As QE3 and low interest rates persist into the indefinite foreseeable future, the weak return environment may be claiming another casualty: no-lapse or "secondary guarantee" universal life policies. Although many insurance companies have already been raising premiums on new no-lapse UL policies for several years now, or ceased offering such coverage entirely as interest rates have fallen, the process of change is being accelerated by the NAIC’s new Actuarial Guideline 38 (AG 38, also known as Regulation XXX), which will require insurers to hold greater reserves on both new and some existing no-lapse UL policies. The consequence of AG 38: new secondary guarantee UL policies will become more expensive, and although existing policies cannot retroactively have their premiums altered, their cash value may perform even worse than originally projected and be even slower to respond with increases in the crediting rate whenever interest rates finally do rise. Although AG 38 is not anticipated to cause the total demise of no-lapse UL policies, the time window is short to obtain coverage before all the premium increases are finalized. And heading into 2013 and beyond, the choices for policies (and carriers offering them) will continue to be fewer, the premiums may continue to rise on subsequent new policies, and some insurance companies may experience earnings hits or outright ratings downgrades – at least until interest rates finally return to more "normal" levels again!
Actuarial Guideline 38
Actuarial Guideline XXXVIII (also known as AG 38 or Regulation XXX) was created by the National Association of Insurance Commissioners (NAIC) to set new reserve requirements for universal life policies that offer so-called "secondary guarantees" (also called "no lapse guarantees") – which guarantee that the policy will remain in force, for life or a specified period of time, as long as any required ongoing premiums are paid, even if the cash value turns out to be insufficient to maintain the policy.
The fundamental problem is that, as low interest rates persist (especially with the Federal Reserve’s commitment of "QE3" continuing through 2015 or beyond), the reserve requirements for such policies are simply no longer viable given the original rate assumptions from years ago. Simply put, the companies anticipated that interest rates from prior to the financial crisis could decline, but not to the extent that they actually have, and not for as long as they already have (and may well continue). To address the fact that money set aside for no-lapse UL policies – including ongoing new premiums – simply cannot be invested at the original interest rate assumptions, the new AG 38 rules stipulate a requirement for higher reserves, both for new secondary guarantee UL policies, and for in-force policies issued after July 1, 2005.
Implications of AG 38 For New Secondary Guarantee UL Policies
For new secondary guarantee UL policies, the response of insurance companies has been relatively straightforward – if higher reserves are needed, then higher premiums will be charged on new policies issued in the future to generate those reserves. As a result, many insurance companies have announced that new UL policies issued going forward will have higher required premiums to maintain the no-lapse guarantee; for some carriers, the new pricing won’t take effect until the new year, although other carriers have already adjusted the pricing this fall. At best, this reduces the appeal of such policies, due to the higher premium cost, and/or may make more people simply consider purchasing a whole life policy instead (where the premiums also guarantee the coverage remains in force, but cash value growth and availability is guaranteed, too). In other scenarios, the new premium levels may create problems because the higher required premiums may disrupt the funding strategies – for instance, where the client’s annual gift tax exclusion paired with a Crummey notice can no longer cover the premiums for a new no-lapse UL policy that was to be purchased inside of an ILIT.
And unfortunately, some insurance carriers have decided that in light of higher reserve requirements and an ongoing low interest rate environment, it’s simply not worth offering no-lapse UL policies at all. As a result, ING and several other companies have simply stopped offering such policies in the face of AG 38; other companies like Sun Life had already decided to stop making no-lapse UL policies available a few years ago, simply from the low interest rates themselves, and most other companies have already made at least some premium increases on new policies from what was typically charged for new no-lapse UL policies prior to the 2008 financial crisis.
