Introduction
In this post I am going to discuss why you shouldn’t judge and illustration based on the current illustrated crediting rates. This is important because interest rates are always changing, yet illustrations typically only show one rate for the life of the insured.
Let’s be realistic for a moment: Do you really think that the interest rates today will be the same for the next 30, 40, 50 years? That’s highly unlikely. Yet, when I run a life insurance illustration, I’m generally running it at one rate for the entire life of the insured. The illustration will be inaccurate almost immediately.
Goal
The goal of this post is to show you why you should not compare life insurance illustrations based on the illustrated crediting rates used by the insurance company.
I’m going to start with a general overview of dividend and interest-crediting rates. Then I’m going to show you why those rates really don’t matter and what you should be looking at instead.
So if this sounds interesting to you, keep reading.
What are “illustrated crediting rates”?
Illustrated crediting rates are the rates used for projected values in the policy illustration. They may or may not be the current dividend rate of the company. Whole life policies are typically illustrated using the current dividend rate. The agent, however, can use a different rate as long as it is lower. The agent does not have the discretion to pick a higher, more optimistic return projection.
When interest rates are very low and likely to rise, the actual policy will likely outperform the illustration. However, when interest rates are high and but trending downward, the actual policy will likely not perform as illustrated.
Indexed Universal Life (IUL) illustrations are subject to Actuarial Guideline 49 (AG 49) and Actuarial Guideline 49-A (AG 49-A). These guidelines are intended to keep IUL interest-crediting rates reasonable and conservative. The Guideline requires that insurance companies back-cast against the index using their current cap to see what annualized returns would have been with this low cap.
In addition, the rates are also limited to 145% of the General Account Investment Earnings.
Just as with Whole Life, when interest rates in the marketplace are very low, as they were recently, back-casting with current low caps results in very low interest crediting rates. While low, these rates still generally well-exceed the General Account Investment Earnings. That is the beauty of an IUL.
Why rates don’t matter
It is important to understand that the interest crediting and dividend rates are just guess when it comes to projecting future performance. It is nothing more than a table of projections showing how the policy would perform if rates remained at this level for the life of the policy. It is not a contract and it is not a guarantee. As the graph below shows, interest rates are constantly changing.
In the 30 years from 1920 until about 1948, interest rates were trending downward. From 1948 until about 1982, interest rates were trending upward. And from 1982 until the present, interest rates have been trending downward. Those trends have not been consistent. There has been some small amount of volatility.
As you are looking at these interest rate trends, try to imagine the effect on a life insurance policy in place during any one of those trends.
My goal is not to scare you away from purchasing a life insurance policy. My goal is to make sure that you understand that dividends and interest crediting are a function of the market interest rates. They will rise and fall over time.
What does matter?
Understand that dividend and interest crediting rates will change over time. Focus your attention on finding the best policy possible for any given interest rate climate. When you compare life insurance quotes, the things I think you should be looking at are the policy’s charges, the company’s competitive advantages, and the company’s financial reserves.
Policy Charges
It is important to understand that different companies will have different charges. Don’t focus on the rate that each company uses to project their illustrations. Instead, tell the agent(s) to use a consistent set of assumptions. If all of the illustrations are done with the same assumed rate of growth, then the illustration that looks the best is the one with the lowest internal costs. You may not have noticed this if you focused your attention on the one with the best projection.
You should do this whether you are comparing IUL to WL or IUL to IUL or WL to WL. And since agents usually can’t show a higher crediting rate, find the lowest common denominator. You should also use the same rates regardless of the interest crediting option that are selected. Just make them all the same.
Competitive advantage
While the insurance industry is pretty steady, occasionally one company will come up with something that will provide a competitive advantage until other companies are able to copy it. For example, most companies that offer an IUL, farm out their hedging activities to Wall Street firms in exchange for a fee. However, one large IUL company decided to take their hedging in-house. They claim that they have reduced their hedging costs by 2/3rds. This allows them to offer higher caps than other companies might be able to offer. On the flip side, it also allows them to invest their reserves in safer assets while still offering competitive cap rates.
Financial reserves
You should realize that for the most part, Insurance companies all invest in safe, secured, debt instruments. While they have an incentive for the cash value to grow as quickly as possible, they also cannot risk losing money either. And for a life insurance policy to function properly, the policy merely needs to meet its minimum actuarial rate (Guarantee). They don’t need to speculate.
However, its also important to note that differences in dividend rates between companies can also be explained by subtle shifts in the risk of their underlying holdings as this graph illustrates:
This graph shows the difference in the reserve holdings between two companies. As an agent, I’m not making a judgement call on their worthiness of either approach. I don’t want to talk with their lawyers 😉 You need to make your own judgement call on what you think is the appropriate level of safer, high quality bond holdings versus lower quality debt.
You should be aware that there is an inverse relationship between safety (risk) and potential return. Higher risk bonds need to offer a higher yield in order to attract investors. However, the default risk is higher with those bonds as well.
Do your own due diligence. Look at the annual reports from a variety of different companies to try and get an idea of what your own preference.
Conclusion
The goal of this post was to show you why you should not compare illustrations based on the illustrated crediting rates currently used by the insurance company. Those rates are just a guess! Those projections are based on rates that are sure to change dramatically over the next 30, 40, or 50 years as history shows.
It is best to run apples-to-apples comparisons between several companies to find the one with the lowest charges. If the rates of one company are higher than anothers, it would be wise to look for the reason. Is it a sustainable competitive advantage? Is it because they have a higher risk profile in their general fund (reserves)?
Don’t make a decision based on the rates alone.
