Are Your Indexed UL Earnings Underperforming Pricing Expectations?
By Nik Godon and Francis Hebert-Losier
Product Matters!, February 2024
U.S. insurers haven’t necessarily seen the growth in indexed universal life product sales achieve expected profit levels. Why, and what can they potentially do about it?
Indexed universal life (IUL) continues to be a hot product in the U.S. life insurance market, with many carriers continuing to enter the market. In 2022, IUL sales increased to 25% of total life sales premium (from approximately 8% in 2010) and totaled close to $3 billion.
The growth has been driven in part by the long-term reduction in interest rates. This has made traditional universal life (UL) products less attractive from an accumulation perspective and has caused a shift away from universal life with secondary guarantees (ULSG) due to increased prices and carriers’ desire to reduce long-term interest rate and guarantee risk. (Note: We focus on accumulation IUL products in this article, as 80% of the IUL sales premium is in this category, and most carriers view accumulation IUL as being less risky than ULSG products due to their long-term guarantees.)
But while many carriers have seen strong increases in the sales of IUL, are they achieving the growth in earnings that they might have expected and hoped for with the sale of these less risky products?
Based on talking with several major IUL writers, the answer is no. This is partly for the same reasons as the recent underperformance of UL products, such as the continued reduction in interest rates and policyholder behavior experience; however, there are also IUL-specific reasons for the perception of underperformance.
Realistic Targets?
But before we get to those, let’s consider return targets for context. In our 2023 WTW Pricing Methodology Survey (survey), IUL with and without secondary guarantees had the highest median ROI target across all the different types of life products. Stock companies were targeting a median ROI of 10% for IUL, though the range of targets was 7.5% at the 15th percentile and 12% at the 85th percentile. And 94% of the surveyed companies felt that 2022 issues of non-secondary guarantee IUL (NSGIUL) were somewhat likely or very likely to hit their targets.
These figures raise several questions. For example, given historical financial performance on IUL inforce blocks, are such expectations realistic? Have companies adjusted their 2022 pricing assumptions to reflect items that have been driving IUL earnings below original expectations? And, as a result, are current expectations for IUL based on what has been learned from past sales?
Or should we conclude that some blocks of IUL business may continue to underperform?
Only time will tell, but let’s backtrack to some of the potential reasons that might account for why some insurers, up to now, are falling short of previously sold IUL return expectations—and, importantly, potential remedial measures.
Hedge Ineffectiveness
Unlike most fixed indexed annuity sales, IUL products have to deal with the complexity of monthly premiums, the impact of higher levels of surrender/lapse activity (outside of the large shock lapses at the end of the surrender charge period) and the impact of monthly deductions.
While some companies attempt to address some of these issues by limiting indexing dates and policy issue dates, hedging effectively while taking into account these factors can be difficult. And that’s before even considering the multiple variations of index crediting options that are available (including some more exotic “rainbow” indices) or the impact of certain IUL features such as cap buy-ups and multipliers.
We observe that practices to tackle these issues vary among carriers. Some use static hedging, while others use a dynamic hedging approach, given the difficulty of trying to match up static options with all of the monthly premium deposits, different index parameters and the impact of differing lapse/surrender rates. Carrier practice also varies when it comes to hedge targets and decrements reflected, if any. Some carriers assume no decrements, given the difficulty in trying to estimate what those decrements may be, but in doing so expose themselves to additional equity risk. Many carriers who assume decrements take a simplified approach and use a single combined total decrement rate, which can lead to hedge imprecision.
A related investment issue is that in early years the statutory reserve for NSGIUL will typically be less than the account value, while indexed crediting will be based on the full account value. So, the investment income earned on the assets backing the statutory reserve will not necessarily provide the support for the option budget that is needed for the expected interest crediting.
To better understand hedge effectiveness and IUL earnings, carriers will benefit from robust attributions, including a granular comparison of hedge performance to indexed crediting/account value movement and the drivers of differences between the two. Even then, understanding what may be causing hedge ineffectiveness is not always clear, and some carriers could simply be getting lucky with their hedging given the potentially offsetting impacts of different pieces.
Policyholder Behavior
Misestimated decrement assumptions and assumed versus actual lapse/surrender rates can certainly drive product underperformance.
For many companies, combined lapse/surrender rates will start off high in early durations and then decrease over time until mortality starts to have a more material impact on decrements; however, the lapse and surrender rates can vary by multiple factors (e.g., duration, attained age, issue age, presence of a surrender charge, face amount, risk class). So, if you’re using a simplified total decrement rate in hedge targets, you could certainly introduce ineffectiveness, particularly if the assumed total decrement rate becomes stale due to lack of regular updating. The use of a single decrement rate can also lead to hedge ineffectiveness across issue year cohorts, as more recent IUL sales would typically have a higher actual decrement rate than previously issued vintages.
