Trusts & Estates Article

8/11/2019 Trusts & Estates Article

1/6

T he world of life insurance presents what feelslike a never-ending array of products and choic-es. One of these emerging product structures,indexed universal life insurance (indexed UL), maybe heavily marketed to your high-net-worth clients.Typically illustrated at rates higher than traditionalpolicies, these indexed UL products appear to offer anopportunity to manage risk.

The value proposition seems simple, but proceedwith caution: The mechanics of this product are com-plex and often not clearly articulated by those pro-moting this product structure. To help you determinewhether to recommend indexed UL for your client, letslook at how indexed UL works, learn why its importantto carefully evaluate the sales illustrations promotingthe product, evaluate the efficacy of combining it withpremium financing and suggest questions for you as anadvisor to high-net-worth clients to ask along the way.

How it WorksIndexed UL is much like traditional UL in its basic struc-ture. The fundamental difference is how interest getscredited to the policy. Traditional UL has a stated interestcrediting rate thats based on the insurance companysunderlying pool of assets, primarily bonds, which sup-port the product.

Do Your Homework on IndexedUniversal Life Insurance

Answer four key questions before combining this productwith premium nancing for your high-net-worth clients

Equity indexed products, on the other hand, creditreturns in a very different way. Policy earnings arebased on the performance of an equity index likethe S&P 500. The policy is structured to have upsidepotential based on the performance of the market,while maintaining a guaranteed downside protec-tion of a minimum 0 to 2 percent return, which isset by the insurance company offering the contract.

Indexed products offer what appears to be a desirablecombination of upside potential with limited risk, all ina universal life structure.

The S&P 500 is the most common equity index usedto calculate market upside in indexed UL products,although some carriers offer accounts linked to otherinternational and domestic indices or combinations ofindices. The insurance carriers dont actually purchasethe indices, but credit performance to the policy basedon the purchase of options linked to the relevant index.

Since indexed UL products dont actually investpremium dollars in the index, carriers have broad dis-cretion in determining the methodology for creditingthe gain in the index to the policy. The most commonand intuitive method, known as the annual point-to-point strategy, is to calculate the gain from the pointthe premium enters the indexed account to exactly one year afterwards. Carriers may offer several other ways tocalculate and credit the gain.

Participation LimitsIndexed UL products limit the degree to which thepolicy will enjoy the gain (that is, the maximum possible

annual return) in the index; this is expressed as a caprate. (See How to Credit Returns, p. 2.) The productmay also limit the degree to which the return is credited

Kenneth R. Samuelson, far left, and Brandon W. Davis,center, are principals at The Morehead Group, Inc.

in Charlotte, N.C. Bobby

Samuelson is the principalof SamuelsonDesign, LLC,in Austin, Tex.

By Kenneth R. Samuelson, Bobby Samuelson & Brandon W. Davis

Feature: Insurance

1

A Penton Media Publication

The Journal of Wealth Management for Estate-Planning ProfessionalsSince 1904

Trusts & Estates

--FOR PERSONAL USE ONLY--
http://trustsandestates.com/http://trustsandestates.com/http://trustsandestates.com/http://trustsandestates.com/http://trustsandestates.com/


2/6

UL charge structures, traditional UL products arethe best benchmark for determining reasonablepolicy expenses. With some notable exceptions,mortality charges inside indexed UL products are,on average, meaningfully higher than traditionalUL products. Consequently, indexed UL contractsrequire better return performance than their tradi-tional UL counterparts to offset the increased coststructure.

Illustrated rates. Life insurance illustrations are acentral part of the life insurance sales process. Theyillustrate the possible future performance of thelife insurance product based on a wide variety ofassumptions, the most prominent of which is theassumed credited interest rate. Unfortunately, lifeinsurance marketing often turns into an unproduc-tive exercise of illustrating higher and higher hypo-thetical rates. Indexed UL products are particularlyprone to excessive focus on illustrated values becausethe products dont fall under the specific illustra-tion restrictions of variable UL or traditional UL.

Thus, carriers have significant leeway concerning

to the policy; this is called the participation rate. Aparticipation rate determines the percentage of the totalindex gain transferred to the policy values. These twolimits are jointly referred to as participation limits.Each indexed UL product has a unique combination ofthese two elements.

But take note: When evaluating indexed UL prod-ucts, read the fine print. Many indexed UL productsoften contain caveats that can have a wide range ofsignificance to the policy owner. For example, virtu-

ally all policies allow the insurance carrier to change

cap rates and participation rates at any time duringthe life of the policy. Carriers even have the right tochange participation limits down to guaranteed mini-mums stated in the contract, typically so low that theexpected credits would be less than Treasury yields.Additionally, insurance carriers arent obligated tomaintain consistent participation limits between newpolicies and in-force policies.

