Since universal life (UL) products were first introduced in the U.S. in the late 1970s, they have contained non-guaranteed elements (NGEs). The two main NGEs are crediting rates and cost of insurance (COI) rates. Insurance companies have always actively managed UL crediting rates, but active COI management has been less common. Despite UL policy forms containing contractual language that permits insurance companies to change their COI rates, subject to certain conditions and maximum guarantees, many insurance companies opt not to. Those that do choose to increase their COI rates have often faced significant legal issues, and recently, multiple companies have been subject to litigation for failing to decrease their COI rates.
In theory, non-guaranteed COI rates reduce various risks for insurance companies and can be a tool to help manage future profitability to be consistent with original pricing expectations. However, if an insurance company never intends to use this tool, have its risks really been reduced? And what if that tool potentially increases litigation risk, even if the company never chooses to use it (i.e., from non-decrease COI litigation)? Shouldn’t we be asking ourselves whether it makes sense to keep that tool in the toolbox?
One of the main historical drivers for non-guaranteed COI rates in the U.S., besides the potential risk mitigation benefit, is that use of guaranteed COI rates that are lower than the statutory valuation mortality table will increase statutory reserves and may lead to the need to hold alternative minimum reserves. To determine the UL statutory reserve, the UL Model Regulation requires the calculation of a guaranteed maturity premium (GMP) based on contractual guarantees, which results in the endowment of the policy at the maturity age. The GMP is then used to determine projected guaranteed maturity fund (GMF) values. The UL Model Regulation statutory reserve uses a ratio with the guaranteed maturity fund as the denominator and the actual fund value as the numerator. Lowering the guaranteed COI rates lowers the GMP and also lowers the GMF — and consequently increases the ratio and thus the statutory reserve.
The UL Model Regulation also requires that if the GMP for a policy is less than the valuation net premium (NP), then reserves must be recalculated by replacing NP with the GMP, resulting in greater statutory reserves. If guaranteed COI rates are less than the statutory valuation mortality table, the chance of this happening is greater (i.e., GMP < NP). The Valuation of Life Insurance Model Regulation (a.k.a. XXX) Section 7.A.(1)(b) also defines policies with secondary guarantees to include: “A policy in which the minimum premium at any duration is less than the corresponding one-year valuation premium …”. So policies with guaranteed COIs less than the valuation mortality table could also have made the policy subject to XXX and this could also have driven an increase to statutory reserves. Increased statutory reserves will create a drag on earnings, increase the amount of capital needed to support the business and reduce expected ROI. And within VM-20, the UL Model Regulation still applies as the net premium reserve (NPR) for UL products without secondary guarantees. The NPR for UL policies with secondary guarantees (ULSG) will also be impacted, as VM-20 also uses a similar ratio approach to determine the NPR for a ULSG policy once the secondary guarantee has expired.
As a consequence of these statutory reserving requirements, most UL contracts set the maximum/guaranteed COI rates to equal the current statutory valuation mortality table to help avoid the need for increased statutory reserves and alternative minimum reserves. Many companies have well-developed solutions to address the impact of non-economic (some might say redundant) reserves similar to the alternative minimum reserves in this case. Given these solutions, perhaps having guaranteed COI rates that are lower than the statutory valuation mortality table can be a viable feature for UL products.
On many UL policies, U.S. insurance companies have, since the late 1990s, already essentially been offering lifetime guaranteed COI rates that are lower than the statutory valuation tables. They do so in the form of a lifetime secondary guarantee on the death benefit but don’t provide that guarantee for policy account values and cash surrender values. If an insurance company is willing to guarantee lower COI rates for purposes of death benefit risk, which is the main risk on life insurance, should they really have concerns about also guaranteeing the COI rates for purposes of cash surrender values?
They likely shouldn’t be concerned, as they offer lifetime cash surrender value guarantees in non-par whole life contracts, which they have been selling for a much longer period of time than UL policies. From a risk perspective, U.S. insurance companies have been implicitly dealing with the risks of guaranteed mortality rates that are built into guaranteed cash values for many years. Hence many should already be comfortable with it given the large amount of non-par whole life that continues to be sold. And with UL products, they would still have the ability to pass on a portion of the investment and interest rate risks to policyholders using non-guaranteed crediting rates. The risks from that perspective would still be less than those they currently take on non-par whole life business.
UL policies in many other countries, including Canada, have guaranteed COI rates and other charges. Insurance companies in other countries are also comfortable with this risk; why aren’t U.S. insurance companies? Canadian companies have had profitability challenges on their legacy UL insurance blocks, but many U.S. companies have not fared any better, despite having non-guaranteed COI rates. Fortunately for Canadian companies, they have been using principles-based reserving methodologies for a long time and as a result haven’t had to deal with the redundant reserve issue.
As we noted earlier, to the extent companies view their statutory reserves to be redundant, there are various means of dealing with the redundancy. The use of onshore or offshore captives can help to mitigate the impact of redundant reserves. This was and still is common practice for in-force term and UL with secondary guarantee blocks, and some companies continue to use captives to address non-economic reserving from VM-20.
As noted earlier, an insurance company guaranteeing its COI rates at rates below the valuation mortality table can cause increased statutory reserves and alternative minimum reserves, driving a higher NPR under VM-20. However, guaranteeing current COI rates likely won’t affect deterministic reserves or stochastic reserves, unless current COI rates are varied in those projections. As a result, a business that has these lower guaranteed COI rates is more likely to have the NPR dominate due to the increased statutory reserve and alternative minimum reserve. This could present an opportunity to group this business with other products where the deterministic reserve or stochastic reserve is dominant over the NPR. This would potentially create offsets that reduce the impact of the lower COI guarantee product’s redundant NPR.
It’s important to keep in mind that the National Association of Insurance Commissioners recently updated the C2 calculations for life insurance to have higher factors for permanent products “without pricing flexibility.” The introduction of fully guaranteed COI rates could potentially push a product into that category. So there could be an increase to required capital from fully guaranteeing COI rates.
Using lower guaranteed COI rates would also affect some additional product-related items, the main ones being 7702 and 7702(a) related premium and funding limitations. By lowering guaranteed COI rates, an insurance company will lower all of these premium limitations and/or increase the corridor factors under the Cash Value Accumulation Test. So lowering the guaranteed COI rates can make life insurance policies less efficient from a tax-deferred cash accumulation basis. However, most sales of life insurance are focused on providing death benefit protection, so once again, should this be considered a true deterrent for lowering guaranteed COI rates?
A more minor consideration to keep in mind is the impact to maximum surrender charges. While lower guaranteed COI rates will not affect the initial expense allowance, they will affect the amortization pattern.
Guaranteed products have always sold well in the U.S. market and are appealing to customers when priced at a reasonable level relative to a non-guaranteed product.