A further point to consider is that IUL is still a relatively new product, with the large increase in sales happening after the Great Recession. So, while short-term lapse/surrender experience may be credible and useful, many questions still exist surrounding long-term IUL policyholder behavior. IUL policies are often illustrated and priced with an expectation for material loan/withdrawal activity in the future for either retirement income or education funding purposes. Many IUL products also offer some form of persistency bonus. These features add more uncertainty to predicting what long-term behavior might be.
We have also heard some carriers talk about the impact of lapse versus surrender on earnings.[1] Many companies price their products with an assumed premium pattern and a total non-death termination rate (combination of lapse and surrender). Where there is positive cash surrender value modeled in pricing, those total non-death terminations will lead to an expected revenue source from collected surrender charges. But what happens if the total decrement rate is made up of significantly more lapses than surrenders? That situation could lead to collecting less actual surrender charges than was expected in pricing.
Cap “Stickiness”
IUL sales can be heavily influenced by illustration performance, which depends heavily on the current index parameters, such as the index cap. Consequently, companies are often hesitant to change their cap when economic conditions suggest they should. And of course, companies are typically more hesitant to lower caps than they are to raise them.
Prior to 2022, portfolio yield rates had been on a steady decline, mainly as a consequence of interest rates being on a declining path until 2020. There have also been periods of greater market uncertainty when implied volatility increased, leading to higher hedging costs. Due to competitive pressures, many companies would have held on to a higher cap rate despite the reduced portfolio yields and, in some periods, higher option costs. This will generally result in a negative earnings impact of some kind as companies are not achieving their targeted spread due to the impact of this stickiness and not lowering caps as quickly as they should.
Charge/Investment Spread Source of Earnings
When UL products were first introduced, many companies priced a profit margin of some kind into each component (i.e., expense loads, cost of insurance, investment spread, surrender charges). Over time this approach changed, and more companies began to use alternative designs with varying mixes of profit sources.
This has been very much the case for certain IUL products and, in some cases, has been exacerbated by illustration performance concerns. To improve and maintain caps and illustration performance, some companies price with very little investment spread or negative investment spread due to bonuses. As a result, profitability can depend heavily on non-investment spread sources.
The consequence of this product design is that, as actual conditions deviate from pricing expectations, earnings have a greater chance of materially deviating from expectations. In particular, if fund values grow faster than originally expected, margins from cost of insurance will now be lower than expected, and future negative investment spread margins can be worse than expected.
Looking at what happened to equity markets during the period of growing IUL sales, prior to the COVID-19 pandemic, we lived through a 10-year bull market. So, many IUL carriers with low-to-negative investment spread margins might not have benefited from the potentially larger-than-expected growth in IUL account values.
This could be exacerbated by lower actual surrender activity, as there would be less surrender charge collected and potentially more future negative investment spread to be collected. The survey indicated that most carriers experienced lower-than-expected surrenders on both their IUL and IUL with secondary guarantee products. With the recent rise in interest rates, surrender activity could also now increase, given potential attractiveness of new money or new portfolio IUL offerings. This could also lead to market value losses on sales of bonds.
In addition, the survey indicated that many companies still use simplified methods for IUL pricing and model it very much like a UL product under the assumption that effective hedging will essentially turn the product into a UL. This could result in a lack of recognition of the potential impact of different equity market scenarios (e.g., a strong bull market) and the impact of product designs.
Weighing up the Risks is Key
Effectively hedged accumulation IUL is a product that should in theory be less risky than UL with higher guaranteed minimum interest rates or with secondary guarantees; however, being less risky does not guarantee the achievement of better earnings—especially to the extent product designs introduce other risks and hedging is not as effective as planned. Certain IUL designs and charge structures can also discourage product lapse or surrender, and these designs are prevalent in the market.
So, to the extent you are selling IUL and wanting to increase those sales, as well as your earnings, consider the risks you are taking both now and in the future. To enable your understanding of the actual and potential impact of those risks on your IUL earnings, develop a robust earnings attribution process.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.
Nik Godon, FSA, MAAA, FCIA, MBA is a senior director at WTW. He can be reached at nik.godon@wtwco.com.
Francis Hebert-Losier, FSA, MAAA is a director at WTW. He can be reached at francis.hebert-losier@wtwco.com.
Endnotes
[1] At WTW we use the term “surrender” to denote voluntary terminations with positive cash surrender value, whereas we use the term “lapse” for involuntary termination due to such things as account value or secondary guarantee exhaustion.