What type of life insurance should I have?

The short answer just might be ‘all of them’

In the 1970s, all we really had to offer was Whole Life and One-Year Term.  The investment element was based on the general account of the life insurance company, which invests predominantly in long-term debt (bonds and mortgages).  These investments are used to help calculate the premiums, as well as to create cash value.
What happens to the value of bonds when interest rates increase?  The value decreases.  As interest rates began to explode, not only did the value of general accounts of life insurance companies plummet, but life insurance companies were also hemorrhageing cash.  Policyholders were taking loans at 6% or 8%, walking over to their local bank and took out a double-digit CD.  I moved to New England at the end of 1980 and secured an 18% mortgage.  I felt real good when interest rates hit 21%.  The life insurance industry response was to create Universal Life.  They established a separate account on their balance sheet holding only short-term debt to keep pace with the increasing interest rates.  

Of course, short-term debt also keeps pace with decreasing interest rates.  As interest rates began their decline from 21% to 2% (or lower), Universal Life funding needed to change.  If a level premium was calculated based on a double-digit return and experiences single-digit returns instead, the coverage simply will not last as long.
In the 1990s you could eat breakfast, lunch, and dinner by attending financial planning seminars introducing Asset Allocation and 401(k) plans.  Everyone believed that they could play the market and win.  The life insurance industry response was Variable Universal Life.  If you want it to perform like Whole Life, select the subaccounts for your cash value that invest predominantly in long-term debt.  If you want your Variable Universal Life to perform like Universal Life, select subaccounts that invest mostly in short-term debt.  If you want your VUL to perform like your 401(k), then select an asset allocation portfolio of subaccounts, and remember to re-balance.  It is that lack of re-balancing that created most of the problems with 401(k)s and VULs.  

However, during the booming 1990s, 401(k)s and VULs were flourishing.  People quickly forgot October 1987.  On one day in October 1987 the Dow Jones Industrial Average dropped 25%.  That would be like a 3,000 point drop on a DOW of 12,000.  It only took a few months to return to the value before that horrific drop.
One of the principle elements of Asset Allocation is re-balancing.  But, re-balancing is counter-intuitive.  Let’s say that you have $30,000 and your risk tolerance results in a portfolio of $10,000 in A, $10,000 in B, and $10,000 in C.  If after a period of time, your portfolio is now:
         $10,000    declined by 20% to     $  8,000
    B       $10,000    increased by 50% to     $15,000
        $10,000    stayed the same at    $10,000

    TOTAL    $30,000    increased by 10% to    $33,000

Re-balancing says return to the original equal thirds:

    A        $  8,000    BUY $3,000        $11,000
    B        $15,000    SELL $4,000        $11,000
    C        $10,000    BUY $1,000        $11,000

    TOTAL    $33,000    increased by 10% to    $33,000

The typical investor said, “Are you nuts?  You want me to BUY more of those losers?  I lost 20% on A and did nothing on C!!  And, you want me to SELL any of my big winner!!  That is just crazy.  So, many investors did not re-balance.  In too many cases that moved everything to B.  They bet the house on one asset class.  As a result, many lost a great deal of value in their 401(k) and VUL accounts in September 2001.

The insurance industry response to 2001 was Guaranteed Universal Life.  Real guarantees, without dividend assumptions, interest assumptions, mortality tables, etc.  If you pay X dollars for Y years, your beneficiaries will receive Z dollars when you die.  You can use these products as term coverage.  If you only want death benefits for W years or until W age, you calculate how many X dollars are needed for Y years to pay Z dollars out if you die before the selected age or years W.

One problem with Guaranteed Universal Life is that people may very well be over-paying for what they likely need.  Running a male age 75 on a guaranteed basis for lifetime (based on age 125) is unrealistic.  His grandchildren may live to age 125, but someone who is 75 now is not very likely to do so.  If that 75 year old is rated, then running to age 125 is absurd.  The underwriter just told you that the likelihood is that he won’t make it that long.  As the underwriting result declines, the number of years the coverage needs to last is likely to also decline.  And, you can fund more later if health improves.

So, with perfect 20:20 hindsight, what product should you have purchased when?
In 1970, you should have purchased Universal Life, but it was not available yet.  You would have grown value as interest rates increased exponentially.

In 1980, when everyone was running to Universal Life, you should have 1035 (tax-free) exchanged to Whole Life (at a time when everyone was running away from whole life).  You would have benefited from the decline in interest rates (from 21% to 2% in 20 years).  Remember, values increase on long-term debt as interest rates decline.

In 1990, you should have 1035 exchanged to Variable Universal Life and taken advantage of the roaring 1990s.  However, you should have continually re-balanced the subaccounts.

Today, interest rates are just now starting to increase.  What should you be buying?
Since we cannot predict the future (know what to buy, when, and what to exchange for, when) my answer is ALL OF THE ABOVE!!

Build a portfolio of life insurance coverage.  How much should be TERM?  How much should be PERMANENT?  Of the Permanent coverage, how much should be FIXED (whole life and universal life) and how much should be VARIABLE (variable universal life)?  MetLife offers a very useful tool that is NOT specific to its products.  It helps prospects and clients determine HOW MUCH life insurance coverage they should have to cover their HUMAN LIFE VALUE and then help them determine how to build the proper portfolio of Term, Whole Life, Universal Life, and Variable Universal Life.

by Herb Daroff, JD, CFP
Mr. Daroff is a contributing editor for LIFE&Health Advisor. He is affiliated with Baystate Financial Planning, in Boston.  Published in the March 2011 issue of Life & Health Advisor. www.lifehealth.com
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