Illustrated Rates and Indexed Life

Perhaps one of the biggest differences between indexed annuities and indexed life is the use of illustrations. In order for an indexed universal life or indexed whole life policy to be issued, an illustration compliant with the National Association of Insurance Commissioner (NAIC) Life Insurance Model Regulation must have been delivered to, and signed by, the policyholder. Not only is this not the case with indexed annuities, but most companies do not even use illustrations for the products. Less than a third of the insurance carriers in the indexed annuity market offer illustrations on their products, where 100% of indexed life carriers do because of the model regulation imposed by the NAIC. The model regulation was developed to protect and educate policyholders as well as provide rules for life insurance illustrations. The model regulation specifically provides disclosures, formats, and standards that are to be met with regard to illustrations. The primary goal of the regulation was to ensure that life insurance policyholders were not mislead and to make illustrations less confusing and easier to understand. If an insurance carrier identifies a policy form, or product, as one that is going to be marketed with the aid of an illustration a basic illustration must be delivered and signed in accordance with the model regulation. When using an illustration to aid in the sale of a life insurance policy, an insurance carrier or producer can not:

1. Represent the policy as anything other than a life insurance policy
2. Use or describe non-guaranteed elements in a manner that is misleading or has the capacity or tendency to mislead
3. State or imply that the payment or amount of non-guaranteed elements is guaranteed

Taking the model regulation into consideration, illustrating traditional universal life is a fairly straightforward process. An illustration has essentially two sections- the guaranteed and nonguaranteed projections of account values, cash surrender values, and death benefits. The guaranteed ledger projects guaranteed values assuming guaranteed maximum charges and guaranteed minimum interest. The current ledger projects current charges at the current crediting rate, and does not take renewal rates into consideration. This is the section of the ledger that addresses the “non-guaranteed elements” of the policy, or the premiums, benefits, values, and charges that are not determined or set at policy issue and subject to change. Traditional whole life illustrations are similar, but rather than projecting a current crediting rate, they usually assume a current dividend scale. By contrast, variable product illustrations are able to illustrate a maximum gross illustrated rate of 12% on the current ledger (but the agent may assume a lower rate). The guaranteed values on a variable product are projected in a similar manner to the traditional plans mentioned.

When it came time for the insurance carriers to determine how to illustrate indexed life, the question that arose was “What current rate should the product be illustrated at?” It was not nearly as easy as traditional plans where you could assume a current credited rate because these products used participation rates, caps, and spreads. In addition, many products utilized numerous crediting methods that they client had the option of allocation a portion of the premium amongst. However, the indexed product was not like variable- it was a fixed insurance product and insurance carriers did not want to give agents the discretion to choose which illustrated rate to use when proposing a policy to a potential policyholder. The solution was developing the illustrated rate basis, sometimes referred to as a “lookback method.”

The illustrated rate basis gave insurance carriers something to use as a premise, or historic proof, that their illustrated rate is a reasonable expectation of what the policyholder can expect to receive as current credited interest on their indexed policy. As of the date of this entry, illustrated rates on indexed life ranged from 4.01% to 10.28%. In all actuality, past performance of an index is no indication of future performance. In fact, indexed life illustrations disclose this fact on the illustration that the policyholder must sign. The disclaimer goes a step further to indicate that past or future performance of an index is not representative of the performance of the indexed life policy, and that actual performance may be greater or less than that illustrated. No one knows what the market will do tomorrow or a year from now. However, past performance of an index is the best indication we have of what future performance may look like. Realistically, all life insurance policy illustrations are not representative of how the policy will perform once the policy is issued, whether the policy is indexed, fixed, or variable. Why? Interest rates/dividends fluctuate, policyholders pay premiums differently than scheduled, cash flow may be unexpectedly necessary, changes in coverage may occur- it is so important for a policyholder to understand that an illustration is merely a guideline of how their policy may perform as illustrated. Some years, the client may receive zero interest crediting. Some years, they may receive double-digit returns. What will likely happen with the policy’s performance is something between the guaranteed ledger and the current ledger- a midpoint if you will. (Note that some insurance carriers do offer a midpoint ledger on their illustrations.)

How is an illustrated rate developed? An illustrated rate basis reviews the history of the index that the crediting method is based upon (i.e. Standard & Poor’s 500^® Index) for a specified period determined by the carrier. Then the crediting method is reviewed, as well as the current participation rates, caps, and spreads. This results in an illustrated rate for each crediting method offered on the indexed life policy. Some carriers may illustrate a “weighted average interest rate” on their illustrations, which takes the amount of premium allocated to each crediting method into consideration. For example, if the insurance carrier requires a mandatory 50% of the premium to be held in a fixed allocation at a rate of 4.50% in the early years, and the policyholder requests that the remaining portion be allocated to an annual point-to-point strategy at an illustrated rate of 7.50%, the illustration may show a weighted average interest rate of 6.00% early on. However, as the cash values accumulate and a smaller percentage of the policyholder’s premium is required to cover insurance charges, more premiums may be allocated to the strategy with the 7.50% rate. This may be reflected in the illustration on the current ledger showing an illustrated rate that changes each year, getting closer to the 7.50% rate as the cash values compound.

Every carrier has their own illustrated rate basis, although a small handful of products use no basis at all, but merely a flat illustrated rate. Although the NAIC regulates the illustrations for indexed life products, they do not regulate the formulas or methods for determining the illustrated rates on indexed life. This can make it especially difficult to compare products against one another. One example that compounds the confusion is the fact that two carriers with the same illustrated rate basis will use different formulas for determining their rates. For example, if two different insurance companies had the same participation rates, caps, and spreads on their annual point-to-point products, they may choose different dates during their ’20-year lookback’ of the S&P 500^® to determine which illustrated rate to use.

The most common illustrated rate basis is the 20-year Lookback, with more than one third of the products on the market utilizing this method. This illustrated rate basis merely looks at the past twenty years of the index as a basis for the illustrate rate. The second most common illustrated rate basis is the 57-year Guideline with more than a quarter of the products on the market using this method. Illustrated rate basis utilized by carriers today include (in order of utilization):

1. 20-year Lookback
2. 57-year Guideline
3. No Lookback (flat illustrated rate)
4. 20-year Average
5. 30-year Lookback
6. 25-35 year Lookback
7. 15-year Lookback
8. 22-year Lookback
9. 25-year Lookback
10. 20-30 year Lookback

As you can see, this adds another dynamic to selling indexed life products. It is an important aspect of the product to understand, as the policyholder needs to know the differences between what is guaranteed and what is a realistic expectation of the policy’s performance. Less important than the illustrated rate utilized by the insurance company is the renewal rate history of the carrier as well as the current participation rates, caps, and spreads/asset fees. As always, consistent monitoring of an indexed life policy through inforce illustrations is necessary due to it’s interest sensitive nature. Policyholders have the right to receive a minimum of one inforce illustration annually, in order to view how the policy’s present state should affect future values and death benefits in an illustration, once it has been inforce for one year or more.

The following can result in a change in indexed life illustrated rates:

1. Change in participation rates
2. Change in caps
3. Change in spreads/asset fees
4. Change to the crediting method
5. Change in illustrated rate basis
6. Updates due to the calendar year
7. Change in renewal rates (inforce illustrations)

Illustrated rates such as flat illustrated rates and maximum illustrated rates in software can also be changed at the insurance carrier’s discretion.