-established life products (mainly traditional whole life and term insurance). Universal life (UL) was vastly different than any other life product that had existed prior to that, although there were some very valiant attempts at mimicking a universal life type product through the use of a few existing participating whole life plans and adjustable life.
The concept for universal life had been around for quite some time, many tracing its initial discrete mention back to G.R. Dinney's presidential address at the Canadian Institute of Actuaries in 1971. There were many social and economic changes occurring in that time frame that were beginning to make traditional life products lack relevance to a good portion of the financial market.
It was not until certain changes were made to the Standard Valuation
sLaw (SVL) in the late 1970s that UL began its path to displacing traditional life products as the major selling product in the industry. In 1979, E.F. Hutton Life designed and marketed what is acknowledged as the first successful UL product. The Deficit Reduction Act of 1984 (DEFRA) helped clarify a number of unanswered tax issues that UL had started. The next several years saw universal life plans continue to proliferate and eventually dominate the market throughout the 1980s.
While traditional life insurance was somewhat of a black box to the purchaser, universal life took an "unbundled" approach and was transparent to the policyholder with respect to policy expense charges, cost of insurance charges, policy level activity and interest rate credits to name a few.
At that time (early 1980s) market interest rates were very high. The prime rate hit an all-time high of 21.50% on December 19, 1980 and this provided a solid launching point for universal life sales as UL credited a market-like interest rate in the double digits.
As universal life continued to dominate the market in the 1980s, more companies began to enter this market until most companies had at least one universal life insurance product on the books. The ongoing potential of UL seemed endless.
There were variations of UL developed including interest sensitive whole life plans that, similar to UL, were unbundled and credited market interest rates, but were different in that premium payments (i.e., scheduled premiums) were required to be paid (similar to a traditional whole life plan). Variable life (including variable universal life) started to enter the fray in the mid-1980s.
In addition to the unbundled aspect of universal life and other non-variable interest sensitive life plans of the day, the market interest rate credited to many of these plans was a big driver of UL's success. Traditional life plans, both participating (i.e., dividend paying) and non-participating were not able to keep up with the values that were being generated by UL illustrations. Quite a number of UL sales of that era came from insured individuals exchanging their traditional whole life plans for the newer interest sensitive life plans.
UL illustrations were, as mentioned, crediting interest rates in the double digits (or high single digits) for most of the 1980s on a current (non-guaranteed) basis. Most UL products guaranteed a minimum of 4% interest (though I've personally seen some guarantees as high as 6%), with the thought that anything lower than 4% would never come to pass. In today's market, by contrast, it is not uncommon to see a 2% interest rate guarantee on new UL policies sold.
The interest rates illustrated on many of the universal life plans led to their downfall in the 1990s as interest rates started their aggregate drift downwards. Many companies had illustrated double digit credited interest rates in their UL illustrations assuming that such level of credited interest rates was going to last forever. As market interest rates began their long path downwards, many insurers realized that they had to start crediting lower interest rates than originally illustrated.
As a result there was a spate of class action litigation in the 1990s relating to interest sensitive life insurance illustration performance. Insurance companies began to rethink their universal life product line, especially with respect to interest rates that were projected on illustrations.
During this timeframe (mid-1990s), the Life Insurance Illustrations Model Regulation was promulgated in response to issues such as interest rates projected on illustrations, but also to eliminate what some in the market had deemed as misleading illustrations.
The roaring bull market in equities, in addition to the litigation and model regulation, saw numerous sales moving away from universal life and into variable life (VL) products (including variable universal life). Variable universal life (VUL) did not have the same issues with respect to interest rate crediting that non-variable UL did, because VUL interest rate crediting in the separate account was based on the underlying performance of the subaccounts. This contrasted to non-variable UL where the interest rate credit was generally in the control of the insurance company.
