Why Does Indexed Universal Life Have Such a Bad Rap?

The purpose of this article is to explain why Universal Life Insurance (UL), and specifically Indexed Universal Life (IUL), has a bad rap and why that reputation is unwarranted. My goal with this article is for you to understand that any UL/IUL Policy is really nothing but an unbundled Whole Life. Any two permanent life insurance policies designed with the same premium, same death benefit, and same interest-crediting or dividend-crediting assumptions, will likely perform identically over time.

Why is that? Because under the hood, they are based on the same mortality tables. Both types of policies have exactly the same resources, invest their reserves in the same assets, and face the same mortality risks.

So if they are the same, then why the bad rap for Universal Life?

I equate a UL insurance policy to a high-performance racing car. In the right hands, a high-performance racing car can win races and get you from point A to Point B faster. However, it probably too much power for many people to handle. Those without the proper skills and training may wrap the car around a pole and injure themselves. A UL is much the same. Products like UL, IUL and Variable Universal Life (VUL) offer a lot of potential for someone who understands how they work and are willing to take on some of the responsibility to manage the cash value.

This article will cover a little bit about the history of UL. I’ll explain the market forces that were in play in the late 1970s that led to demand for an unbundled life insurance product. I’ll cover some of the advantages that UL offers over Whole Life. I’ll also explain what happened in the environment after UL was introduced and how that contributed to the bad rap.

I will also discuss how you can prevent an existing UL from failing and how a UL should be designed so that they never fail in the first place. Lastly, since my business is all about maximum over-funded life insurance, I will discuss whether or not the perceived risks that apply to minimally-funded policies also apply to maximum over-funded policies.

I’ll be spending most of the time addressing minimally-funded policies because its easier to understand and visualize the problem that the insurance companies were trying to solve. I’m also going to show you why right now might be the best time ever to buy a UL insurance policy.

History of Universal Life

The idea for UL was born in the very high inflation climate of the late 1970s. Because Insurance companies held lower yielding bonds that were purchased before rates began to rise, the return on their entire portfolio lagged the current higher rates available in the market. As a result, dividend rates on Whole Life policies lagged current yields in the debt markets. Savings flowed away from traditional whole life insurance and into other bonds and investments.

Because consumers were shifting their assets away from Whole Life insurance in favor of buying term life insurance along with their own investments (“Buy Term and Invest the Difference”),^[1] the insurance companies responded with Variable UL. VUL allowed the policy owner some control over the return on the cash value. Since the cash value of a life insurance policy is not an “investment”, it offers significant tax savings over the “Buy Term and Invest the Difference” approach. Unlike “The Difference”, the cash value grows tax-free and can be accessed tax-free.

Life Insurance 101

In any permanent life insurance policy, the cash value is essentially the policy owner saving up the death benefit over the life expectancy of the insured. For all practical purposes, the insurance company is “buying term and investing the difference”. In a Whole Life policy, the insurance company is responsible for maintaining adequate reserves to meet the guaranteed obligations of the policy. The insurance company can easily calculate how much premium they need to collect if they know the rate at which it will grow. They simply use a worst case rate (The “Guaranteed” rate”) to make sure they don’t over estimate.

There are two key factors involved in maintaining adaquate reserves: the growth rate on the savings and the amount of savings. If you are saving money and you want to make sure you reach a specific goal at a specific time in the future, you have to start with the rate that you think you can earn on your money. You can use this rate to calculate how much you need to save each year to reach your goal. If the actual growth rate is higher, you will have accumulated more than you needed. If the actual growth rate is lower, you won’t have saved enough.

Insurance companies can’t afford to not save enough. Once they quote premium to the client, they cannot change it. So if they don’t collect enough premium or they underestimate the growth rate, they won’t have sufficient reserves to pay claims. As a result, they use a very safe and conservative estimate. This is also known as the “Guaranteed Rate”. This is not the rate the actually expect to achieve.

In a UL policy, the key components of a permanent life insurance policy, the savings component and the mortality costs, are unbundled. In addition, both the death benefit and the premium are flexible in a UL. With the premium flexibility, policy owners have some control over the two key factors involved in maintaining adequate reserves. Where the insurance company would be extremely conservative, the policy owner can reduce the premium if they think that the growth will exceed the guaranteed rate. If the policy owner is wrong, they must make up the shortfall in the reserves by adding more premium to the policy.

By giving the policy owner some control over the funding of the policy the insurance company is absolved of the responsibility of maintaining the reserves. Since the policy owner makes investment decisions regarding the cash value, they assume responsibility for maintaining adequate growth over time.^[2]

THIS is the fundamental difference between Whole Life and UL. In the right hands, a UL Insurance policy is a very powerful financial tool. But in the wrong hands, it can be risky because it introduces the opportunity for speculation into a life insurance product.

This is not a problem with universal life, it is the advantage of universal life.

It is essential that this core difference between whole life and UL is adequately explained to policy owners.

