Reassessing Risk

Considering indexed universal life as an alternative to traditional conservative investments

Journal of Financial Planning: August 2015


When investing, we generally seek to obtain the highest return possible given the amount of risk we are able and willing to tolerate. Unfortunately, gauging the degree of risk associated with various investments is not always easy.

People tend to prefer known risks over unknown risks. This propensity, often referred to as ambiguity aversion and illustrated via the Ellsberg paradox, can cause us to exaggerate risks we can’t quantify or that we do not entirely understand. People are also prone to downplay risks that are common and familiar. (“I’ve done this for years, and nothing bad has happened, so it must not be very risky.”)

These biases can prevent us from properly assessing our alternatives, resulting in decisions based on perceived risk, rather than actual risk. One example of this in the investment world is the way in which some people attempt to evaluate the use of life insurance as an investment.

Consider Joe, a 50-year-old man with better-than-average health who is weighing the purchase of an indexed universal life insurance policy. Joe’s insurance adviser recommended the product as a conservative way to build cash over a mid- to long-term horizon. It would also pay an attractive death benefit to Joe’s family in the event of his death. According to the policy illustration:

Joe would pay total premiums of $500,000 over seven years ($71,429 per year), after which point it was projected—not guaranteed—there would be no further premiums required.

The policy’s initial death benefit would be $1.3 million, but it was projected—again, not guaranteed—that this would begin to grow each year beginning in year seven.

Each year, the policy’s cash value would be credited with interest based on the performance (excluding dividends) of the S&P 500 Index, collared by a guaranteed floor of 1 percent and a current cap of 13 percent subject to fluctuation (upward or downward) at the discretion of the insurance carrier.

Based on the non-guaranteed assumptions that policy charges would remain at their initial projected levels and that the collared return on the S&P 500 would average 7.5 percent per year, the policy’s cash surrender value at the end of the 10th year is projected to reflect a 4.6 percent internal rate of return (IRR) on the scheduled premiums. By the end of year 15, the cash surrender value IRR is projected to reach 5.65 percent, and 6.04 percent by the end of the 20th year.

The proposal sounds attractive to Joe, so he consults his financial adviser who cautions that the strategy sounds risky, as most of the benefits projected under the policy illustration are not guaranteed. The projected 7.5 percent average return on the S&P 500 seems aggressive, and the adviser is concerned that a lesser return could eventually cause the policy to lapse—without cash value or a death benefit. Joe’s adviser points to the columns on the policy illustration labeled “guaranteed assumptions,” where the policy’s cash surrender value is never projected to increase above $376,000 (notably less than the scheduled premiums), and the policy is only projected to last until age 80 before lapsing.

Joe goes back to his insurance adviser and states that, from now on, he only wants to look at policies where all of the benefits are guaranteed.

Stories like this are not uncommon. Stocks, bonds, mutual funds, and real estate carry their own varying degrees of risk and also lack guaranteed results, but many people consider these known risks, where they believe they have sufficient information available to confidently project future results. The lack of familiarity with life insurance as an asset class can prevent people from applying a similar, objective analysis to insurance products.

Nothing in life is risk-free, and indexed universal life insurance products are no exception. Interestingly, though, the concerns about these products that are most often cited are ones that are (at least statistically) extremely remote.

In an effort to demystify this conservative investment alternative, what follows is an overview of how indexed universal life insurance works and the risks most likely to impact performance.

Understanding Indexed Universal Life

An indexed universal life insurance policy is a flexible premium, permanent life insurance policy that contains an insurance component and a cash/savings component. They are not stock market investments and do not directly participate in any equity investments.

Like other permanent life insurance products, premiums are deposited in the policy’s cash account, which is reduced by policy charges and increased by a crediting methodology set forth under the terms of the policy. What differentiates an indexed UL policy from other types of permanent life insurance used for cash accumulation is that the growth of the policy’s cash value is based on the performance of an equity index (usually the S&P 500), excluding dividends, collared by a cap and a floor1—rather than based on a flat crediting rate established by the insurance carrier and adjusted from time to time (current assumption universal life), based on a flat dividend rate established by the carrier and adjusted from time to time (whole life), or based on the actual returns of specific equity investments (variable universal life).

