Regulatory Arbitrage and Indexed Universal Life: Why Lax State Insurance Regulations Allow Clients to Take Unlimited Bets in a Game with Loaded Dice

Leslie Scism 's latest article in the WSJ, entitled Stock Selloff Hits Life Insurers' Fastest-Growing Product highlighted the National Association of Insurance Commissioners' third attempt at reigning in abusive Index Universal Life (‘IUL”) illustrations through Actuarial Guideline 49-B (AG 49-B). This story follows previous stories in the Journal and Forbes detailing how some IUL policyholders lost millions of dollars in a scheme that encourages them to take out loans (often collateralized by a substantial part of their net worth) from banks to finance Index Universal Life (IUL) policy premium payments. Based on significant underperformance from the projected performance of these IUL policies, many of those clients are now suing insurance companies and their agents that recommended these plans for failing to disclose the significant downside risks of these transactions.?This most recent attempt (AG 49-B) to fix the use of aggressive IUL illustrations, a solution deemed by the NAIC as a “quick fix,” will not go into effect until May 2023, leaving consumers vulnerable to policy illustrations that regulators have recognized as susceptible to being highly inaccurate.

As a result of some of my public commentary, including various whitepapers and postings on LinkedIn and YouTube, I’ve been contacted by individuals who have either purchased an Indexed Universal Life policy on a leveraged basis or were considering putting money into such a transaction. ?Interestingly, I’ve also been contacted by a handful of attorneys representing similarly-situated individuals as well.?Once these individuals fully understood that the life insurance companies issuing these IUL policies had the ability to unilaterally change key benefits provided by the IUL contact to the detriment of policy owners, almost all of them asked “how can this be legal?”

The simplest answer to that question is that this is what can occur when a product has little to no regulation and is not regulated like a security. It’s important to remember that in January 2009, the Securities and Exchange Commission issued a rule to regulate these products as securities -- starting in 2011.?However, through some clever last-minute lobbying, the insurance industry was able to insert a provision into the final version of the Gramm-Leach-Bliley Act, enacted in November 2009, to block the SEC rule and put the regulation of these products under the purview of state insurance regulators.?As a result, this also shielded these transactions from the basic suitability standards that apply to securities or the even more rigorous best interest standard subsequently applied to securities transactions.?This helps explain how, without any regulatory repercussions, unscrupulous insurance agents can encourage policyholders to make outsized bets on these complex products by leveraging their IUL purchase and taking out giant bank loans to fund their purchase, sometimes several times greater than the policyowner’s annual income.

Why are premium-financed IUL policies akin to a game played with “loaded dice?” It’s because IUL policies are complex insurance products that promise clients their cash value will be credited at “market level returns” with a floor on credits of 0 or 1%.?When these projected market-level returns are illustrated in sales presentations with the leverage of a bank loan charging 2% or 3%, the products appear to be able to pay for themselves.?What is not so clearly disclosed to clients is that the insurance company issuing their IUL policy may in the future materially change the upside performance of their contracts – often expressed as a cap or participation rate.?

It’s important to understand that insurance companies do not invest an IUL policy’s cash value directly into equities (i.e., stocks), but rather, they invest somewhere between 94% to 96% of that cash value in fixed-income securities (i.e., bonds) with the remaining 4% to 6% being invested in derivatives (i.e., options) referenced to an index like the S&P 500. And remember, options do not receive dividends from the underlying securities. ?So, when one thinks about historical equity returns, one also needs to factor out the 20% to 25% historical returns received from dividends. So, given this bond-heavy asset mix, it is not unsurprising that the returns on IUL products have not kept up with what was promised.?In fact, since these products first came out a little more than a decade ago, IUL contract cap rates have dropped precipitously from what had been originally promised to unsuspecting IUL purchasers. ?In some cases, clients now receive less than half of what they were originally shown by their agent.

The National Association of Insurance Commissioners, through its Index Universal Life Illustration (A) Subgroup, has attempted, through the promulgation of Actuarial Guidelines, to reign in overly optimistic performance illustrations used by agents selling IUL. ?In its first attempt, the NAIC issued AG 49 which strangely limited IUL policy illustrations to the assumption that insurance companies would earn 45% options profits and pass it on to policyholders!?The NAIC’s next attempt, AG 49-A, prevented bonuses and multipliers on top of the anticipated 45% options profit. ?And the NAIC’s third attempt, AG 49-B, focused on the newest trick used by insurance carriers to bolster illustrated IUL returns -- proprietary indexes.

As cap rates on the popular S&P 500 index continue to fall, insurance companies responded by creating new, proprietary indexes. ?These indexes are often created by, and branded through, a licensing agreement with the name of a major bank, leaving the false impression that the consumer’s cash value is being managed by this investment bank.?However, a careful reading of the IUL contract will reveal that all the consumer is purchasing is the ability to have their policy cash value invested according to a back-tested formula created by that investment bank that allocates assets in and out of other indexes. ?The use of these proprietary indexes is almost always cheaper for the insurance company than using options on a more standard benchmark like the S&P 500, and AG 49-B characterizes them as non-benchmark indexes. ?These non-benchmark indexes are designed to take advantage of a loophole in AG 49 that came out around two years ago.?This loophole allows these non-benchmark/proprietary indexes to illustrate 50% more money coming out of IUL products than indexes pegged to a benchmark index like the S&P 500.?Again, none of this would be permitted to happen if these products were regulated as securities.

At Valmark, we recognized that consumers would never get anything close to what was promised from aggressively illustrated, leveraged IUL transactions.?We also recognized that there would likely be a significant day of reckoning when policies fell well short of aggressive projections fueled by large loans (estimated at more than 20 billion dollars nationwide).?As a result of this position, we’ve prohibited Valmark firms from soliciting transactions funded by premium-financed IUL policies.?Even for those IUL policies recommended without leverage, we require robust disclosures and alternate lower rates not predicated on 45% options profits.?We also joined a coalition of independent actuaries and insurance industry professionals who have attempted to influence the NAIC to take more decisive action with its Actuarial Guidelines.?This group, known as the Industry Coalition of Concerned Insurance Professionals, includes Bobby Samuelson , Richard Weber , Barry Flagg, CFP?, CLU, ChFC, GFS?, AEP? , Sheryl J. Moore , and Bill Boersma .

While we applaud the NAIC’s latest attempt, AG 49-B, as a step in the right direction, putting proprietary, non-benchmark indexes on equal par with other IUL products using benchmark indexes, we believe market conduct abuse will continue.?From the NAIC’s first attempt to fix IUL in 2017 through AG 49, until now, we argue that this product allows agents to create unreasonable expectations for consumers and will continue to do so as long as the assumption of 45% option profits is part of IUL illustrations. We came within one vote of the NAIC accepting our proposal of limiting IUL crediting rates to not exceed the credited rate of other general account products at 4.5% to 5%. Consumers who believe they are gaining financial arbitrage through the combination of high leverage and the use of a complex, non-benchmark proprietary index are actually the victims of regulatory arbitrage...and so, the game with loaded dice continues.?

Until projected rates are tamed and gimmicks are eliminated, clients with IUL premium financed policies are no more likely to get their projected results than they are to win the Powerball.

Informed and ethical financial professionals who truly wish to act in their client’s best interest will help their clients choose less costly and less risky alternatives.

It was Cicero who said, “What is permissible is not always honorable.”

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