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Indexed Universal Life: Back Testing and Cap Rates and Averages, Oh My!

July 30th, 2020 No comments

In a recent engagement, an agent trying to convince a client to enter a premium financed indexed universal life (IUL) transaction was touting returns on his own IUL policy over the past decade or so.  I found a number of aspects of this peculiar.  One was that he was touting the average interest rate on his own policy, which has happened to be in force during the longest bull market in U.S. history.  This was supposedly a reason the product was so great and could/might actually outperform the crediting rate of the sales ledger, which I already deem to be too aggressive based on significant objective data.

Another oddity is that he evidently doesn’t understand the difference between an average interest rate and the internal rate of return (IRR), which is the difference between an arithmetic mean and a geometric mean.  The geometric mean will generally be lower, and it’s the number any sensible person would use when evaluating an investment.  As an example, what if you get a 0% rate of return for three years and then a 40% return in the fourth year?  The average rate of return is 10% but the IRR is 8.78%.  It’s respectable but not accurate.  No one would reasonably look at the track record of this product as 10%.

Next, the agent was sharing past rates of return that are higher than currently possible due to falling cap rates.  In an IUL product, the cap rate is the highest crediting rate possible regardless of the actual index return.  On the flip side, there’s a minimum, often 0%.  Therefore the product is postured as having upside potential with downside protection.  This is not untrue but rather misleading without a full discussion of internal policy fees and charges and what’s going on with caps.

Everyone knows that past returns aren’t indicative future performance, but that’s especially true when one takes the higher returns off the table.  I’ll make a silly example of hypothetical historical returns.  Let’s say that over the past 10 years, consistent great returns were limited by a falling cap.  We’ll assume returns of 16%, 16%, 14%, 14%, 12%, 12%, 10%, 10%, 8% and 8%.  The IRR would be 11.96%.  Relating that to a prospective client when the current cap is 8% would be incredibly misleading because the cap makes the 10s, 12s, 14s, and 16s impossible.   Going into the same sequence of returns with the lower capped policy will result in an 8% IRR, resulting in a 30% reduction in value from returns alone and more when incorporating expenses.

“How Caps Affect Returns,” below, is based on a recent IUL sales ledger on my desk.  It shows an IRR of 8.12% for the S&P 500 Index (remember that indexes don’t include dividends that add a couple hundred basis points to the return) for the 25 years from 1994-2019.  Now let’s apply caps.  I’ve included what caps at 14%, 12%, 10%, 8% and 6% would do to the return.  At 14% the average actually increases because removing the negative years makes a difference.  However, check out the return as the cap falls.

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Caps are Falling

Why does this matter?  Because caps are falling.  I’m not going to get into a discussion on this now, but due to market volatility, changes in options budgets and pricing, etc, caps are falling meaningfully and quickly.  Many that were well into the double digits are sinking through single digits now.  A cap on one product that was at 17% is now at 9.75%.  As seen in “How Caps Affect Returns,” this is having a huge impact on projections and crediting of products moving forward.  Reductions are being announced all over and regularly.  If a contract has a current cap of 9%, how ethical is it to crow about a 13% crediting years ago that’s contractually unavailable now?

The reason this affects sales ledgers and projections is because Actuarial Guideline 49 (AG 49) integrates caps into the formula for allowable crediting assumptions.  A product that may have been illustrated at 9% before AG 49 might be illustrated after AG 49 at 7% but now with falling caps at 5.75%.  The proposed AG 49A updated regs are meant to reign in abuses by insurance carriers who have found ways to skirt the rules since AG 49 was implemented.

Backtesting

Many promoters lean heavily on backtesting, and this concept has its place.  However, putting a ton of weight on it when cherry picking data can be dangerous.  For example, that 25-year IRR of 8.12% is 4.02% if I look at 20 years instead.  (See “Gaming the System” below)  That’s the difference when you look at a data set that includes the first five years with an arithmetic mean of 26.32% rather than one that starts with a three year arithmetic mean of negative 15.52%.  Let’s shorten it to 10 years.  Now we jump to 11.22% IRR.  This gets to be a little bit silly.  We can game numbers all day long.  Yes, the AG 49 rules use a 25-year backtesting rule, but does anyone think it will be front and center at a point when it doesn’t tell the desired story?