Projections of indexed UL policy performance are based on the forecasting of (1) annual policy charges; and (2) the collared return on the index.

Annual policy charges. Four different charges are typically deducted from the cash value of an indexed UL policy. Two of these—a premium load charge and a monthly charge per $1,000 of death benefit—are essentially sales charges. The premium load charge is assessed each time a premium is paid, while the monthly charge per $1,000 of death benefit is assessed for the first 10 years after the policy is issued. The third charge, an annual expense charge, is generally nominal. The fourth charge, the monthly cost of insurance per $1,000 of death benefit, is the mortality charge associated with providing the policy’s death benefit. This is the only charge that is scheduled to increase each year.

Collared index return. Consider again the previous example that the historical average compound return on the S&P 500 Index with a 1 percent floor and a 13 percent cap is 7.5 percent.

To better explain what this number means, a bit of background is in order. The average annual (uncollared) S&P 500 Index return for all calendar years between 1920 and 2013 was 8.38 percent. Of course, receiving varying returns that average 8.38 percent per year is not the same as receiving level returns of 8.38 percent each year. If you had a bank account that was credited with actual S&P 500 Index returns from 1920 to 2013 (excluding dividends), your average compound return would only be 6.45 percent. In other words, volatility reduced the compound return on this investment by 1.93 percent.

Now look at the return over the same time period, but with a collar of 1 percent and 13 percent. The average collared return for all calendar years between 1920 and 2013 was 7.80 percent (0.58 percent less than the average return without the collar). However, because the collar dramatically reduces volatility, the average compound return on an account credited with the collared return from 1920 to 2013 would have been 7.65 percent. The collar reduces the impact of volatility from 1.93 percent to 0.15 percent.2

As we know, past performance is no guarantee of future results. In any given one-year period, it is not only theoretically possible to realize a return equal to the 1 percent floor, but this is, in fact, what happened in 33 of the 94 one-year periods between 1920 and 2013.

But what if we focus on performance over a 10-year period? There have been 85 rolling 10-year periods between 1920 and 2013. While it remains theoretically possible to realize a 10-year average return equal to the 1 percent floor (a result that would require the S&P 500 Index to produce an actual return of 1 percent or less for 10 consecutive years), this never occurred in any of the 85 rolling 10-year periods dating back to 1920. Over the 94-year time frame, the worst rolling 10-year period (1969–1978) produced an average return of 5.6 percent, and the best rolling 10-year periods (1980–1989 and 1982–1991) produced an average return of 9.5 percent. The average rolling 10-year period produced an average return of 7.66 percent.

Analysis of Perceived Risks

The primary concern of Joe and his financial adviser is that the benefits projected in the policy illustration are not guaranteed. Inherent with this concern, however, is the suggestion that only results that are guaranteed can be reasonably expected to occur. The adviser’s focus on the guaranteed assumptions and the fact that the policy would lapse after 30 years under those circumstances left Joe with the impression that this dire scenario had some reasonable likelihood of occurring. But is that really accurate?

As noted previously, over the past 85 rolling 10-year periods with a 1 percent and 13 percent collar on the S&P 500, the very worst period produced an average compound return of 5.6 percent (5.42 percent after volatility is taken into account). With current charges and a 5.42 percent annual return, the policy would never lapse, it would have a cash surrender value that exceeds the amount of premiums paid by the end of the seventh year, and it would have a cash surrender value IRR of 2.50 percent after 10 years.

Would it be possible to realize worse results than this? It would, but for that to happen, some combination of the following conditions would need to occur:

  • the 10-year compound return on the collared index would have to fall below 5.42 percent, something that never happened over the past 85 rolling 10-year periods;
  • the insurance carrier would need to dramatically increase policy charges from their current level; and
  • the insurance carrier would need to lower the adjustable 13 percent cap on the collared index.

When you look at 30-year rolling averages with a 1 percent and 13 percent collar, the statistics are compelling. If the average return on the collared index over the next 30 years is equal to the worst rolling 30-year period since 1920, the cash surrender value IRR at the end of year 30 will be 5.56 percent, rather than the 6.32 percent that is projected on the policy illustration assuming a 7.5 percent index return.

Subjective Risks Associated with Indexed UL

In addition to the statistical analysis applied to concerns about worse-than-projected market performance, a different sort of analysis must be conducted with respect to concerns about an adverse exercise of insurance carrier discretion.