One of the most significant details often over-looked is that indexed UL products dont account fordividends from the underlying index. Remember, thecarrier doesnt purchase the index, but rather an optionassociated with the index. This means that dividendsarent included in the return calculations, which couldbe a significant reduction of performance when com-pared to the index with reinvested dividends.

Policy Charges/Illustration RatesThere are several issues associated with indexed ULinsurance that could affect whether it makes sense for your client to purchase it. Lets look at two of thesecomponentspolicy charges and illustrated rates.

Policy charges. Policy charges are as important aspolicy credits in the performance of life insurancecontracts. When making a comparison of indexed

How to Credit ReturnsIndexed UL often bases its performance on the S& P 500and limits the degree to which a policy enjoys gain

Bobby Samuelson, SamuelsonDesign, LLC

Feature: Insurance

Indexed UL contracts require better

return performance than their

traditional UL counterparts to offset

the increased cost structure.

2 --FOR PERSONAL USE ONLY--


3/6

Feature: Insurance

illustrated rates in indexed UL, whereas variable ULis a registered product and traditional UL is restrictedto projecting at currently stated rates.

Carriers typically illustrate future product perfor-mance based on some method of observing historicalperformance of the subject index. The challenge is thatindexed UL products havent been around long enoughto use actual historical indexed UL performance. As aproxy, carriers estimate historical returns by applying

their current, non-guaranteed cap and participation ratesto historical index data. Illustrated rates using this typeof analysis generally range from 7 to 10 percent, which ishigher than traditional UL products in the current inter-est environment of 2010.

Dissimilar ComparisonsIndexed UL products are actively marketed as an alter-native to traditional UL products. These traditionalproducts illustrate at a rate comparable to highly ratedcorporate bonds of, say 4 to 5 percent. Insurance carriers

and promoters point to the indexed UL illustrated ratesgleaned from hypothetical historical back-testing to sub-stantiate a consistent performance advantage over tradi-tional UL of 200 to 500 basis points or 2 to 5 percent.

But the two illustrated rates, however, arent readilycomparable. Indexed UL rates are based on hypotheticalhistorical performance with analysis covering past eco-nomic environments, often 20 to 50 years, during timeperiods with significantly higher risk-free interest rates.Traditional UL illustrations are limited to the current yield offered in the product, based on a carriers currentgeneral account assets. Carriers are, in effect, using his-torical index returns to show a performance advantage

for indexed UL over current rates in traditional ULproducts. Again, these arent comparable.To compound the problem, carriers make no adjust-

ment for the impact different interest rate environmentsmay have had on caps and participation rates over time.A 12 percent cap may be competitive in todays interestenvironment when Treasury rates are at 2 percent, but itwould be uncompetitive in the 14 percent rate environ-ment of the early 1980s. Comparison of indexed UL totraditional UL based on hypothetical historical analysiscreates an environment for misinterpretation.

Hedging Risk

Insurance products are, at their core, financial instru-ments. Indexed UL products have a unique structurebecause the carrier has promised upside exposure toan equity index thats largely uncorrelated to its owngeneral account yield. The carrier can either retainthe liability associated with this promise on its ownbooks or purchase insurance in the form of options tocover the cost of this added benefit to the policy.

Most carriers choose to hedge the risk and purchaseoptions to remove the liability from their books. Thislimits the equity exposure to the carriers bond-basedgeneral account. This liability removal transaction forms

the foundation for indexed UL pricing. The price to pur-chase these options determines participation limits, car-rier profitability and long-term product performance.

This means that the carrier pushes market risk inher-ent in the product to a third-party option seller and thusis largely profit-neutral to the actual performance of theindex. Annual profit and loss on the policy from the car-riers point of view is determined by the relationship ofoptions prices to the options budget, which is derivedfrom general account yields.

Suppose a carrier markets a 12 percent cap and a0 percent floor but must pay more for the options thanthe general account yields justify. The carrier has threechoices: (1) lower the interest cap rate; (2) change theparticipation rate; or (3) financially subsidize the prod-uct from elsewhere in the company. The carrier faces thesame decision if general account yields decrease withouta corresponding decrease in options prices for the capand participation rates its promoting.