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Talking about gaming, there’s a push to only apply AG 49A to policies sold after it’s effective so the same contract sold before and after a given date will illustrate differently though they‘ll operate identically.  It’s like the National Highway Traffic Safety Administration discovering a deadly flaw in an automobile and not telling people who bought the car before the problem was discovered.  We certainly wouldn’t want to confuse the people who purchased the car before thinking it was safe, would we?

Now let’s apply a cap to these numbers.  Looking only at a 10% cap, the 25-year IRR is 6.51% versus 5.65% for 20 years and 6.85% for 10 years.  This is significant when realizing that a single digit basis point change on projections can spell the difference between success and failure. (See “Applying the Cap,” below.)

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Being Judiciously Skeptical

Some might flip the script and say I’m the cherry picker now that we’re at the end of a historic bull market and caps are falling and regulations are changing, but I’ll push back.  The very reason IUL has been so popular is because of recent stock market returns and the high caps and increasing premiums of guaranteed universal life and falling dividends of traditional whole life.  The markets and marketers always chase returns or lowest perceived cost.  This is why, starting about 1980, the market has pivoted from traditional whole life to universal life to variable life to guaranteed universal life to IUL.  What’s easiest to sell based on what’s just happened in the market is the product with an increasing market share.  It’s like clockwork, and data backs this up.

While IUL isn’t an inherently bad product and does have features some are going to appreciate and it’s an appropriate product for people with certain objectives and appropriate risk tolerances, the very fact that it’s the product du jour is reason enough to more closely scrutinize it.  If we know the product with the rosiest projections of low cost and high returns is going to be the most aggressively marketed now through financing programs that make it look like it costs even less and returns even more, to jump in without independent third party analysis is absolutely insane.

These issues are only the tip of the iceberg when it comes to possible and actual manipulation of data, but at least the problems with leaning on backtesting when it looks good, misposturing averages and ignoring falling caps can be understandable to many current and potential consumers and their advisors.

 

Bill Boersma is a CLU, AEP and LIC. More information can be found at www.OC-LIC.comwww.BillBoersmaOnLifeInsurance.info, www.XpertLifeInsAdvice.comwww.LifeLoanRefi.comTheNAPIC.org, www.LifeInsExpert.com or email at bill@oc-lic.com.

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Video: Funding a Buy-Sell Agreement with Life Insurance

July 28th, 2020 No comments

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Woes of a Fee-Based Life Insurance Consultant

July 21st, 2020 No comments

Why are policy owners so reluctant to pay for these services?

I’ll admit it.  I get frustrated at times.  I’m a fee-based consultant brought in by attorneys, CPAs, trustees, financial advisors and family offices to review, create, fix and do whatever else is needed regarding life insurance products and concepts.  I’m approached to analyze policies and programs already in force for years or even decades, and sometimes it’s new proposals that I’m retained to opine on.

History Can be a Guide

I’ve been around long enough to say “I told you so” a lot.  When I first started doing “policy audits” 20 years ago, which was already 15 years into declining interest rate markets, most policy owners and their advisors hadn’t seen many, if any, examples of underperforming whole life (WL), universal life (UL) and variable life policies.  Few people understood how modern life insurance worked and how the interest rate markets affected it, so few even looked to monitor, let alone manage, life insurance policies and portfolios. For full post, click here…

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Speaking to Clients About Premium Financed IUL Policies

June 16th, 2020 No comments

It’s important to understand the details and risks. This sample letter may help clients and advisors alike.

