Why Would My life insurance policy Underperform?
Through a combination of factors, a number of individuals are maintaining life insurance policies that are ticking time bombs. The reason for this is that a number of policies are not performing up to their original projections and the life insurance companies are not always informing the policy-owner of this.
When a permanent cash-value policy (which can include whole life, universal life, equity indexed life, variable life, survivorship life, etc) - the consumer and advisor are presented with lengthy print-outs and projections known as illustrations. These illustrations are based on a number of moving parts (components) that can and will affect the performance of a life insurance policy:
1. Interest/Dividend Rate credited – On traditional (non-variable) Whole Life and Universal Life policies; the dividends/interest credited are based on the overall performance of an insurance company managed investment account. On Variable Life Insurance products; the interest credited is based on the performance of investment sub-accounts selected by the policy-owner. Performance of any investment is unpredictable and will impact the return on a policy.
2. Expenses – these are the overhead costs - new business costs, commissions, underwriting expenses, etc.
- Declining Credit Rate Changes -- Twenty years ago, for most life insurance companies, the interest crediting rate was around 12% percent and currently the interest crediting rate is approximately 4.5% to 5% which was the guaranteed rate twenty years ago. Currently some companies pay a lower interest rate and most have a lower guaranteed interest rate than 4.5%. Most company’s credit at a higher rate than their guarantee rate. On a variable policy, the return rate can be lower (perhaps 0%) depending on the policy.
As we well know, the return rate for any investment over the last couple of years has been dismal which has impacted the return on the policy even more than the lower interest rates of the 1990’s and 2000’s.
Example Of Declining Interest Rates On A Universal Life Policy
A Universal Life policy was issued with a large, well rated carrier on March 5, 1997 with a death benefit of $75,000. The annual premium of $1,172 with the assumed interest rate of 6.15% projected to endow (cash value = death benefit) at his policy age 100. In projections run on April 5, 2004; based on current assumptions, the policy will lapse (terminate) at his policy age 91. To have the policy endow (just 9 years later) at age 100, the annual premium would need to be increased to $1,379 – an increase of 18%. Keep in mind that the effects of a decreasing dividend scale on a whole life policy will have a similar effect.
4. Cost of Insurance/Mortality Cost – Also known as the risk charge. These costs increase annually based a table in force on implementation of the new policy. This is the amount applied for the pure cost of insurance.
The most noted and common impact on the performance of a life insurance policy is the interest rate. The larger and usually unknown/non-disclosed impact is a change in the mortality costs. This impact is usually unknown to the policyholder as well as the agent.
A change in mortality costs is much rarer than a change in interest rates as far as anyone knows. A tick in the interest rate has much less impact than an increase in the mortality rates.
As an example, a policy owner with a large, well-known life insurance company faces an extremely bad situation due not only to decreasing interest rates as well as to increased mortality costs. The company was not forthcoming about the increase and finally admitted a .25% (or so) increase in mortality costs.
Here’s the effect on this policy: The policy was purchased on April 16, 1991 with a death benefit of $750,000 and an annual premium of $5,661. The assumed interest rate at the time was 8% (about average at the time). According to current in-force illustrations, the policy is at the guaranteed (minimum) rate of interest at 4.5%. In order for this policy owner to continue the policy to age 100, the premium would have to be increased to $13,000+. If the premium is kept at the current annual premium of $5,661, the policy will lapse (terminate) at his policy age 81.
Over the next few years, policies are going to continue to implode due to low interest rates and often times it will come as a shock to the policy owner. It is not unheard of for the required premium to continue a policy to double, triple or even quadruple especially if premium payments are missed.
Missed premium payments exacerbate the issue even though this has been a key selling point for policies.
Policy loans can also cause issues with a policy. If excessive loans are taken out, then the policy can terminate. The policy owner would then not only be faced with losing their policy, they could also have a phantom income tax gain. (Click here to read an article on Policy Loans).
The general rule for calculating an income tax gain on a life insurance policy is to subtract the basis (usually sum of premiums paid) from the total value received (usually the surrender value and any outstanding loan).
Over the next few years, more and more policies will be terminating due to lower interest rates and higher costs assessed to the policy. The economic collapse of the last few months will have the long range impact on the insurance company’s ability to credit higher interest & dividend rates and need to assess higher charges to a policy.
How a policy was originally set up really doesn’t matter. What’s happened since a policy was put into place is what matters. An in-force illustration is a projection of values based on your current cash value and the company’s current interest rate/dividend scale, cost of insurance (mortality expense) and overhead charges.
If you have a life insurance policy, you should make sure that you review your policy by ordering an in-force illustration from your agent and/or company. The longer you wait, the greater the chances of an unpleasant surprise.
By Anthony Steuer, CLU, Life Insurance Analyst
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