The primary implication for future performance ofthe policy is that all equity-like upside from the productmust come from options returns. Since the vast major-ity of the policy values are dedicated to maintaining

reserves for the guaranteed minimum floor, the rela-tively small premium used for the options budget is theonly piece that has the opportunity to earn interest

Comparison of indexed UL to

traditional UL based on

hypothetical analysis creates an

environment for misinterpretation.



4/6

Feature: Insurance

Step 4: The general account yield dictates the amountof premium required to satisfy the guaranteed floor.

Step 5: The residual amount, also determined by thegeneral account yield, goes to an investment bank topurchase options that exactly replicate the participa-tion limits inside of the policy.

Step 6: The investment bank writes the options andeffectively provides insurance coverage for the liabil-ity associated with the indexed UL crediting rate.

Step 7: The carrier provides an index credit using thereturns from the options.

Step 8: The carrier adjusts participation limits basedon the cost of options as it relates to the generalaccount yield. The options budget must match the costof options for a stated participation rate for the carrierto be profit neutral in the transaction. Step 1 startsagain with newly stated participation rates if needed.

Its reasonable to assume that indexed UL productscould outperform their traditional UL counterparts.In a 5 percent interest environmentand holdingeverything else constantto achieve approximately25 to 50 basis points on average over the long termwould require a return on the options in the 10 to15 percent range per year. (See Return Patterns,p. 6.) An 8 percent projected yield on an indexed ULproduct in a prevailing 5 percent interest rate environ-ment would require a much higher yield, somewherein the neighborhood of 60 percent. This type of returnpattern is challenging in virtually any economic cli-

mate and puts significant pressure on the carriers todeliver the elevated returns typically illustrated inindexed UL products.

Anyone considering a financed

life insurance transaction should

be aware of certain important

disclosures.

above and beyond the guaranteed minimum floor.Lets look at a typical indexed UL hedging transaction

from start to finish. In Hedging Risk, this page, assumea $100,000 net premium payment after premium loadsand policy charges. At the beginning of the year, the car-rier sets a guaranteed floor, assumed to be 0 percent, andsets a general account rate (5 percent in this example). Atthe 5 percent rate, the required premium of $95,238 willgrow to the net premium of $100,000 by the end of the year, thus achieving the 0 percent guaranteed floor. The

residual premium, $4,762, is used to purchase options tohedge the indexed liability. The options returns dictateany excess policy yield above the guaranteed rate floor.

What Goes Where, p. 5, depicts the flow of moneyand interactions between investment costs inside of atypical indexed UL product:

Step 1: The writing carrier makes a published state-ment about participation limits inside of the indexedUL policy.

Step 2: The client pays a premium into the product

and loads and policy charges are deducted.

Step 3: The net premium goes to the carriers generalaccount.

Hedging RiskThe residual premium is used to buy options to cover thecost of promised upside exposurethis removes liability from a carriers books




5/6

Premium FinancingPremium financing is the use of third-party capital topurchase insurance. For high-net-worth estate planning,premium financing typically entails accessing a lendinginstitution to pay life insurance premiums. Traditionallife insurance premium financing uses a fully-collateral-ized note typically structured as a floating or fixed ratebased over the London Interbank Offered Rate. Othertypes of more exotic premium financing are availablebut have become less common with the recent upheavalin the credit markets.

Just as illustrations are an integral part of the lifeinsurance sales process, spreadsheet analysis is equal-ly important to premium financing.Promoters use assumption-drivenspreadsheets to project the potentialoutcome of a transaction. While thisis a useful practice to present one pos-sible result of a transaction, theyrerarely sophisticated enough to accu-rately depict the wide range of possibleoutcomes.

Promoters often overstate policy

returns and understate interest raterisk by illustrating assumptions thatreflect favorably on the transaction.They often stop short of analyzing theprobabilities of the assumptions actu-ally coming to fruition. As with anyleveraged transaction, small variationsfrom expectations can compound intolarge differences over time.

To make an informed decision,anyone considering a financed lifeinsurance transaction should beaware of certain important disclosures. First, pre-mium financing is subject to the lenders collateraland financial underwriting requirements. Premiumfinancing borrowers are required to undergo financialscrutiny from the lender, pledge collateral in additionto the policy itself and, in most cases, theres a riskof the lender calling in the loan. Second, premiumfinancing is complex and involves many risks, suchas the possibility of policy lapse, loss of collateral,interest rate and market uncertainty and failure tore-qualify with the lender to keep the financing in

place and maintain the desired level of insuranceprotection. Third, financing lenders typically requireadditional collateral during the early years of a policy

in the form of cash, cash equivalents, marketable secu-rities, a personal guaranty or a letter of credit from abank approved by the lender. Interests in closely heldbusinesses and real estate arent generally acceptablecollateral. And finally, in certain situations, additionalout-of-pocket contributions may be required to retirethe debt and/or maintain the desired level of insur-ance protection.