 

Dear Ms. Prospect:

It was good to speak with you yesterday morning about the proposed supplemental retirement plan, and I thought I would follow up with a couple of comments. As we discussed, I’m very familiar with indexed products and premium financing. I believe there are appropriate times and places to use the product and strategy, and there are times when it’s not.

Prospective consumers need to fully understand what they’re getting into on both the product and the strategy side. They need to intimately understand the variety of risks. A general rule of thumb is that they should be able to pay the full premium out of pocket but choose to finance it because they’re comfortable with the risks and have the ability to buy themselves out of trouble if trouble shows up (and it does too often). Finally, they need the policy meticulously managed until the day they die.

The proposed product is a newer policy design, and some feel it’s too aggressive. I have access to a tremendous amount of analysis regarding the policy that I’d be happy to share. One reason it’s popular in the premium financing world is because it was created to illustrate very strongly and to win the illustration wars. This doesn’t mean it’ll actually perform successfully. For full post, click here…

Coronavirus-Related Life Insurance Considerations

May 12th, 2020 No comments

Things to keep in mind.

While some insurance carriers are implementing virus-driven underwriting changes, I’ll focus on other issues to think about during the COVID-19 pandemic regarding life insurance. Most, if not all, of these issues are applicable during normal times, but it might be easier to get attention now.

Cash Flow

I recently read a statistic about the percentage of people feeling a cash flow crunch as a result of layoffs and the disruption of business. It’s to be expected, even for the most responsible of us. Even those not in a real crunch now are choosing to delay mortgage payments and discretionary purchases simply because there’s too much uncertainty moving forward.

What should policyowners keep in mind now? If they’re in a cash crunch and life insurance premiums prove an undue burden, there may be

options, but they need to be understood and enacted appropriately. Many life insurance policies can handle not having premiums paid for some period, but policyowners better be sure, and often they don’t know if that’s the case. Also, and this might sound strange, depending on the kind of life insurance, they better not pay the premium the right way. For full post, click here…

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Coronavirus, Preppers and Life Insurance

May 4th, 2020 No comments

Can the current situation help us focus on priorities?

I don’t think of myself as a prepper, but not everyone agrees. My truck has a toolbox, fire extinguisher, jumper cables, flares, extra oil and antifreeze, a medical kit, tow straps, a water filter and more. Some might roll their eyes, but when something is on fire, literally or figuratively, they tend to look in my direction. Yes, my Wrangler looks like an apocalypse response vehicle, my basement has its share of home canned goods, and people joke about heading to my house during a disaster, but it’s only a joke until it isn’t.

I’m not racing to the store now to stock up on anything, and that’s a nice feeling. What does this have to do with life insurance? Quite a bit. Why am I thinking about it now? A year ago, an executive I met started asking me about his life insurance as his term policy was close to expiring. Life gets in the way, and I didn’t hear back from him for quite a while. After he reestablished communication, I learned he was prompted into action after his 50-some-year-old brother-in-law, a professional himself, died suddenly leaving a wife and three children at home … and no life insurance. I see this more often than I care to say. For full post, click here…

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Insurance Policy Loan War Stories

April 24th, 2020 No comments

Why it makes sense to understand what’s going on when refinancing.

After writing a few pieces on loan refinancing, I’ll now share some examples. Over the years, I’ve seen many situations in which policies have significant loans. These include whole life (WL) policies, universal life (UL) policies and others. Some are modest, and the policies can handle the loan, while others are overwhelming and will drive the policies into the ground. Some have reasonable rescue strategies, and others are all but loss causes.

These situations often involve a lack of understanding about how the policies fundamentally work, how loans affect the contracts and how to manage the policies over time. In some situations, the initially chosen policy management features, which have caused the problems to escalate over time, have never been changed. Sometimes I’ve been able to simply make a dividend option change, and a failing policy can be self rescued with the trajectory of the cash value, loan and death benefit reversing itself over time. For example, when a policy has an 8% loan interest rate in today’s market, why would a dividend option be set to buy additional paid up insurance while ongoing premiums are added to the loan and loan interest accrues? Again, it’s a lack of understanding and too often an abandonment of the policy owner by the agent. What may have been true a number of years ago may not be true today given the meaningful changes in the financial marketplace and policy crediting. Policy management is an ongoing responsibility. For full post, click here…

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A Different Kind of Premium Financing

March 18th, 2020 No comments

Concentrate on the spread between borrowing rates and opportunity cost of money.