Universal Life in the New Millennium
Universal life has seen a comeback of sorts in the 2000s as market share as a % of life insurance premium has grown from 27% in 2002 to 42% in 2011 (source: LIMRA International). In the early part of the decade, quite a bit of the growth was due to the significant stock market corrections that occurred, which led to a flight from the perceived riskiness of variable products plus the flight to quality caused by the uncertainty of a post-9/11 financial market.
Quite a bit of the growth in UL in the 2000s also came from changes in product design and the introduction of new products, including fixed indexed universal life, that helped to mitigate the downside risk often associated with products like variable life.
Fixed indexed products are structured to participate in the upside of the equity markets while avoiding/limiting the downside risk of variable products. Like other UL products, there is a minimum interest rate guarantee (2% for example). The upside comes from purchasing call options on the equity market so that if stock prices of the associated stock index (S&P 500, e.g.) increase, the call options are exercised and the gain is applied to the fixed indexed UL (FIUL) account value. If the stock index moves sideways or down, the call options expire and are worthless. There is no deduction from FIUL account values for this.
While FIUL products, like variable products, shift the burden of determining the interest rate credited from the insurance company to the financial markets, there are still significant issues that exist for the FIUL market and for the UL market in general as a result of the current low interest rate environment.
FIUL product issuers use a combination of fixed income instruments (bonds) to provide the underlying interest guarantee while using call options on stock market indexes to provide the upward potential over the interest rate guarantee. Lower market interest rates are inversely related to bond prices so the lower the interest rate, the higher the price of the bond in general. Stock market volatility has been more the norm in the new millennium and this causes the prices of call options to increase as well as volatility is factored into the call option cost.
There has been no life insurance company that has been insulated or immune to the low interest rate environment when it comes to the manufacturing and issuing of universal life products. All have had to grapple with the issues of how to develop products that will provide their insureds with a solid value proposition while having to deal with a less than optimal interest rate market.
While UL holds the dominant market share with respect to premiums vs. competing life insurance products, the share could erode in a bull market (as variable life sales increase) or in a volatile/apprehensive market (as insureds move to whole life and term products in a flight to quality).
Also, there is always the potential for a new product type to enter the market and shift the focus away from UL products, much like UL products shifted focus away from more traditional life products in the 1980s.
As mentioned, FIUL products have made a definite splash in the 2000s by offering the potential for upward appreciation while limiting the downside risk often associated with variable products. The FIUL is more in line with mainstream UL products in that the potential to accumulate significant cash values is the draw.
Another major growth area in the 2000s, perhaps even more so than fixed indexed UL, has been the growth and proliferation of secondary guarantee UL products, commonly referred to as shadow account UL. This is a product line where the emphasis is on securing insurance protection over a prolonged period of time rather than trying to accumulate significant cash values. In fact, many cash values often turn negative in the later years in a typical shadow account product.
The shadow account UL product is intended to provide life insurance protection over a prolonged period of time (there are several products on the market that provide guaranteed insurance coverage all the way to contract maturity). The insurance protection is guaranteed to stay in force as long as the underlying "shadow" account is positive. Premiums are lower than a normal UL product and, at older ages, are attractive enough to lure buyers given that term products are not available or not feasible at those older ages.
The shadow account works in the same way as a normal UL accumulation fund, except that the credits and charges assessed to the shadow account can be quite a bit different in scale and size than the normal UL accumulation fund. While the shadow account is positive, the policy will stay inforce, even if the cash values of the normal UL accumulation fund turn and stay negative.
While most, if not all, life insurance companies have jumped on the shadow account wagon (much like life insurance companies that turned their focus over to selling UL in the 1980s), the amount of capital needed to support a shadow account UL product has given several life insurance companies pause to consider. The amount of reserve needed to support a shadow account UL product is quite large in relation to the reserves held for other non-shadow account UL products. It is the length and nature of the coverage guarantee that has driven the regulatory bodies to develop the current reserving mechanism in use today for shadow account products.
Nonetheless, shadow account products are popular with the insurance buying market as the result of this lifetime guarantee. Shadow account products are easy to understand in concept. As long as this underlying shadow account stays positive, the policy stays inforce. While the actual mechanics, charges and credits of the shadow account are not easy to understand, the shadow account provides a solid guarantee. This product is for those insureds who favor insurance coverage over cash value accumulation.
