The Crisis In Life Insurance
There’s a crisis? Absolutely. The crisis lies in the drawer your clients put their life insurance policy in immediately upon purchasing it. Unfortunately, this is where most policies land, in a file drawer, in the basement in a box, in a safe deposit box, or at the office in their personal files, never to be touched again. Most people believe that as long as they pay their premiums, they will have their life insurance. This is most certainly not the case!
Let’s go back in time to gain perspective on what has happened in the industry that you need to be aware of if you are going to save your client’s life insurance—which, in most cases, represents one of their largest assets.
Before the mid- to late-1970s, whole life insurance dominated the market (whole life, endowment whole life, retirement income whole life, etc.).
Whole life insurance basically has three components: expenses, mortality costs and cash value. Whole life insurance is what most people understand to be permanent life insurance. In whole life insurance if your clients pay their premiums, their heirs are guaranteed to receive a death benefit.
When your clients buy whole life based on their health and age, the insurance company guarantees the expense and mortality cost factors built into the pricing of the policy. The cash value component and its corresponding growth upon continued premium payments returns a dividend which is technically a return of premium, and, thus, it is a tax-free payment normally reinvested back into the cash value each year.
Cash value represents a portion of premium paid that is invested by the insurance company after certain expenses, mortality costs and profits are taken out. The cash value return is a result of the return on the general account of an insurance company, which invests in bonds, real estate, mortgages and long term assets to match the long term nature of the liability (the payment of a death benefit many years into the future). An insurance company builds in expense factors, mortality costs, other various pricing assumptions and a profit margin on a guaranteed basis. The premium calculated for a pure whole life policy is based on a 4 percent reserve rate, which basically means that if there is a return generated from cash value, the premium is assumed to grow at a specific regulated rate of return and the cash value will equal the death benefit at age 100.
Whole life has a long history of cash values generating dividend payments. Each year the boards of directors of the insurance companies declare what the dividend will be after they add to surplus additional reserves to pay future claims. If the expenses or mortality costs increase or decrease in any one year, these costs are either added to or subtracted from dividend payments. But as long as your clients pay their premiums and do not encumber their policies with withdrawals or loans from the cash value, they are guaranteed a death benefit. Therefore, whole life with its guarantees built in is a very good investment with no surprises attached.
What happened in the mid-1970s was that interest rates went seemingly straight up and inflation became the reality. Money market funds were just becoming a mainstream investment and they were getting a 17 to 20 percent return based on the short term interest rate environment. The yield curve was inverted—short term rates were high and long term rates were lower by comparison.
As a result, insurance companies were inundated with requests from policyholders to borrow money from their whole life policies at a 5 to 6 percent guaranteed rate. The borrowed money was then invested in money market funds that were paying 17 to 20 percent interest. This arbitrage was a fantastic opportunity for consumers.
The other effect that became apparent to the insurance companies was that whether policyowners borrowed from their cash value or not, they received the same dividend payment. Thus, it paid to extract cash values from policies.
The industry had to do something, and two actions occurred: First, companies started to “track” whether a policy had a loan and if so, a lower dividend was paid—this became known as “direct recognition” dividends. Second, since consumers wanted higher interest crediting rates (15 percent or more), products had to be redesigned to accomplish that. This was the beginning of the product development phenomenon that continues today—the advent of performance-based life insurance became reality.
The first product that was developed was known as universal life. It was first debuted in 1977 by E.F. Hutton Life Insurance Company.
Universal life was structured by unbundling the components of life insurance. The expense factor that was charged to the policy was the actual current expense ratio for a particular insurance company. For whole life products, the expense factor was built in with a large margin and it was guaranteed; however, for UL the current expense factor was charged. The catch? Expense factors can vary in UL policies to reflect any changes up to a certain guaranteed limit, and the same goes for mortality charges.
What the insurance companies did was to charge a cost of insurance (COI) on a current basis, increasing it each year as an insured got older. COI is a rate per $1,000 applied to the actual insurance or net amount at risk (NAR) in the contract each year.
UL quickly became the “flavor of the day” in the late 1970s into the 1980s.
So what happened? Companies were able to charge a lower expense factor and current lower mortality charge for UL products. Thus began the era when agents assumed a current interest rate of 14 to 18 percent on product illustrations; unfortunately, such illustrations were flawed because they mistakenly projected current market conditions far into the future.
We all know that markets move and so do all the other parts of a life insurance policy. By assuming these high interest rates would continue, the premiums that were calculated to fund all the future costs of a UL policy were extremely low when compared to whole life premiums.
What happens when interest rates declined as they did? In essence policies became under funded. The NAR must decline at a rate where premium and interest credited can pay for the increasing cost of the NAR. If the NAR does not converge quickly enough, the premium and the interest credited will not support the future costs, and at some point a policy will lapse with no value, leaving the policyholder with no life insurance.
After the UL problems started to appear and interest rates declined precipitously, the stock market started to boom. So then consumers wanted those stock market returns! The product that came to the rescue of UL and was built to take advantage of the boom in the market was none other than variable life insurance.
Variable life was built on a universal life chassis, which means that there were no guarantees and the moving parts could all change, as described above. With this product, the thought was that the stock market gains would continue. But the same type of risks still existed.
Once again the only tool to show the client was an illustration which, as I mentioned above, can be flawed. Illustrations take current market conditions and pricing assumptions and project these assumptions into the future. But we all know that markets will be volatile and price components can and will change. With the lack of guarantees, products continue to fail.
We all know what happened to variable life: policies failed and sales decreased. In my opinion, they were failing long before the market crashed in 2008. There is no way for clients to really understand the impact that market volatility has on the success of variable life policies because of the lack of analytical tools.
When the markets go down, the monthly deductions for COI (which increases over time) exacerbates the loss and ravages the cash value. When policyholders approach their eighties, the COI charge per $1,000 applied to the NAR goes up significantly each year and, if the difference between the death benefit and cash value is not relatively close, policies will lapse in a very short period of time. For example, I have seen a variable life death benefit of $1.5 million show $880,000 in cash value at age 82, yet between 83 and 89 years of age, cash value disappeared and the policy lapsed at age 90! The savior that variable set out to be for the universal life policies that were failing also failed the consumer.
Let me go back to the illustration problem I have described. Technology came into the market with the advent of the computer, and over time it became an illustration game, not a relationship game. The old way of marketing (when whole life was the only product) was to show the consumer that the dividends projected that were going to be paid were always lower than the amount they actually paid.
Technology caused a major shift in the ability to illustrate projected dividends, in effect assuming that they would always stay the same or increase from the current level. Now remember, interest rates, were high for a period of time, so instead of being conservative, the “new” illustration systems were able to show these high interest rates continuing into the future. The “illustration” fight was on within the industry.
Everybody boasted about their balance sheet and their ability to keep increasing dividends. Due to the large amount of real estate in many companies’ portfolios, the estimate was that they could support these increasing dividend scales by harvesting capital gains on real estate. Guess what happened to the real estate market (and interest rates) back in the late 1980s. That’s right—real estate went south just as interest rates, making all illustrations flawed.
Despite its volatile past, life insurance is still a wonderful piece of property and can be a tremendous asset in wealth transfer, financial planning and charitable giving. The reasons to own life insurance and the use of life insurance within the holistic planning environment are numerous. But, as you can see, life insurance is a complex financial instrument that merits proper management like any other asset on one’s balance sheet.
Author’s Bio John A. Ruggiero, RFC, CSA, RFC, CSA, serves as the chief marketing officer for the MAF Companies in Oak Brook, IL, a consulting and marketing firm dedicated to the design and development of wealth accumulation planning and risk transfer solutions