Consequences of AG 38 For Existing No-Lapse UL Policies
In the case of existing UL policies with secondary guarantees, the new rules for AG 38 do not allow insurance companies to retroactively change what otherwise have been guaranteed premiums required for the coverage to be guaranteed to remain in force. Nonetheless, the companies are required to increase reserves – which means such reserve contributions will have to come from current earnings, adversely impacting profitability for insurance companies that offered such policies in the coming years and potentially even leading to ratings downgrades (although not necessarily any outright defaults) for some carriers.
Beyond the earnings impact, though, some companies appear to be combating this trend by making adjustments in their non-guaranteed policies, adjusting internal pricing on existing policies and/or repricing new non-guaranteed policies as well. In other words, if the company can’t adjust pricing on their no-lapse guarantee UL policies to maintain their profitability, some are trying to derive the same result by adjusting other policies. As a result, it may be a good idea to review and monitor any and all existing UL policies, both guaranteed and non-guaranteed, in the coming years, to identify if policies are deviating from original projections.
It’s also notable that for some guaranteed no-lapse policies, insurers may continue to adjust some of the few factors they can adjust: the internal expenses of the policy and the crediting rate for the policy cash value. Although this cannot cause the policy to lapse as long as premiums continue to be paid – due to the no-lapse guarantee – such adjustments can reduce the growth or outright sustainability of the cash value, which is not guaranteed and can be fully depleted. In fact, there may be an ever-rising risk that the policy cash value really will be depleted as some companies may even pay a below-market interest rate or raise policy expenses to try to bolster reserves on existing policies. Of course, as long as interest rates are so low, most policies are already at the bare guaranteed minimum interest crediting rate; however, when rates eventually rise, no-lapse guaranteed UL policies may be slow to match the interest rate increase, instead taking advantage of higher rates to earn a greater spread between how the cash value is invested and what is credited to the policyowner. The bottom line: no-lapse UL policies may not bounce back in a rising interest rate environment as much as current projections might suggest.
Outlook For No-Lapse Guarantee UL Policies
Does AG 38 spell the beginning of the end for no-lapse guarantee UL policies? Probably not. Although some carriers have decided it’s preferable to just not offer the policies at all, given the current razor-thin profitability margins, the current low interest rate environment will not persist forever, and some carriers seem willing to keep offering policies and wait for profit margins to expand once rates normalize. In a more normal interest rate environment, no-lapse guarantee UL remains appealing, both for consumers, and the insurance carriers that offer the policies. Nonetheless, the pervasive effect of this ongoing low interest rate environment is to drive carriers away from a wide range of insurance options that depend on earning an interest rate spread or substantial long-term growth on reserves, from secondary guarantee UL policies to long-term care insurance.
Of course, where the insurance need is only temporary, term insurance remains the most appealing option. Where permanent insurance is necessary, though, universal life policies for permanent coverage remain appealing, although higher costs for no-lapse UL policies going forward will make some clients choose to skip the guarantee and just hope the cash value grows sufficiently, and other clients may simply choose fully guaranteed whole life policies instead. On the other hand, the balancing point in between that is available from no-lapse UL policies – a death benefit that can be guaranteed for life, without any guarantee of a cash value that is often not needed anyway inside an ILIT or with other estate planning strategies – remains desirable, and relative to current rock-bottom interest rates the UL policies with secondary guarantees do still offer appealing internal rates of return if held until death at life expectancy.
For those considering using no-lapse UL policies for such strategies in the near term, the time is now to get policies implemented. Many carriers have already stepped away from offering no-lapse UL policies, and/or have already raised premiums on new policies in advance of the AG 38 effective date at the start of 2013, but some more favorably priced options remain, at least for a few more weeks.
And in the meantime, it might not be a bad idea to monitor the insurance company ratings for any existing no-lapse UL policies (and other non-guaranteed UL policies as well!), and the look up the rating of the insurance company for any prospective secondary guarantee UL purchase… just in case. Although in reality, while the transition to AG 38 may be painful for some companies, greater reserve requirements should actually improve the stability and financial security of no-lapse guaranteed UL policies in the long run.