So, instead of just grappling with low interest rates, insurers who sell shadow account UL products also grapple with the capital intensive nature of these products due to the high amount of statutory reserves that companies selling these products are required to hold. Since the reserves held by insurance companies do not directly impact the policy holder, this issue is invisible to the policy holder. It may only become visible if the insurance company was on the brink of insolvency, but there have been many safeguards put in place over the last 25 years by insurance regulatory bodies to minimize the possibility of this happening.
Another risk for the insurance company selling shadow account products is lapse risk. Most shadow account UL products are lapse supported meaning that more lapses mean more profit for the insurance company. This is in contrast to most life insurance products where the opposite situation exists (i.e., fewer lapses lead to more profits).
So, it is very important for the insurance company that manufactures and sells shadow account UL products to be very judicious in their estimate of future lapse rates during the pricing process. Most insurers try to be prudent; some even factor a 0% lapse rate in pricing once the shadow account is "in the money" so to speak (some consider this to be at the point when the shadow account is positive and the regular fund cash values are zero or negative). Lapsing at that point would provide no benefit to the insured as there is no cash value to be had. The only lapses would be from those who no longer can afford (or desire to) pay a premium or for those who feel that they no longer need life insurance protection.
Yet another risk for the insurance company is older age risk that comes when a disproportionate number of policies issued are to older age individuals. Since term insurance for older age individuals is not offered or is so costly as to not be an option, the only way to affordably maintain life insurance protection for this group is through a shadow account UL product. The average issue age of the shadow account UL product is generally in the 60s.
Part of the issue with respect to mortality risk is that there is still limited experience regarding mortality rates and the mortality curve slope at older ages. Given that several shadow account products on the market can last until maturity (age 121, for example), the limited amount of older age mortality experience data that exists at ages 90 and up can be a deterrent to entering the shadow account market for some life insurance companies.
So, while there are numerous risks for the insurance company in the shadow account UL market, as well as capital intensiveness and limited profitability, these products have been a hit with the consumer looking to maintain life insurance protection for a long timeframe at a reasonable price.
As far as our old friend UL whose foundation was to provide cash value accumulation, the fixed index UL and even VUL products provide an alternative for that market. With regards to the type of UL that has been in the market the longest, which is both non-variable and non-indexed in nature, it may be quite some time before interest rates rise to such a level as to make these products competitive in the market again.
While the interest rate spread earned by insurance companies on UL has been compressed and is no longer quite the profit driver it used to be, insurance companies continue to try and find ways to make cash accumulation UL both appealing to the general life insurance buying public and profitable to sell.
These include managing the other sources of profit, such as mortality, expense and surrender, even more closely than before.
For example, as mortality rate studies continue to show a downward trend in mortality rates as more people engage in healthier life styles, some insurance companies may factor this directly into their pricing (as well as future mortality improvements) in attempts to earn a larger spread on expected vs. actual mortality. With respect to expenses, some insurance companies have lowered agent commissions which, while not exactly pleasing to the sales force, can help increase the profitability of a product. Becoming more effective at overall insurance expense control has been another way companies have tried to cope.
Others have used increased policy charges to allow for the crediting of higher rates. Some have increased their earned rates by lowering the quality of the new asset portfolio or going out longer on the yield curve.
Features, such as new riders (LTC, for example), have also been a way to make UL more attractive in light of a low interest rate scenario. Also, market value adjusted products have been introduced.
Whatever method in use, insurance company creativity continues to show through as one of the strong points of our industry. Yet, cash accumulation UL will come back into the forefront one day when interest rates begin their inevitable climb upwards. Until then, companies will continue to exercise their vast creativity to continue selling these products and provide value for their clientele.
William "Bill" Aquayo
SVP, Actuarial Services
FSA, MAAA, CFA, ChFC, CLU