The Ever-Evolving Shadow Account UL

Secondary guarantee Universal Life (UL) product sales have been on the upswing for several years.  Sales of these products have benefitted from lower cost structures and secondary guarantees that allow the product to stay inforce for longer periods than ever before.

Original secondary guarantee UL products sold in the 1980s and 1990s used a no lapse premium design to keep policies inforce.  Essentially, this required the policy holder to pay an amount at least equal to the policy’s no lapse premium (on a cumulative basis) which would keep the policy inforce even if the policy values (fund value and/or cash surrender value) were at or near zero.  Prior to secondary guarantees being put in place, policies ran the risk of lapsing at earlier points in time.

The minimum no lapse premium approach was seen as a way to help keep premium levels up in UL policies so that policies could persist through the early policy years. Most UL plans allow policy holders a flexible approach in paying premiums. Original UL policies (no

secondary guarantee) could have very erratic premium patterns. It wasnot uncommon to see a policy holder pay premiums at the illustrated level for the first year or so, then drop off after that. The minimum no lapse premium (MNLP) approach somewhat forced the insured to keep their premium levels up for at least the first few years.

Many of the early MNLP designs had five year no lapse premium periods. As companies began to get creative and go out further, so that policies could have 10-year, 20-year, lifetime no lapse periods or even allow the insured to dial in the preferred number of no lapse years, the market for this type of low premium product started to grow and prosper. Guideline XXX, which came into play in the mid-1990s, required that the issuing company hold higher reserves for longer no lapse periods in UL products (though admittedly XXX was more focused on level term policy reserves).

Shadow Accounts 

As companies were looking for ways to enhance the secondary guarantee of their UL products, the first shadow account products began to hit the market in the late 1990s.  The shadow account works in a similar fashion as the regular UL fund value.  Premiums are paid, expense charges are assessed and interest is credited to develop the shadow account balance.  However the shadow account cannot be borrowed against or withdrawn from.  Its existence is solely for purposes of keeping the policy inforce.

As long as the shadow account is greater than zero, the policy will stay inforce.  This allowed companies to offer their clients a lower cost product and degree of flexibility not available in a minimum no lapse secondary guarantee UL. The shadow account approach made it easier to target (dial in) a desired no lapse period. Premiums could be structured to keep the shadow account afloat and positive at every point along the way.

Shadow account UL product sales began to take off as more companies began to develop this type of product. Not only was there more flexibility in keeping the policy inforce, shadow account UL products were less expensive to keep inforce than minimum no lapse premium UL plans.

As sales continued to grow, the shadow account Ul approach hit the radar screens of the state insurance regulators who were concerned that statutory reserves produced under the current UL model valuation regulation (even with Guideline XXX additional reserves) were inadequate to support a shadow account lifetime guarantee. Shadow account UL was seen as the equivalent of a term life insurance product buried in a UL chassis. The shadow account UL product only required that the shadow account stay above zero in order for the policy to stay inforce. The regulators saw that death benefit protection could be extended well beyond the years of previous generation UL products.

As Guideline XXX was more geared towards level premium term products,it was eventually supplemented by Guideline AXXX which targeted UL products with secondary guarantees (including shadow accounts). AXXX put a slight damper on the market as companies were unwilling to put up the significantly higher reserves for such products. AXXX ultimately became known as Actuarial Guideline 38 which came into play in 2003.

There were also other issues with shadow account UL products that the regulators were concerned about. Shadow accounts could be prefunded on a short pay basis. Also, some shadow accounts allowed for a “catch up” provision so that even if the shadow account went to zero, the insured could catch up the shadow account by paying enough of a premium to make the shadow account value greater than zero. Typical catch up provisions allowed the insured up to 12 months to put the shadow account back in a positive position. Some companies even allowed the catch up provision to be used more than once.

Furthermore, shadow account UL designs were seen as “lapse supported” which generally means that lower lapse rates decrease profitability. One would expect to see low lapse rates in a shadow account product, especially if the shadow account reaches a levelwhere premiums no longer have to be paid.