In certain markets, premium financing is all the rage and has been for some time.  The basic pitch is that wealthy, sophisticated clients should borrow money at low rates to buy life insurance and let their money grow at a higher rate and over a number of years. The results of this spread or arbitrage can pay back the loan so they’re not out of pocket for the entire cost of the life insurance.

This is perfectly legitimate, but I also believe there’s right way and a wrong way to do it.  I’m not a fan of much of what I see in the market because I feel, or have proof in many situations, that it’s based on misrepresentation and a severe lack of understanding.  The disasters that end up on my desk are almost all based on the perceived spread between borrowing rates and life insurance policy crediting.  Unfortunately, in too many situations, this isn’t real or sustainable, and few consumers and advisors understand how it really works and the risks involved.

The real opportunity with premium financing is on the spread between borrowing rates and opportunity cost of money rather than the policy crediting.  It’s the same reason I don’t pay off my home mortgage.  If I’ve borrowed at 3.5% to buy my house,  I believe I can do better than that over time in the market and I understand and accept the risks and have the wherewithal to deal with the results if things change, why would I pay down my mortgage any faster than I have to? For full post, click here…

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Life Insurance and Policy Loans

March 4th, 2020 No comments

Bill Boersma, Jason Kurchner | Mar 04, 2020

A match definitely not made in heaven.

As a life insurance consultant, I see just about everything imaginable out there. My desk is littered with cases for which I’ve been called in to pick up the pieces after the wheels fall off. In fact, litigation support and expert witness work is the fastest growing part of my practice. There’s a lot of good work, but there are also a tremendous amount of lousy plans. Advisors are regularly bringing me their client’s non-performing policies and structures and I like to use these real life cases to educate as many advisors as possible.

I urge the advisor community to address these issues before clients are dissatisfied and angry. Proactive action can prevent problems and save a ton of money. There’s a common problem that few are aware of that has an obvious and simple solution.

Large Policy Loans

There are a handful of current files on my desk with large policy loans. The loans on these policies range from $500,000 to $3 million. In some of these contracts, money was actively borrowed out, and in some, the loans are a result of borrowing premiums to fund the policy. In others, the policy owners didn’t even know a loan existed. Imagine the shock when they learned this. For full post, click here…

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An Unfortunate Conversation Regarding a Life Insurance Policy Loan

February 12th, 2020 No comments

What your client doesn’t know certainly can hurt him

Life insurance policy loans trip up more people than I thought could ever be possible.  It’s not because they’re so complicated but because they aren’t properly explained to most policy owners.  Worse yet, many policy owners don’t even know they have loans on a policy and when they do, don’t understand how they got there.  This sounds so ridiculous it defies belief.

Consider this: A policy owner recently called me after his attorney sent him a copy of something I’d written about policy loans.  “This story could be about me.” he exclaimed.  I asked him to send me what he had and explain what he was trying to accomplish.  Included was a list of questions he had for his agent, of which the agent answered the simple and inconsequential ones and ignored the balance.  It was easy to understand why, as the balance of the questions had no answer that any agent would want to share with a client.

Here was one of the questions: “When I first talked to you years ago, you indicated that I could borrow my own funds at a 1% to 1 1/2% interest rate, so how did the loan get to over $700,000 when I only borrowed about $175,000 and paid back $225,000 at one point.”  I imagine that would be a good question.

It’s fortunate but sad that I knew the answer before I opened the attachments because this isn’t the first or last time I’ll see this.  I’ll recreate the conversation: For full post, click here…

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