Compared with Homeowners or Auto, clients tend to have different expectations when it comes to their Life insurance. Will you know how to present this kind of business? This document by Dick Weber reviews various types of Life insurance and their variations.
CASH VALUE LIFE INSURANCE
Cash value Life insurance is found in several fundamental formats. The best known and oldest form of Life insurance is Whole Life, whose most significant feature is a fixed and guaranteed premium. The more recently developed Universal Life and Variable Universal Life allow for flexible premium amounts and payment timing. However, unless the policy owner pays the underlying guaranteed premium, the policy isn’t guaranteed in the same way as Whole Life.
Understanding what’s guaranteed and what’s not guaranteed in a Life policy is of great importance. Most cash value policies have certain underlying guarantees concerning mortality charges, investment returns, and expenses that can be assessed against the policy. A traditional Whole Life policy guarantees payment of the death benefit irrespective of time of death, poor investment returns, or higher-than-expected death claims, as long as the policy owner has paid the stipulated premiums. When the insurance company earns more than its guarantee, or has lower than anticipated expenses and/or death claims, the company passes the savings on to the policy owner in the form of dividends (mutual insurers) or non-guaranteed enhancements (stock insurers).
Dividends and non-guaranteed enhancements provide a long-term reflection of a carrier’s ability to manage expenses and earnings beyond those that it guarantees. In some cases, however, uncontrollable external forces might constrain a carrier’s ability to manage its expenses and revenues. An example is investment earnings. Interest returns are substantially lower than they were 10 years ago. Carriers have had little to say about this macro-economic development. Similarly, broad-based mortality experience as dictated by AIDS (detrimental) or new medical discoveries (positive) can affect a carrier far beyond its ability to control that experience.
Perhaps the most confusing issue facing buyers of Life insurance is to understand the purpose of illustration, and the basis of calculation. To seasoned agents, it was simple: pay the premium and the insurance was permanent. Those of us who grew up in the 'good old days' of Whole Life knew that it could only get better, never worse (unless, of course, the agent portrayed the purchase as a 'vanishing premium'). With interest rates falling in 2000-2002 much as they did in the late 1980s to the early 1990s, dividend scales could decline from current levels.
UNIVERSAL LIFE
Universal Life policies offer similar types of guarantees and pass along savings (or investment returns in excess of the guarantees) through non-guaranteed enhancements. But because the policy owner has the contractual right to determine their own payment level and the timing of those payments, the underlying policy guarantees are more difficult to understand.
In some ways, the difference between Whole Life and Universal Life could be compared with the differences between a fixed and a variable mortgage. In a variable mortgage you could make the higher monthly payment defined by the maximum interest rate the lender can charge; and if you do, you’ll never have to pay more, regardless of how high interest rates go. If rates trend lower, making a higher payment can actually be favorable, causing the mortgage to be paid off early with the savings of many thousands of dollars in interest. If you stick to the lower payment allowed by the mortgage, however, higher interest rates would require increasing monthly payments.
One payment procedure is no better than the other, but could better serve a consumer’s needs. Although the effect of the interest in this example is in the opposite direction for Life insurance, the key is to understand the choices in the face of an uncertain and variable future.
Offsetting any confusion in the definition of 'guarantee' between Whole Life and Universal Life, however, is the existence in Universal Life of expressed charges (expenses and mortality) and expressed earnings that are more clearly defined in the policy. This allows the knowledgeable client and agent to fine tune the performance of the Universal Life policy during times when the carrier’s actual experience requires payment adjustments in order to maintain the policy on the basis originally planned.
Universal Life introduced a new era of policy flexibility, but also resulted in confusion and misaligned expectations. Universal Life in the 1980s was mostly sold with substantially lower premiums, since the high credit ratings of the 80s allowed for a calculated premium that was 50% or less of the Whole Life equivalent. Many lawsuits in the past seven years have focused on Universal Life underperformance relative to the illustration.
VARIATIONS ON A THEME
In the mid-1980s a new hybrid policy merged elements of Whole Life and Universal Life. Such policies incorporate policy design and illustration design, which offers a greater degree of initial flexibility, but also creates potential confusion over what’s guaranteed and what isn’t. Typically called Blended Whole Life or Blended Universal Life, they contain specific proportions of permanent insurance (Whole Life or Universal Life), as well as Term insurance, and sometimes Paid-up Additions of Whole Life. Incorporating Term insurance into the Whole Life or Universal Life policy can lower the apparent cost of the insurance if the projected cost of the Term coverage doesn’t change and the dividends or non-guaranteed enhancements continue in the future as projected.