The ComboWhat happens when you mix indexed UL and premium

financing? Today, indexed UL is promoted in the mar-ketplace as a viable structure for premium financing. Its

high-illustrated rate produces what seems like a success-ful spreadsheet analysis. Financed indexed UL showsmore long-term arbitrage, or positive spread betweenpolicy performance and financing costs, than wouldbe possible using a traditional UL illustration. Assuch, promoters have eagerly embraced premiumfinancing of indexed UL products despite the factthat the mechanics behind it are largely the same aswith traditional UL.

Typically, premium financing with indexed UL devi-ates from traditional UL when presented in a spreadsheet

to the client. Indexed UL products are typically illus-trated at a rate well above 7 percent, which assumesa 1.5 percent-plus long-term performance advantage

Indexed ULProduct

Policy Premium

Indexed CreditIndexedCredit

Liability

LiabilityHedging

Costs

IndexedLiabilityCoverage

HedgingBudget

Net Premium

Guaranteed Floor

ProductParticipation

Limits

CarrierGeneralAccount

IssuingCarrier

InvestmentBank

What Goes WhereHeres a look at the flow of money and interactions between investmentcosts inside of a typical indexed UL product


1

7

68

2

4

5

3

Feature: Insurance



6/6

some lenders require, that clients pay loan interest annu-ally to limit debt exposure. Some promoters guide theclient to work with attorneys or advisors to implementestate-planning vehicles that develop a source of repay-ment for the external financing. These methodologiesare very helpful in reducing the risks of the structure.

Bottom LineBefore you recommend financed indexed UL insurancefor your client, we recommend that you ask the follow-ing questions:

1. Does this strategy work if the indexed UL policyis illustrated at a crediting rate similar to a tradi-tional UL?

2. What rationale was used to determine an accept-able illustrated loan interest rate?

3. Does the carrier have different cap and participa-tion rates for new business and in-force policies? Ifso, why?

4. When illustrated at the same crediting rate as thetraditional UL product offered by the same car-rier, does this product perform better or worse? Ifworse, what are the additional policy expenses inthe indexed UL product that arent present in thetraditional UL?

As you can see, financed indexed UL insurance is acomplex transaction, to say the least. A spreadsheet analysis of premium financing and indexed UL shows one ofan infinite number of possible outcomes. The structuresthat have the highest possibility of manifesting a positiveoutcome will be based on conservative illustrations andassumptions as they relate to both the product as well asthe financing structures. These structures are too newto judge whether they are a good or poor idea. Advisorsneed to be informed about the nature of the indexed ULinsurance structures as well as the specifics of the financ-ing to make a wise recommendation to clients.

This article is provided for informational purposes onlyand is not specific to any particular situation. All guaran-tees are based on the claims paying ability of the issuing

insurance company. The indices mentioned are unman-aged and cannot be invested into directly. Past performanceis not indicative of future results.

over traditional UL. In todays interest rate environ-ment, loan rates are typically illustrated at between 2 and5.5 percent for the life of the arrangement.

Disregarding policy charges, promoters point to thedifference between the indexed UL hypothetical credit-ing rate and the arbitrarily projected future loan interestrate as a possible sustainable arbitrage (that is, theongoing positive spread between cost and performance).Based on the theory of sustainable arbitrage, the clientcan essentially acquire large amounts of life insurancewhile paying little or no costs out-of-pocket.

According to the financial spreadsheet, loans oftenpay the entire policy premium and incorporate all loaninterest and loan origination costs. Clients may beshown an additional collateral commitment for thefirst few years of the loan, but interest rate arbitragebased on illustrated index yields is often shown toquickly build cash values sufficient to offset the loanbalance and related collateral requirements. Unlikemost traditional UL premium financing arrangements,the financed indexed UL spreadsheet often doesnt showa need for any repayment of debt aside from the policy

death benefit at maturity.Not all indexed UL and premium financing illustra-tions are this extreme. Some promoters recommend, and

Return PatternsHigher projected yields on an indexed UL productin a 5 percent interest environment require higheroptions yields


Feature: Insurance

TE

Copyright 2010 by Penton Media, Inc.6 --FOR PERSONAL USE ONLY--

Trusts & Estates Article

Documents

Transcript of Trusts & Estates Article