Indexed Life Illustrated Rates: When is 8% not really 8%?
Many Indexed Life carriers have products that will "out illustrate" most products in the industry. These competitive illustrations are based on one factor—a high illustrated rate.
There is little doubt that Indexed Life products present the potential for a higher illustrated rate than traditional fixed UL. However, it is very important to understand how insurance companies derive their "recommended illustrated rates."
Ultimately, illustrations are used for one thing—setting expectations with your clients. If you don't want to have post-sale conversations with your clients explaining why their policies didn't meet expectations, you must be careful what illustrated rate you use.
Let's go through an example. There are two products, both with one-year point-to-point crediting strategies tied to the S&P 500 with 100% participation rate subject to a cap. Product A has a 12% cap and an 8.0% recommended illustrated rate. Product B has a 14% cap and an 8.2% recommended illustrated rate. Summarized below, the two products are illustrated side by side and perform very similarly—both meeting the client's expectations.
| Product A | Product B | |
|---|---|---|
| Cap | 12% | 14% |
| Illustrated Rate | 8.0% | 8.2% |
| Age 65 Cash Value | $243,363 | $237,260 |
| Age 70 Cash Value | $398,566 | $397,714 |
| Age 75 Cash Value | $645,896 | $650,980 |
| Age 90 Cash Value | $2,455,070 | $2,472,256 |
| Age 100 Cash Value | $5,835,983 | $5,805,927 |
At first glance you may think to present Product A, based on the fact that it has a lower illustrated rate that is "more conservative" and it has a slightly higher age 100 cash value. However, how will each of these products actually perform over time? The answer to that question is unknown. What we can see is how each of the products would have performed historically using their respective cap rates. The numbers may surprise you!
For example, if you would have contributed a single premium in each policy on January 1 in 1970, 1975, and 1980 the following shows the average credited rate on each deposit as of January 1, 2005.
| Deposit Date | Product A | Product B |
|---|---|---|
| 1/1/1970 | 7.1% | 7.9% |
| 1/1/1975 | 7.5% | 8.5% |
| 1/1/1980 | 7.5% | 8.6% |
| Cap | 12.0% | 14.0% |
| Illustrated Rate | 8.0% | 8.2% |
So even though Product A had a 0.2% lower illustrated rate than Product B, it would have had a 1.1%, 1.0%, and 0.8% lower average credited rate over a 25, 30, and 35 year period of time. More importantly, Product A would have underperformed the illustrated rate in each of the three time periods whereas Product B would have beat the illustrated rate handily in two out of the three time periods. The reason for this is quite simple, Product A is much more aggressive in determining its illustrated rate—perhaps too aggressive!
So, how do you know what illustrated rate to use for each product? When relying on historical data to determine an illustrated rate, the most important factors are 1) using a long enough period of time to capture different economic environments and 2) using as many data points as possible to provide a range of results.
One method becoming widely accepted as the most realistic approach in determining long term expected credited rates for Indexed Life averages the historical index movements over the last 25–35 years. This methodology assumes premiums are deposited every business day between 1/1/1969 to 12/31/1979 and calculates the average credited rates through 12/31/2004 for each deposit. It is a robust analysis as it includes more than 3 decades of data and uses almost 3,000 data points.
Using this analysis, the historical average credited rate for Product A is 7.3%, which is 0.7% less than the company recommended illustrated rate. The historical average credited rate for Product B is 8.2%—identical to the company recommended illustrated rate. The conclusion is that Product A is much more aggressive than Product B, and the impact of this can be detrimental in the long term. Our original hypothetical illustrations have been revised below to show the impact on the projected cash values.
| Original Product A | Realistic Product A | Product B | |
|---|---|---|---|
| Cap | 12% | 12% | 14% |
| Illustrated Rate | 8.0% | 7.3% | 8.2% |
| Age 65 Cash Value | $243,363 | $222,729 | $237,260 |
| Age 70 Cash Value | $398,566 | $352,858 | $397,714 |
| Age 75 Cash Value | $645,896 | $555,715 | $650,980 |
| Age 90 Cash Value | $2,455,070 | $1,948,165 | $2,472,256 |
| Age 100 Cash Value | $5,835,983 | $4,363,097 | $5,805,927 |
As you can see, the values for Product A are impacted dramatically by using a more realistic illustrated rate. Age 65 cash value is reduced by 8%, age 75 cash value is reduced by 14%, and age 100 cash value is reduced by 25%—Product B suddenly becomes the obvious choice.
In the end, there is no one magical method that can be used to determine an Indexed Life illustrated rate. Actual results are always going to be either better or worse than what is presented. However, you owe it to your clients to be diligent in providing them realistic expectations, and when you are comparing different products with different caps or participation rates you need to look at them on an apples-to-apples basis.
Always remember that insurance companies are constantly trying to show the validity of their products. This sometimes leads them, although not intentionally, to set unrealistic expectations about the product performance. However, insurance companies are not responsible for setting expectations with your clients—you are!