Unfortunately, that is exactly what happened in the case of UL. Agents failed to fully and properly explain the nuances and risks to their prospective clients. Policy owners may not have completely understood that UL put the responsibility upon themselves. In any case, the responsibility for maintaining the growth on the cash value ultimately falls upon the policy owner. When the policy owner’s policy became underfunded, it was the policy owner who needed to add premium in order to make up for poor performance.  

The Problem With “Illustrations”

A life insurance illustration is just that: an illustration of how the policy will perform. It’s not a part of the policy and its not a contract. We’re simply projecting how the policy will perform over time with some assumptions on the earning rate on the cash value. To run an illustration, you need to make some assumptions about the growth rates of the cash value of the policy. As I discussed above and in Do Life Insurance Guarantees Matter?, a Whole Life guarantee is only the actuarial minimum growth rate necessary to ensure that the reserves are adequate to cover all expected liabilities. It is not the rate at which the cash value actually grows.

The insurance company is investing their reserves in US Treasuries, bonds, mortgage-backed securities, preferred stocks, etc. And, as was the case during the late 1970s, the actual rate of growth may far exceed the minimum required rate of growth.

As a result, the insurance company typically shows the client both the guaranteed projections as well as some “reasonable” projections. No one knows what rates will really do in the future. Most agents and insurance companies simply show the projections based on rates in place at the time.

THIS is the reason IULs have a bad rap.

If you think that the cash value will grow at a very high rate, then the policy would not need as much premium in order to cover its costs. Let me explain.

This graph shows a typical minimally-funded life insurance policy. The death benefit is in orange and the cash value accumulation over time is shown in blue. Again, the purpose of the cash value is to save up the death benefit over the expected lifetime of the insured. The policy owner is essentially saving up the death benefit over the lifetime of the insured. You can see that the risk to the insurance company is very high in the early years and very low in the later years by looking at the gap between the orange line and the blue line.

The insurance company is responsible for covering the gap between the death benefit and the cash value. While the mortality costs may rise over time as the insured ages, the net amount at risk to the insurance company declines. Note that this is true for both Whole Life and for UL. Yes, even Whole Life faces increasing mortality costs as the insured ages. They just aren’t made explicit as in an unbundled UL.

If the cash value grows faster than expected, then the cash value intersects with the death benefit early as shown in this graph. In this example, the client could have paid even less premium into the policy. Understand that as the cash value accumulates, it generates more in interest-crediting or dividend-crediting and is more able to meet the rising mortality costs. This is exactly what happened with UL. Policy owners believed that interest rates would remain high and make up for the lower premiums they were paying.

This graph shows a policy where the interest or dividend crediting rate is lower than projected. In this example, the policy does not accumulate enough cash value by the time the insured reaches their life expectancy. In this case, the mortality costs of covering the large gap between the cash value and the death benefit pose a great burden on the policy and it may consume the cash value.

This is exactly what happened in the years right after UL policies were introduced. Inflation and interest rates in the economy peaked at just about the same time these policies were introduced. Interest rates fell over the next few decades and are currently at the lowest rates ever seen.

Many of the policies sold at that time did not collect enough in premium to maintain adequate cash value when the interest crediting rates declined. Policy owners were ultimately forced to either pay higher premiums to make up for the growth that did not occur or they needed to lower the death benefit to reduce the mortality cost in the policy.

What is important to understand going forward, however, is that we are now in an environment where interest rates are at historic lows. Actual performance of the cash value could in fact greatly exceed the low interest rate projections used in illustrations today.

The Bad Rap 

Many policies lapsed or were surrendered when policy owners realized that they needed to pay more in premium to keep the policies active. UL detractors seized on this as a reason NOT to purchase a UL policy.  However, the policies worked exactly like they were supposed to. Either the agents, insurance companies or the policy owner THOUGHT that interest rates were going to remain high. When they didn’t, the policies needed more cash in order to maintain adequate reserves/cash value.

Is The Bad Rap  Warranted? 

Properly-designed policies issued today, with very conservative growth assumptions, could likely outperform the growth projections on current illustrations if interest rates rise again. It is the exact opposite of the situation in the early 1980s. The problem with UL is not the policy itself. The policies performed exactly as one would expect them to during a period of declining interest rates. Both the agent and the client need to agree on the assumptions used.

A UL policy that is properly-designed and funded is going to perform very much like any other permanent policy. Agents need to educate their clients properly. If a UL Insurance Policy is too complicated, clients should choose a simpler product, such as whole life.

A UL insurance policy should never be funded with the minimum required premium given the interest rate risk. UL policies should ideally be used in maximum over-funded policy designs where the death benefit is held to an absolute minimum. There is virtually no risk of a policy lapsing when it is properly designed and maximum over-funded.

Responsibility

The difference between Whole Life and UL is who has the responsibility to maintain the performance of the policy. It’s a case of be careful what you wish for. If you are mainly concerned with the death benefit and making sure your premium never changes, then a Whole Life is probably best for you. The insurance company offers guarantees and collects more in premium dollars to offset their lower growth estimates. You won’t have to worry about the policy lapsing as long as you pay your premiums.

