Indexed universal life (IUL) first debuted as an alternative to whole life insurance in 1997. Today, insurance agents commonly take to social media to post the benefits of such policies, often comparing them to other financial accounts and vehicles such as 401k plans and stocks. This leads many consumers to ask whether IULs are legitimate financial products. While there is mixed evidence as to the efficacy of these policies, they should not be categorized the same way as pyramid schemes or similar fraudulent devices. Nevertheless, we find these products to be oversold and unsuitable for many consumers. Before purchasing, it is vital to properly vet the agent who is selling you the policy and thoroughly conduct due diligence to determine whether such a product is right for you.
Recent events surrounding IULs
Litigation surrounding IULs is on the rise in America. In just the past few weeks, several large insurance companies have been sued over their cash value life insurance (CVLI) policies, including:
Lincoln National
Pacific Life
Principal
State Farm
Symetra
It is unsurprising that the insurers—not their agents—have been the targets of these suits. After all, insurance companies have “deep pockets,” but that also means they possess the means to hire the best legal representation. For every settlement or plaintiff success story, there are countless more that were unsuccessful, as in the 2015 case Walker v. Life Insurance Company of the Southwest (LSW) where plaintiffs failed to prove consumer expectations when purchasing these policies. Before delving into the legal analysis, it’s best to discuss some life insurance fundamentals.
Basics of life insurance
Life insurance is a contract in which one person (the insured)transfers the chance of dying too soon (called mortality risk) to a company (the insurer). In exchange for this transfer, the insured pays a premium, often monthly, to the insurer. The insurer pools all these insureds together, which lowers the cost of insurance (like health or auto insurance). Even though the risk is smoothed over countless insureds, each policy owner’s contributions are tracked separately.
There are two primary types of life insurance: term and CVLI (also known as permanent life insurance). Term insurance remains in force only for a set number of years—10, 20, 30, etc. Term policies build no cash value and therefore are relatively inexpensive. If the insured dies during the term while the policy is in force, the insurance company pays the beneficiary listed on the policy a death benefit, free from income tax.[1] If, however, the insured survives the term, then the policy expires and no death benefit (or refund of premium) is paid.
Permanent insurance premiums are much higher. Any amount contributed to the policy that exceeds the cost of insurance builds cash value over time. At its core, the cash value component separates permanent from term life insurance. A particular product may contain unique features, which may incur additional cost. However, the main differentiator between the two types of insurance is the cash value. This affords the owner of a CVLI policy added financial flexibility to:
Pledge the value of the policy as collateral;
Withdraw part or surrender all of the policy for its cash value; or
Borrow against the cash value of the policy.
Many agents highlight the third option when selling these policies, advertising it as a retirement supplement. When loans are taken against the policy’s cash value, the account still accrues interest at its full amount while the loans exist. This is different from an employer-sponsored retirement plan like a 401(k) in which loans reduce the amount of principal against which interest is paid within the plan. These policies are marketed in such a way that the loan interest will be equal or less than the internal growth rate of the policy. Because the money distributed from these policies to the owner is in the form of loans, no income tax need be paid. Once the insured passes away, the insurer deducts the outstanding loan balance from the death benefit.
Permanent insurance varieties
There are three main types of CVLI: whole life, indexed universal life, and variable life. The primary difference across these policies consists in how each one builds cash value over time.
Whole life
The oldest kind of permanent insurance, whole life is also the most expensive because everything regarding the contract is guaranteed: the scheduled premiums, the death benefit, and the cash value accumulation. In general, the stronger the guarantees, the higher the cost when it comes to insurance. Whole life policies build cash value based on a guaranteed annual amount. Some also pay yearly dividends to their policyholders.
Variable universal life
Created in 1986, variable universal life (VUL) sought to wed the cash value component of whole life insurance with the equity exposure of the stock market. A variable life policy’s cash value is directly tied to the value of a subaccount in which securities (stocks, bonds, mutual funds, etc.) are held. The main problem that plagued variable life insurance in its early years was stock market downturns that lapsed the policies due to extreme underperformance (think 2001 and 2008). Many insurers have since implemented internal safeguards within these policies to prevent such lapses should the underlying securities lose significant value.
Indexed universal life
The newest form of life insurance, IUL policies are linked to a particular market index like the S&P 500 or the FTSE. These policies are also complex due to the plethora of moving parts, first among these is the floor. Also known as the minimum rate that is credited to the policy. Most IUL products have a 0% floor, which means that if the market performs poorly over the year, the cash value neither increases nor decreases. Next is the participation rate. This is the rate at which the credited interest amount correlates with the linked market’s performance. A 100% participation rate, for example, means that for every 1% of stock market growth, the policy’s cash value also increases by 1%. A 120% participation rate, in the same scenario, would appreciate 1.2% for every 1% of market gain. The cap rate is the maximum amount the cash value can grow from credited interest in a single year. Thus, if a policy’s cap rate is 12%, and the stock market gains 20% in one year, the policy’s cash value only increases by 12%. Typically, the higher the participation rate, the lower the cap rate, and vice versa. Lastly, IULs are unique in that they offer maximum flexibility in terms of premium payments. Every policy contains a minimum premium and a modal premium. The minimum premium is the least amount required to keep the policy in force. The modal premium is the scheduled amount that underlies the assumptions made at issuance that can be found in a hypothetical illustration the insurance agent shows to the applicant.
Risks of IULs
Like any other asset, IUL policies carry specific risks that every applicant should know prior to purchase. It is the duty of the insurer properly train its agents, and it is the agent’s responsibility to properly educate the consumer, which necessarily entails understanding and communicating the risks described below.
Surrender charge risk
Partial or total principal loss can occur when the owner surrenders the policy during the surrender period, which typically lasts 10 years from policy issuance. Some products have shorter surrender periods while others are longer. The surrender penalty is greatest during the first year of the policy and slowly lessens each year until it disappears entirely at the end of the surrender period.
Lapse risk
Should the policy fail to sustain enough cash in the policy to cover the cost of insurance, it will lapse. Lapse risk is due to several factors:
Insufficient premium payments – Should the policy owner fail to make premium payments at all or only make the minimum payment, rather than the modal payment, their IUL policy may lapse;
Market underperformance – When the linked market performs worse than the illustrated projections, this stunts the policy’s cash value growth, which may be insufficient to keep the policy in force;
Overly aggressive distributions – Should the owner withdraw too much cash from the policy—either through distributions or loans—this may cause the cash value reserves to diminish to the point of policy implosion; and
Mortality expense – In an IUL, everything is flexible—including the cost of insurance or mortality expense. Pursuant to the terms of the contract, the insurer may raise the cost of insurance, which will reduce the excess premium that buoys the policy’s cash value.
Any or all these risks may occur, thereby lapsing the policy.
MEC risk
Should the owner overfund the policy to drive the cash value irrespective of the death benefit, the IRS might deem the insurance policy a modified endowment contract. If this happens, the policy will lose the feature of tax-free distributions from loans, surrenders, and withdrawals.[2] In short, “too much, too soon” may doom the policy in the owner’s eyes who may have purchased the policy for the favorable tax treatment as a retirement supplement.
Is there a solution?
If you are involved in a controversy surrounding an IUL or any life insurance contract, we can help: Contact Steven Lee Ph.D., D.C.J. for the following:
Obtain an in-force illustration from the insurer;
Ensure the accuracy of the agent’s permanent record (both state and federal);
Trace all client-advisor interactions to gauge expectation setting and management; and
Should a finding of wrongdoing exist, calculate economic damages.