Increase in policy charges. Many life insurance policies provide that the carrier may increase policy charges under specified circumstances (generally a reference to the company’s expectations regarding future mortality, investment, expense, and persistency experience). However, this discretion is very rarely exercised. For example, in response to an inquiry about historical increases in policy charges, Hartford Life and Annuity Insurance Co. (just prior to the completion of their acquisition by Prudential Financial) stated that it increased policy charges on just two occasions; once in 1919 in response to an influenza pandemic, and again in the 1980s as a result of the widespread outbreak of AIDS.

Even under circumstances where an increase in charges could be justified, there are two compelling reasons why an insurance carrier might still be reluctant to do so: adverse selection and reputation.

Reduction of index cap. When analyzing the risk associated with most indexed UL policies, a potential reduction of the index cap should arguably be listed as the primary concern. In our 1 percent and 13 percent collar example, each percentage point subtracted from the cap reduces all of the rolling average yields by anywhere from 0.45 to 0.60 percent per year.

Most carriers periodically adjust index caps—upward as well as downward. Because most indexed UL policies have relatively low guaranteed cap levels (in nearly all cases, 4 percent or lower), a decision to lower the index cap to the minimum guaranteed level could significantly impair the performance of the policy. However, similar to increasing policy charges, an insurance carrier that lowers its index cap to the point where policies become economically unattractive would risk a swift departure of all healthy members of its risk pool and risk substantial damage to its reputation.

The risk of being harmed by an adverse exercise of the insurance carrier’s discretion is mitigated over time by the fact that an increase in policy charges or a decrease in the index cap would be prospective only; neither of these changes would have an immediate impact on policy value.

The owner of an indexed UL policy can generally liquidate the investment after the occurrence of an adverse event (such as news that the index cap is being reduced) for the exact same value they could have received before the event had occurred. Surrender charges impose a cost to exiting the policy within the early years, but once the cash surrender value of the policy climbs above the total amount of premiums paid (which, in the case of the example policy used here, is projected to occur at the end of the fourth year), the policyholder should be able to get out without experiencing a loss. Of course, the health of the insured and the income tax consequences associated with surrendering the policy are other factors that should be taken into account before a policy is surrendered.

A Final Note

Anyone considering an indexed UL policy as an alternative to more traditional conservative investments should have a thorough understanding of the income tax treatment of life insurance, as well as how that tax treatment compares with the way in which other investments might be taxed. Although the general rules are that inside cash buildup, the proceeds of policy loans and the death benefit on the policy are non-taxable for income tax purposes, exceptions to these rules can be traps for the unwary. Accordingly, it is important to work with a life insurance professional who is well-versed in tax matters, or consult with an outside tax adviser when making decisions regarding the policy.

Jordan H. Smith, J.D., LLM, is vice president of advanced design at Schechter Wealth, a third-generation wealth advisory firm, where he works with advisers and their clients in the design and implementation of advanced strategies.


  1. The analysis in this article assumes that the policy has a participation rate equal to 100 percent of the index return between the cap and the floor. Although some indexed UL products offer alternatives of a lower cap paired with a participation rate that exceeds 100 percent, those are not discussed here. It is the author’s belief that such arrangements are statistically less favorable.
  2. The point of this analysis is not to suggest that the collared return from an indexed UL policy will outperform direct investment in the S&P 500 (in the long run, it won’t, because direct investors receive dividends in addition to market appreciation), but instead to illustrate how reducing volatility can dramatically improve investment returns.

Editor’s note: For another take on indexed universal life insurance, see Peter Katt’s column in this issue.


A Fresh Look at Life Insurance in Periods of Uncertainty

by E. Peter Tiboris,  CFP®, CLU®, ChFC®, CAP®

A properly balanced planning strategy can allow clients at any stage of their financial plan to capture the significant long-term appreciation of the equity markets while thoughtfully apportioning assets in cash or cash alternatives for liquidity needs. These liquidity needs start with death, continue with emergencies and the inevitable bear market, and extend to distressed investment opportunities such as buying a piece of real estate amidst a market crash. Theoretically, a properly balanced, long-term financial plan will include cash and/or cash alternatives to avoid the need to sell shares in a down market, and hence should outperform the alternative plan without adequate cash-equivalent assets.

