Disadvantages of Equity Indexed Life Insurance

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Equity indexed universal life insurance, also called an EIUL, is a type of life insurance that uses call options and bonds to credit interest to the cash value account of the policy. This type of policy is also a variation of universal life insurance. Equity indexed life insurance, while it has many advantages, also has many disadvantages.

Crediting Methods

Interest in an equity indexed life insurance policy is credited to the cash values of the policy using a variety of crediting strategies. The most common are the annual point to point (or "ratchet") method, the monthly point to point method, and the monthly averaging method. Both of the point to point crediting strategies begin the crediting cycle with a "marker" at the beginning of the contract, and track the movement of the underlying stock index to the next point. For annual point to point, the index is tracked for one year. For monthly point to point, the index is tracked every month. The difference from the first point to the second point represents the percent of interest that is credited to the policy. Any losses are simply ignored. So, for example, if the index rose 5 percent over the course of a year, your policy would be credited with 5 percent under the annual point to point method. Under the monthly point to point, if the index rose 1 percent in a month, your cash values would be credited with 1 percent interest. Under monthly averaging, index changes are tracked and then averaged over 12 months and then credited to the cash values at the end of the year. The problem with the interest crediting strategies is that they are sometimes hard to understand for the client. Additionally, it is never known in advance which crediting strategy will produce the best outcome for the client over the course of the next 12 months. Also, many crediting strategies make the policy holder commit to the strategy for five-year segments, which means that if a particular crediting strategy does not perform as the client had hoped, the money that is already allocated to that crediting strategy cannot be moved until the end of the five-year segment.

Cost of Insurance

The cost of insurance is separate from the cash values. This allows the insurance company to raise the cost of insurance and make the policy more expensive to own. This is problematic with all universal life insurance. However, indexed life insurance has a particular kind of risk associated with it that could make it extremely susceptible to higher cost of insurance charges in the future. Since interest is credited using index call options, the insurance company needs to make sure it is fully hedged (that it has enough call options to pay the promised interest rate in the contract). However, insurance companies are not mandated to be fully hedged. If an insurance company does not purchase enough call options to cover its liabilities, it may need to raise the cost of insurance to raise money to pay future claims.

Cap Rates

All indexed universal life policies use cap rates to control the amount of interest that can be credited to the account. For example, if your indexed life policy has a cap rate of 8 percent on an annual point to point crediting strategy, and the stock market index moves up by 12 percent in the year, your account will only be credited with 8 percent. This is to ensure that the insurance company can profit and also raise enough money to purchase the call options needed to cover the promised interest payments. When index call option prices rise, cap rates can fall to reflect the higher cost of purchasing the options contracts. This in turn can severely limit your interest earnings potential in the contract.

Participation Rates

Insurance companies also control interest crediting through participation rates. For example, if your policy earns 8 percent in any given year under an annual point to point crediting method, and it has a 100 percent participation rate, then your policy cash values will be credited with 8 percent. However, if the participation rate is only 60 percent, then your interest credited to the policy will be only 4.8 percent. If your participation rate is 140 percent, your policy would be credited with 11.2 percent interest. Participation rates typically vary from between 60 and 150 percent. Participation rates can also be adjusted up or down, which makes future growth uncertain. If you have a low participation rate on your contract, obviously this reduces interest crediting potential.

History

There is simply not a long history with index life insurance. Modern index life policy design began in the early to mid 1990s. As such, it is simply unknown as to how well these products will perform over very long periods of time through repeated bull and bear market cycles (i.e., 50+ years).

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References

  • "Practicing Financial Planning for Professionals"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
  • Advisor Today: EIUL
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