INSIGHT: U.S. insurance regulators pressured over universal life premium increases

September 8, 2016
By Lawrence Hsieh, Practical Law for Thomson Reuters
 The post-crisis regulatory environment and ultra-low interest rates that ravaged bank proprietary trading desks have also hugely affected the insurance industry. This includes universal life insurance, which offers policyholders a cash value savings component earning tax-deferred interest on top of the death benefit. State insurance regulators face increasing pressure to stop insurers from raising premiums to offset their obligation to make guaranteed interest payments on the savings component at rates that were fixed during the high-interest rate “bubble” of the 1980s and 1990s.

Regulators also must figure out how to deal with insurers who harness captive reinsurance or newly devised transaction structures to upstream dividend payments to shareholders even as they raise policyholder premiums.

Several universal life insurers, including Transamerica, AXA Equitable, and VOYA Financial, who guaranteed a fixed rate of return of at least 4 percent on the savings component during the 1980s and 1990s now face the wrath of policyholders who had hoped to rely on the income in retirement. Policyholders claim in recently filed class action litigation that the insurers breached their contracts by raising premiums upwards of 40 percent to subsidize the increased cost of the guarantees and to recoup past losses. Policyholders argue that the rate increases have essentially rendered their policies underwater – where the cost of the policy exceeds the cash value, thus inducing them to abandon their policies.

Insurers traditionally invest their premiums in corporate or government bonds. The interest earned on the bonds is the return on investment that insurers use to fund the policies that they write. The earnings also help insurers pay claims and overhead, including executive compensation. The profits support share prices and justify dividend payments to shareholders.

Policyholders’ dilemma

Life insurers who promise a high fixed rate of return, however, face a shortfall if there are no high-yield, low-risk bonds available to reinvest in when the old bonds expire. They must fund the shortfall from other sources. One way is to invest in higher yield, higher risk investments such as hedge- and private-equity funds, real estate investments and even aircraft financing. Under the Dodd-Frank regulatory reforms, the “Volcker rule” prohibits depository institutions, but not state-regulated insurers, from making such investments for their own account. The other way is to increase premiums under the policy.

This puts baby boomers locked into these policies since the 1980s and 1990s in a tough spot. The policies continue only as long as cash value is sufficient to cover the monthly deductions that insurers make to pay themselves. But raising monthly deductions threatens to quickly drain the cash value and leave policyholders high and dry. For some policyholders, the least unpalatable decision is to cut their losses by surrendering their policies and giving up their death benefits. They can salvage the remaining cash value, even if they can’t afford to replace the policy with a modern product that is less sensitive to interest-rate risk, such as an indexed universal life insurance policy. Indexed policies link growth to an equity index like the S&P 500, but include a floor that protects against negative returns when the indexes underperform.

Cost of insurance (COI)

The outcome of the litigation ultimately hinges on interpretation of the policy’s contract language related to cost-of-insurance (COI) increases. Insurers will likely argue for an expansive interpretation that gives them the flexibility to increase rates for a variety of reasons. They have argued that the new rates do not exceed the rate capped in the policy.

Policyholders and consumer groups such as the Consumer Federation of America (CFA) generally favor a strict interpretation that allows insurers to raise rates only for the reasons explicitly set out in the contract. For the plaintiffs, rate increases are justified mainly by a clearly demonstrated and unexpected increase in projected policyholder deaths based on current mortality tables. Some policyholders have even argued that insurers inappropriately failed to lower premium rates in response to improved mortality data.

The CFA sent a letter earlier in the year to all state insurance regulators urging them to intervene and stop insurers from raising premium rates to avoid making guaranteed interest payments.

According to J. Robert Hunter, CFA’s Director of Insurance and former Texas Insurance Commissioner, “We haven’t heard from the state regulators on what they plan to do, but I’m not surprised that there hasn’t been a response so far. They have a lot on their plates, but my experience is that regulators typically respond more quickly to industry than to consumer advocacy.”

It will be interesting to see whether state insurance regulators respond with formal regulation before the courts decide the cases. It will also be interesting to see how insurers respond to any regulation or court decisions by changing the way that they draft their COI provisions, and whether consumers will actually pay attention to how any language changes impact the way that they view policy illustrations.

Illustrations are presentations akin to bank stress tests that agents use to show prospective policyholders how the policies will perform under a variety of hypothetical interest rates and other scenarios. As we’ve seen time and again with complicated financial products like adjustable rate mortgages and payday loans, reform won’t make any difference if consumers either don’t understand how the products work or hear only what they want to hear.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters and author of the Corporate Transactions Handbook. The views expressed here are his own.)

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