Most financial planners recognize that the benefits of liquid cash for various purposes are high. However, we must further recognize that the cost of this liquidity premium is high: yields on short-term liquid investments are relatively low, and interest-bearing investments generally translate into ordinary income tax.

Once inflation and ordinary income tax is considered, the cost of these investments is high. For example, an investor might have liquid investments paying 3 percent interest. Assuming a 35 percent tax bracket, the post ordinary income tax interest on these investments is 1.95 percent. As a result, at 3 percent inflation, the investor’s liquid investment has a negative return relative to inflation.

Unique Characteristic
Life insurance is an asset whose unique and most important characteristic—the death benefit— provides certain cash to heirs at the policyholder’s death. Irrespective of the market and the values of assets in the client’s portfolio, the appropriate death benefit allows the survivors to create an orderly disposition of the family assets to meet liquidity needs. If the insurance amount is large enough, the survivors might not see a financial case for selling any of the invested assets. In this case, the life insurance death benefit represents choice. Having an ability to choose whether or not to dispose of assets could allow the family to maximize the overall legacy for generations to come.

Living Benefits
What about the living benefits of life insurance? How might these fit into a client’s overall portfolio in periods of distress? Our clients use traditional, high-quality, dividend-paying whole life insurance contracts as an efficient means to accumulate cash value over long periods of time.

The concept is intuitive. For the moment, put aside the costs of insurance and other factors that impact individual product performance, and consider:

Whole life insurance contracts rely on the performance of the life insurance company and its general account. That general account is invested in primarily corporate and government bonds. It is very difficult for the individual investor to replicate this blended diversification on a risk-adjusted basis.

Most of these life insurers are highly rated and some have been incorporated since well before 1900.

The insurance company dividend scale interest rate is not directly subject to market volatility. Some companies boast that they have never missed a dividend through every bear market in history and even through the Great Depression and Great Recession. For a relatively recent example, we can look to 2009, the year following the Great Recession of 2008. In that year, the following insurance companies had these dividend-scale interest rates:

Mass Mutual: 7.6 percent
Guardian: 7.3 percent
MetLife: 6.25 percent
New York Life: 6.14 percent
Northwestern Mutual: 6.5 percent

This historic reference helps to illustrate the relatively low volatility of insurance companies’ dividend scale interest rate in times of high overall market volatility. Because of the mortality and expense charges, the dividend scale interest rate should not be used as a measure of the policy’s internal rate of return; rather it is one factor used in determining a policy’s total dividend. The method an insurer uses to determine the total dividend paid on a policy can vary from company to company.

Traditional whole life insurance contracts have a guaranteed set of cash surrender values at contract inception. Once a dividend is earned and reinvested by a policy owner, it becomes part of the guarantee. As a result, the cash value can never go down. 

Life insurance is not subject to tax as the cash value grows. Further, borrowing against or surrendering additions from a non-modified endowment contract policy via loan/surrendering dividends up to the cost basis are not subject to tax and can be received quickly. For example, a policy owner could have had a lion’s share of their insurance cash value available within a week in the most perilous periods of 2008–2009.

Lastly, and perhaps most importantly, life insurance offers flexibility. The life insurance benefit itself allows clients the flexibility within their financial plan to help them meet their goals before and after retirement with some certainty. 

Most clients don’t plan on using life insurance cash values in the future, but they do find opportunities over time where it can be useful. Our clients often borrow from the insurance company using their cash value as collateral to help meet liquidity needs. When they are flush with cash again, they repay the loan. This may allow them an option to avoid having to liquidate equities, bonds, real estate, or other investments in a down market, providing the opportunity for those investments to recover. Of course, loans taken against a life insurance policy, surrendered values, or withdrawn values can have potentially adverse effects if not managed properly. 

Traditional dividend-paying whole life insurance on its own can be a compelling asset to own in any market environment. When you factor in the benefits of its unique liquidity characteristics at death and during life, it can have a significant impact on an individual’s overall portfolio performance.

Peter Tiboris is a wealth management adviser based in New York City. His team specializes in working with individuals and businesses across all financial planning disciplines with a focus on tax efficiency.

Risk Management & Insurance Planning