The days of buying a life insurance policy, paying the same annual premium, and putting the policy away in a safe deposit box are over. There are two converging factors leading to greater uncertainty in the retention of long-standing life insurance policies.
Life expectancies used to project policy performance have proven to be too short.
First, people are living longer. In some cases, a lot longer. Advances in medicine, including preventive care and new treatments for heart disease, have combined to change the leading cause of death from heart disease to cancer. Decades ago, most insureds dismissed the prospect of living to age 100. Consequently, most policies purchased were only illustrated to run to age 85 or 88 based on a woefully inadequate funding scenario.
Carriers are unilaterally raising premiums on policies sold decades ago.
The second factor is that major insurance carriers are breaking a long-standing tradition by raising rates on life insurance policies that were sold to consumers decades ago. This is a fallout from prolonged low interest rates. A review of historical interest rates shows that one has to go back to post-war 1950s to see interest rates at this level.
Industry analysts say most insurers have cut expenses and taken numerous steps to manage profitability over the years, but now they are running out of options. Since insurance companies don’t get to pocket the premium paid to them, carriers rely on the earned investment income from premiums collected. Unfortunately, years of low interest rates have squeezed investment income which has pressured carriers to improve their margins. This means that, with certain products, some people in their 70s and 80s are facing substantially higher charges for their life insurance purchased decades ago. The escalation in charges could be just the beginning, with higher charges for potentially millions of Americans on certain types of policies. In some cases, the combination of escalating premiums with the realization that the insured could live to age 100 or beyond has resulted in a capitulation by some policyholders and an increase in lapse rates.
How Do Carriers Get Away with Escalating Insurance Costs?
The short answer is they don’t. Carriers must gain approval from each state’s department of insurance for products offered. This is both expensive and time-consuming. The products have designated CSO tables referenced in their contracts that provide maximum allowed mortality charges. Typically, the carrier only charges a fraction of the table’s annual mortality charges. In recent years, carriers have opted to charge a higher percentage of CSO table rates, and their right to increase rates is clearly disclosed to customers in policy agreements. In some case, I have seen carriers double the percentage of mortality cost used in determining their monthly deductions—even for policies that have been in force for decades.
Primary Life Products Impacted
There are two broad categories of permanent life insurance products: Whole life and universal life. The original permanent policy was whole life, or “straight life.” This obligates policyholders to pay premiums typically to age 100 at which point it endows.
As graphically illustrated (in chart 1) the policy owner pays a level premium (illustrated by the flat black line) where the cash value at maturity (illustrated by the green line) is equal to the death benefit. The red line shows the contour of the Common Standard Ordinary (CSO) table rates associated with the product’s mortality cost. The red line steepens dramatically at age 80 and beyond as mortality risks grow substantially.
In the mid to late 1970s, a new generation of policy known as universal life (UL) came to the market. For a permanent policy, this product offered a lower, more efficient, premium obligation relative to the size of the death benefit. However, it came with some risk since the endowment guarantees were not there, and the policyholder had to accept mortality and interest earnings risks. Consequently, these policies required illustrations based on funding scenarios determined by the agent and client. These assumptions became even more refined by assuming a finite number of level-premium payments with the policy’s future monthly deductions being paid from a steady drain on the life insurance savings account or cash value.
Decades ago these policies used interest rates of six to eight percent, considerably higher than the rates guaranteed in the contract. It was assumed the insured would live to 85 or 88, at which point he only needed minimal cash value present in the account. These assumptions allowed for relatively economical premium payments. It is for these reasons that you typically see UL policies used when a large face value is required, such as in key man policies or in substantial estates.
While UL policies do not technically endow in the sense that whole life policies do, they require routine monitoring and timely re-evaluation.
Over the years multiple types and generations of UL products have evolved. A typical current assumption UL product can be illustrated (see chart 2). In this ideal scenario the insured lives to approximately age 85 and historical interest rates of six percent or better prevail. Low level premiums are consistently paid from a buildup in cash value and decline to zero at age 85 when the policy’s death benefit is realized.
Alternatively, if the insured lives to policy maturity the UL policy will pay out only the cash value remaining. (Depending on the contract, the maturity date might be age 95, or 100, or even 110.) Assuming the client has a $1 million policy and lives to age 100 with a cash value of $300,000 he then gets a check for $300,000, while anything over tax basis would be taxed at ordinary rates.
Certain types of guaranteed policies can take the cash value at maturity and extend it as the new death benefit, while some guaranteed policies allow the full benefit to stay in force until death regardless of age. A typical guaranteed policy’s maturity is more likely to extend to age 112, 118, or even 120, but the client has to choose how long to fund it. Another benefit of guaranteed policies is that the premium can be locked in for the extended maturity date. Yet once the guarantee is lost due to late payment, premiums are free to escalate. I have witnessed annual premiums doubling or tripling in such cases.
Life Expectancy
Understanding the insured’s life expectancy (LE) is essential in determining if the policy is guaranteed beyond LE and whether the policy is economical. Estimating how long the insured will live requires considerable study, but there are firms that specialize in estimating life expectancies using algorithms based on 40 years of history in scoring LEs and tracking subsequent death outcomes. Of course, an LE’s accuracy is contingent on the law of large numbers, involving portfolios of 200 or more lives. Since we are dealing with the life of one individual, it reduces accuracy substantially. Nevertheless, the exercise provides a relative perspective on longevity compared to that individual’s specific peer group.
The customized mortality table produced by an LE report gives probabilities of death at different ages. We can apply these probabilities against updated and revised projected premiums modeled for the policy to calculate relative returns.
Policy Options and Tax Considerations
Timing is of the essence in developing alternative solutions for a client. You have to have sufficient lead time given the client’s budget constraints. Even if the policy is auto loaning its premium payments, the amount of available cash value is finite. Further, the insured’s underwriting status of standard or better is also finite. The client needs to rationalize their budget and their ability to cover future escalations in premiums.
The tax consequence of making changes or cancelling a life insurance policy cannot be ignored. The presence of cash value complicates things; the difference in tax basis versus cash value will result in taxable income in the event of terminating a policy.
Alternatively, in the event the client elects to sell the policy in the secondary market, the amount the third party pays the policyholder for the policy up to the cost basis is tax free and any additional money up to the cash surrender value is treated as ordinary income. Any value in excess of the cash surrender value is taxed as capital gain. A simple matrix illustrating the various options and outcomes is provided in the table seen below. The options available to a policyholder are numerous and complicated from the perspective of an insurance specialist. Therefore, policyholders who are left to their own devices are likely to disadvantage themselves.
The Importance of a Policy Review
Most clients have minimal understanding of their policy. They may not even know which type of policy they own. The combination of escalating premiums with changes in longevity requires a routine review of UL policies. Educating the insured and their financial professionals can often result in a timely call to action.
Most clients’ financial lives are based on a tightly scripted budget, and any change in the trajectory of future expenses can have a profound consequence.
To be competitive, carriers typically assume lower future operating expenses and higher interest rates in generating illustrations at the time of sale. Consequently, the base case is always the most optimistic in projected outcome. The reality is that the original illustration will likely fall short. The question is to what degree?
From annual statements agents can determine the current revised monthly deductions compared to the monthly deductions charged in the past. Sometimes we can approximate the percentage of CSO table rates being charged and the potential for escalation. A policy review can produce new illustrations to help clients better understand the trajectory of the cost of insurance and potential rate increases. With the right analysis and planning, a client’s policy can continue to work in his best interests. They key is to act now, before it’s too late.