However, if you want to keep the premium as low as possible and think that you can manage the cash value better than the insurance company, then a UL policy may be better for you. If the cash value doesn’t perform, then the onus is on you to add more premium later.

Maximum Over-funded Life Insurance Policies

Everything I’ve discussed thus far relates to minimally-funded life insurance designs. Private banking strategies like The Double Play, Infinite Banking, Bank on Yourself rely on over-funded policy designs where the policies are purposely funded with much more premium than is necessary. While The Double Play can be done with either IUL or Whole Life, other Private Banking proponents insist that these strategies must be done with Whole Life. All of these strategies rely on over-funded life insurance policy designs.^[4] 

The risk in UL insurance is that the policy owner does not pay enough premium in order to build up adequate cash value to meet the policy’s obligations. The reason that UL policies lapsed or were surrendered was that policy owners made minimum premium payments thinking that the growth of the cash value would make up for the lower funding.

An over-funded policy is a policy that is funded more cash than is absolutely necessary as the name implies. So should you be concerned about a Maximum Over-funded Policy lapsing due to inaccurate growth assumptions?

NO

These policy designs hold the cost of insurance to an absolute minimum and have way more cash in them than is necessary to cover their expenses. The problem of UL is a non-issue because the policy is funded to the maximum. It is almost ridiculous to think that proponents of other private banking strategies are using the arguments against UL as their reason for preferring Whole Life. This shows a lack of understanding of the true nature of UL.

This graph shows a maximum over-funded policy design. This policy was funded with premiums for the first 10 years only. You can see the minimum amount of life insurance death benefit being pushed up as the cash value grows. So rather than constantly trying to close the gap with a very high death benefit, as in a minimally-funded policy design, here the death benefit is minimized from inception and is pushed up as the cash value grows. After the 10th year, when premiums cease, the death benefit can be reduced to the Minimum Non-MEC level. At this point, we are only barely maintaining the definition of life insurance. Only a minimum percentage of the cash value is spent on death benefit protection.

Understand that whether the cash grows at a high rate or the cash grows at a low rate, the same percentage of the cash value is being spent on death benefit protection. Rising mortality costs have little impact on the accumulation. If mortality rates doubled, the result inside the policy would be that the same amount is spent on death benefit protection but only half as much death benefit is purchased.

The arrow indicates that if the growth rate of the cash value increases, then both sets of curves will shift upward and to the left as the cash value grows faster. The opposite is also true. If the cash value growth is lower, the curves will shift down and to the right as the cash value grows more slowly. At no point is the policy ever in danger of lapsing.

How To Fix A Universal Life That Is Failing 

Both the premium and the death benefit are flexible in a UL Insurance Policy. If the high mortality costs are consuming the policy’s cash value or it looks like it may be going backward, the policy’s death benefit can always be reduced to the legal minimum in order to preserve the cash values. This works in cases where the policy owner wants to preserve the cash value they’ve accumulated.

However, many times an elderly client wishes to maintain the high death benefit because that has more value. If that is the case, then there is no other option than to pay enough premium to keep the policy active and in force. Unfortunately, the time to properly fund the policy was in the early years when the policy owner was making minimum payments. Early premiums would have allowed the cash value more years of compounding to make up for the shortfall.

If we look back at the graph of the properly-designed, minimally-funded policy, you can see that the cash value rises and reduces the net amount at risk in the policy. At some point in time, the mortality costs are easily absorbed by the growth of the cash value. If the cash value never reaches that critical mass, the rising mortality costs will consume the cash value.

Conclusion 

Hopefully I made it abundantly clear that all of the hype over UL is just that. A properly designed and funded UL is going to perform the same as a whole life funded exactly the same way. The user of a UL will only get in trouble if they rely on interest-crediting growth that doesn’t occur. And since a Maximum Over-funded life insurance policy has as much premium/cash value as legally possible, concerns about UL do not apply to maximum over-funded policies.

^[1]

See Should I Buy Term and Invest the Difference? and Myth Exposed! Buy Term and Invest the Difference for more information on the advantage of Life Insurance over the “Buy Term and Invest the Difference” approach.^[2]

ee Life Insurance 101 for more detail on the inner workings of Universal and Whole Life as well as an explanation of the piece parts of a policy such as the cash value and mortality risks.^[3]

Even the insurance companies did not expect the prolonged streak of extremely low interest rates currently observed (March, 2021). As a result, new regulations are loosening the guarantees that a Life Insurance company must offer. I’ll address these new rules in an future blog post that I’ll link here. So keep checking back if you’re interested.^[4]

See Minimum and Maximum Over-funded Life Insurance Policies for an explanation of the differences in policy design. But basically, the goal of minimum funded policies is to get as much death benefit for as low a price as possible. The goal of a maximum over-funded policy is to maximize cash value accumulation.