Actuarial Guideline 38 (AG38) attempted to deal with the new issuesposed by shadow account UL products that were not addressed in the originalversion of Guideline XXX. In a nutshell, AG38 required that companies hold higher reserves for shadow account UL products and added more steps to the original Guideline XXX reserving process for shadow account UL products.

As the only regulatory requirement on shadow accounts involved the statutory reserving process under AG38, companies continued to get creative with shadow account designs, specifically the charges and interest credits for the shadow accounts. Regulators once again took notice as it appeared that some companies were trying to circumvent AG38 (and thus hold lower reserves) by manipulating the policy’s design.

AG38 went through many gyrations as regulators tried to plug holes in the shadow account reserving method. Currently, the application of AG38 varies based on the era when the UL policy was issued.

Product Design 

As mentioned, the regulation of a shadow account product involves how the reserve is determined. Since the actual design of the shadow account with respect to interest credits and policy charges is somewhat unregulated, product design continues to evolve and varies greatly from company to company. Admittedly, a few companies may still try to design a UL shadow account product so as to minimize the reserve strain and increase profitability, but this is more difficult under the current version of AG38. AG38 brought the profitability of shadow account UL products down to a lower level than most companies were willing to consider. Nevertheless, companies that did not market shadow accounts were at a distinct disadvantage in the UL market.

The earlier designs of shadow account products in the new millennium saw higher charges imposed in the early durations of the policy as well as higher expense charges on premiums in excess of target.

ART premium designs and multiple interest rate buckets were also popular. While minimizing the AG38 reserve is important, making sure that less profitable policy funding methods of a shadow account UL are kept to a minimum is just as important. A company’s shadow account UL product is generally most profitable if the insured pays premium over the entire life (or large portion thereof) of the policy. Policies that are prefunded (short pays) or minimally funded (where the shadow account UL product is only used for temporary protection like a term policy) are less profitable scenarios.

So, not only must the shadow account design attempt to keep AG38 reserves at a level enough for the plan to turn a profit, the design must also discourage the use of the shadow account as a temporary protection mechanism (term plan) or a short-pay vehicle. Actually, the mechanics of AG38 discourage the use of a shadow account UL as a short pay vehicle via higher reserves, so it is in the company’s interest to find ways of discouraging short pay scenarios primarily due to the reserve impact on profitability.

Most shadow account designs are structured to keep the shadow account low during the initial years of the policy by utilizing heavier charges and/or lower interest credits than the regular accumulation fund of the policy. By maintaining a shadow account lower than the regular accumulation account in the early years, this in part helps maintain the funding of the policy at an acceptable level from a company perspective. Several companies even overlay a 5- or 10-year minimum no lapse premium on top of the shadow account in the early policy years to boost funding. Once the policy enters into the outer years (years 20 and up), the shadow account charges tend to reduce and the interest rate credited increases. This causes the shadow account to “cross” over (exceed) the regular accumulation balance and allow the policy to stay inforce to the maturity age while the regular accumulation account runs out of value several years. prior to maturity.

As shadow account designs began to evolve, AG38 enhancements put a damper on the use of high expense loads on excess premiums. Higher expense loads could be used in such a manner as to reduce reserve strain. The current version of AG38 makes the use of higher shadow account expense loads irrelevant with respect to lowering reserves.

In addition, AG38 prescribed lapse rates for policies issued between 2007 and 2013. This preempted the carrier from using more aggressive lapse rates (higher, in this case) to drive up the perceived profit of the product.

Later versions of the shadow account product design have seen companies use two, sometimes three shadow accounts in their administrative systems for a single policy. Some of these designs are meant to keep pre-funding the shadow account or using the shadow account product as a term vehicle to a minimum.