It’s also possible to blend in Paid-up Additions riders. Generally, these riders represent an injection of 'pure' cash value into the policy and facilitate a 'pour-in' of cash from another source at the outset of the policy. Paid up riders are generally less susceptible to fluctuations in future earnings and expense performance of the carrier than Term riders. Nonetheless, you should monitor policy performance to ensure that the policy values are adequate to accomplish your goals.
Such policy design — blending with Term riders and/or paid-up addition riders — and their subsequently illustrated values are highly complex and technically sophisticated. A policy of this type should be examined and explained in great detail before being purchased.
Blended Whole Life/Term products were a logical response to UL and other current assumption products that could illustrate substantially lower premiums. They also held the potential for more confusion and misunderstanding, since the base policy was Whole Life (pay the premium/permanent coverage). One of the things we’ve learned since 1994 is that judges and juries have frequently ignored the existence of policyowner signatures on illustrations as proof that the agent discussed the illustration with the client. Yet, illustration acknowledgments have been the 'state of the art' when it comes to defending the actions and representations of the agent. If nothing else, legal activities in the past few years have made it imperative for agents to provide a substantial, written record of any policy and illustration design considerations that they discuss with their clients.
AND MORE VARIATIONS
The policies discussed previously are typically found in both ‘one insured life’ and ‘two (or more) insured lives’ formats. Most people purchase a ‘one insured life’ policy for income replacement or business planning. Current estate tax law has encouraged a variation called ‘Joint Lives, Second-to-Die,’ which describes (typically) a husband and wife insured under one policy with a death benefit that pays only after both die. This type of insurance can be beneficial for estate tax purposes, but is generally inappropriate for replacing the income of a breadwinner in the event of a premature death.
To amplify the variations of Life insurance further, all three permanent types of insurance discussed — insuring one or two lives — are available from mutual and stock carriers that invest, manage, and maintain cash values as a general obligation of the company. These policies are referred to as General Account policies. The carrier bears the obligation to invest your premiums prudently and prosperously; you have no say in their activities.
Many stock and mutual carriers also offer Separate Account policies in which you — the policy owner — can direct the investment of your premium dollars and bear the consequences of those investment decisions directly. Such policies are typically referred to as ‘Variable’ policies. A variety of investment alternatives are available, from money market accounts and fixed return accounts to more aggressive growth stock funds. A prospectus must be delivered to you prior to purchase and you should make certain you understand the advantages and liabilities you’re taking on when purchasing this form of insurance.
HOW NOT TO SELECT A POLICY
These brief definitions explain how the three basic types of Cash Value Life insurance (Whole Life, Universal Life, and Blended Policies of either) work, the variations in the number of lives that are insured, and who has the obligation to invest your premium dollars. For all these variations, you’ll frequently view a Policy Illustration to assist you in making your purchase decisions. The illustration, however, is not the policy! The illustration attempts to project today’s experience — with respect to expenses and earnings — to give you an idea of how the policy works, or how the policy’s values might look in the future. The illustration could also demonstrate the policy’s flexibility in the event that the insurance company continues to enhance policy values in excess of the guarantees of the policy. Because policy illustrations merely project a current set of assumptions, they’re inappropriate for choosing between one type of policy and another, and especially for deciding among the policies of different carriers.
Illustration flexibility manifests itself in a number of ways. One method of using potential excess earning power is to allow enhancements to take over the payment of premiums. The term 'premium offset' or 'disappearing premium' is most often associated with this type of illustration. But the policy itself isn’t designed to eliminate premiums. The illustration simply calculates when non-guaranteed enhancements give the policy owner the option of paying premiums out of excess policy values — if those values in fact materialize.
Another popular illustration — not an inherent policy design — is 'cash flow.' This type of illustration demonstrates paying premiums for a period of time, and then withdrawing cash from the policy — typically to supplement retirement income. Policy owners need to understand that most of the benefits from such an illustration come from an assumption of substantial dividends or non-guaranteed enhancements. The amount of cash that can ultimately be taken from the policy without causing the policy to lapse (and create a potential income tax liability) can only be determined over time.
There’s nothing wrong with a policy illustration. It’s the way the illustration is used and what the client understands of it that can create problems. As agents, we have experience generating and using policy illustrations. We know (or at least should know) that an illustration is a linear projection that by its nature is unlikely to occur as portrayed.
But a client generally won’t have the same appreciation. In fact, a client’s experience in buying things tells them that they should be able to see what they’re getting and compare prices. This is why illustrations became so popular. However, an illustration can’t predict the price of a policy, and can’t be used to choose one policy over another.