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July 16, 2009 at 08:00 PM
If you ask me, indexed universal life insurance is the perfect life insurance product. It’s permanent, it can never lose value as a result of market declines, and it has the potential to earn greater interest than traditional UL products.
However, some alarming trends are occurring in this market that needs attention–and correction.
If not addressed now, these issues will surely catch the eye of lawyers, legislators, and outside regulatory entities, for IUL’s problems are very similar to those plaguing the index annuity industry in recent years.
To unpack this, one must understand the differences between types of UL plans. Traditional UL is a type of fixed life insurance that is regulated by the state insurance divisions. It credits a minimum guaranteed interest rate, as well as a stated fixed interest rate on an annual basis. It is generally known for its high guarantees, and steady, lower credited rates. 
IUL is also a type of fixed life insurance, regulated by the insurance divisions. It credits a minimum guarantee usually less than annually, although there is an annual 0% floor on all IUL plans. The credited interest rate on IUL is based on the performance of an outside index, such as the Standard and Poor’s 500 (S&P 500). Potential index interest is limited through the use of participation rates or caps.
IUL is generally known for its lower guarantees, but also for its ability to earn interest that is higher than that found in traditional UL (although it may be on an inconsistent basis).
Variable UL, by contrast, is a type of securities product that is regulated by the Securities and Exchange Commission. VUL typically has no minimum guarantee, except on any fixed bucket strategies. The credited interest rate on a VUL is based on the performance of stocks, bonds, or mutual funds that the consumer selects.
Consumers cannot lose any of the money they have in a fixed UL or IUL as a result of market performance, but they could lose funds in a VUL as a result of market performance.
The problems with IUL all boil down to one single issue: illustrated rates.
What is an illustrated rate? First, recall that an illustration is a projection of future policy values; it answers the question, “what will my policy cash values and death benefit be in [20] years?” The National Association of Insurance Commissioners mandates that all permanent life insurance policies must have an illustration that is signed by the purchaser at point-of-sale.
The “illustrated rate” on the illustration is the interest rate at which the policy values are projected.
For traditional UL, the illustrated rate is the current credited interest rate on the policy (presently 4%-5.5%). This rate represents what the insurance company is currently crediting on the UL for new business. In-force ULs may receive higher or lower renewal rates. However, most ULs sold today are illustrated at a rate that is constant throughout the policy.
For VUL policies, the illustrated rate is a hypothetical gross rate (presently 8%, but cannot exceed 12%, as per the Securities and Exchange Commission). This rate is supposed to be a reasonable expectation of what the VUL may be credited as a result of market, fund, or bond performance (based on the policyholder’s premium allocation).
Here again, VULs may receive a higher or lower rate in future policy years, but most VULs sold today are illustrated at a consistent rate throughout the policy.
For IULs, the illustrated rate is a hypothetical rate selected by the insurance company. This rate is supposed to be a reasonable expectation of what the IUL may be credited as a result of the outside index’s performance. Although IUL illustrations may assume a varying rate in the early years, this rate usually levels out to a constant illustrated rate in later policy durations.
Keep in mind that IULs are priced to return about 1%-2% greater interest potential than traditional fixed UL, so a reasonable expectation is that today’s IUL credited rates would be 6.5%-7.5% at best.
The concept of illustrated rates is important because interest-sensitive life insurance products, such as UL, IUL, and VUL, can have dramatically different policy performance compared to what is illustrated at point-of-sale. Changing renewal rates, premium payments, policy loans and withdrawals all have an effect on future policy values. Consumers may not realize how dramatically their future policy values can change from what was illustrated to them at policy purchase.