Future of Shadow Accounts 

Certainly, the shadow account UL market has prospered even in light of regulation. The shadow account UL product is a good vehicle for those who desire insurance protection over asset accumulation. Shadow account UL has been used in asset transfer situations and has been used in generalby older age insureds as a manner in which to have low cost insurance protection. Many term products, for example, have issue age limits and cost structures that make buying a term policy at an advanced age either not possible (due to issue age limits) or cost prohibitive. The shadow account UL product works quite well for the older age insurance population (the shadow account UL product has a higher average issue age than most products as a result).

For companies looking to get into the competitive shadow account UL market, there are many other considerations. Reinsurance coverage is critical as most companies have retention limits that would not allow them to issue higher face amount policies without reinsurance coverage. Early on, it was not uncommon to offshore the reserve strain and use a letter of credit (LOC) for the difference between the U.S and offshore reserve. The credit market turmoil of 2007-2009 put a crimp in this market as LOCs became either costly or unavailable.

An additional twist involves reinsurers going beyond traditional mortality coverage on shadow account UL products. Some reinsurers participate in the lapsation element as well since the policy can last well beyond the traditional lapse caused by the regular accumulation account (or cash surrender value) going to zero at some point along the way. As mentioned, the shadow account can keep a policy inforce as long as the shadow fund is greater than zero.

Larger companies have an advantage in this market as they have the means to develop offshore captives and/ or find other ways of financing the reserve strain (such as securitization or self-funding). Not only that, large companies can develop complex shadow account designs as they have the means to afford the cost of enhancing the various software systems used to market and administer shadow account UL policies.

Shadow account designs have also been found in Indexed UL and Variable UL policies, though these types of plans tend to emphasize greater than average growth potential as opposed to death benefit protection.

Regulators have also been concerned about stranger owned life insurance (STOLl) which has made use of shadow account UL plans of late in a life settlement capacity. Life settlements, in theory, involves the sale of a life insurance product that is no longer needed by the insured for a price that is greater than the cash surrender value of the policy. The price that the insured received is mainly based on their perceived life expectancy, with lower life expectancy cases yielding higher prices. These policies are sold to investor groups.

While there has been more regulation of the STOLl 1 life settlements market in the past decade, sales of life insurance policies with the intent of turning the policy into a life settlement has been cause for concern. There are also concerns regarding insurable interest and, in a worst case scenario, foul play.

Principles Based Reserves (PBR) is also on the horizon (2014). PBR is a significant change to how insurance companies establish reserves and should lead to more creative product designs. Currently, most statutory reserves are formulaic, whereas PBR will lead to reserves that take the policy cash flows into account in determining reserves as well as adding a significant stochastic element.

Summary 

Shadow account designs have prospered over the last decade as they provide a solution for those who want death benefit protection but may be too old to purchase term insurance or may not have the means to afford other types of coverage, such as minimum premium no lapse UL. Shadow account UL products are meant to be cost effective and allow the insured to determine the time frame over which they want the policy to stay inforce.

The regulatory focus on shadow account UL products has been on the statutory reserve and making sure that it is of sufficient magnitude to eventually pay off the liability when the insured passes away. AG38 evolved from the original Guidelines XXX & AXXX which also sought to keep reserve levels sufficient to eventually pay off the liability.

Nonetheless, the actual design elements with regards to the shadow account, which includes interest credits, COl charges, premium loads and per unit charges, are not currently regulated. This has allowed companies a significant amount of latitude in designing and implementing shadow account UL products and has also accounted for the wide variation in product designs.

Given the popularity and sales growth of the shadow account UL product, more and more companies are looking to get into this market, as the older generation minimum no lapse premium Uls are not as cost effective nor as flexible as the shadow account design. Companies marketing only minimum no lapse UL (as opposed to shadow account UL) are at a competitive disadvantage.

Expect the shadow account UL market to continue growing, as it provides a cost effective method of keeping insurance protection inforce as well as providing a means for the older insured market to have access to life insurance coverage.

William “Bill” Aquayo
SVP, Actuarial Research
FSA, MAAA, CFA, ChFC, CLU
Insurance Technologies