LIFE INSURANCE Dispelling Illusions

By Joseph E. Godfrey III

In Brief

There’s No Magic, Only Magicians

Purchasing life insurance has never been, and never will be, fun. Nevertheless, it is important—especially for the high-net-worth individual who must provide liquidity for estate planning purposes. To put the purchasing decision in perspective, the author presents a brief history of life insurance, explaining the developments that have led to today’s array of products. Their variegated evolution means certain inevitable compromises that an advisor can illuminate and some salesmen may obfuscate. Purchasing (or advising the purchase of) life insurance involves the careful considerations of current and future financial circumstances and a studied observation of the policy’s provisions. A successful policy benefits both the insured and the insurer. Only by properly understanding all the pluses and minuses of the myriad policies and provisions available can a wise purchase be made.

Most people, especially CPAs and other financial professionals, think they know what “life insurance” is. But what does it really mean? First, it’s not really life insurance. It’s “death insurance.” It’s the promise of an insurance company to pay the face amount (the initial death benefit, which may change over time) upon due proof of the death of the insured and the surrender of the policy with a properly completed claim form.

One of the facts of life is that people don’t want to think about death—especially their own—which is why this contractual promise is called life insurance. Today’s life insurance is the product of a long history of continuous change and has become substantially more useful as a result.

Brief History of Life Insurance

“[L]ife insurance as we know it … began in the 19th century … Industrialization—with its cities, factories, money economy, and an urban ‘saving’ class—set the stage for life insurance as a large-scale, national institution. Life insurance, it can truly be said, is a product of modern industrial society.” [Davis W. Gregg and Vane B. Lucas, “A Brief History,” Life and Health Insurance Handbook (1973)]

The first life insurance company in North America, the Presbyterian Ministers’ Fund, was established in 1759. The Insurance Company of North America, chartered in 1794, was the first commercial enterprise to sell policies; it sold only six policies in five years and discontinued operations in 1804.

The insurance business took off in the 1840s because of the confluence of the rapid growth of the US industrial economy, the start of mutual companies, and the development of the agency system of distribution. The in-force level rose to $97.1 million by 1850, and $173.3 million by 1861. Numerous companies failed during the general depression of the mid-1870s, and by 1882, only 55 of 129 survived. By 1970 there were around 1800 companies, but today there are hundreds fewer, because of failures, consolidations, and mergers and acquisitions. Today, most life insurers are stock companies owned by shareholders. Fraternal companies make up a very small piece of the total pie, and only a small number of the mutual companies remain as such. The primary allegiance to the policyowner is the most obvious competitive advantage that a mutual company has over a stock company.

Risk Assessment and Ratings

The cost of life insurance protection is based on a number of factors used by the actuary in pricing the product. The home office underwriter collects and reviews the prospective insured’s personal information for these factors in order to obtain a clear picture of risk. These underwriting and actuarial factors include:

• Age
• Sex: Women typically live longer than men, so their rates are lower.
• Smoker status: Actuarial data prove that cigarette smokers die at a younger age, so their mortality charges are higher; cigar and pipe smokers are treated variously.
• Health history: A family history of early deaths due to cancer, heart disease, or stroke will affect mortality.
• Face amount: People have an unlimited insurable interest in their own life; as a practical matter, carriers and their reinsurers do have aggregate upper limits, which cap out around $150 million on an individual life or second-to-die basis.
• Motor vehicle record: Speeding tickets and drunk driving arrests could presage an early demise.
• Vocation: Some jobs are riskier than others.
• Avocational pursuits: Sky diving, hang gliding, mountain climbing, scuba diving, auto or motorcycle racing, and private flying can increase the risk of an early death.
• General reputation and personal character.

Once these items are all reviewed for their plusses and minuses, the insured is assigned to an underwriting risk category. Thirty years ago, the only variables affecting the premium were age, sex, and face amount. Now carriers primarily rely upon age, sex, and tobacco use; then other items are reviewed to further categorize the risk. Most carriers now have three to seven risk categories. Although there are different names and requirements at different companies, some examples from a five-point scale (illustrated in Exhibit 1) include:

• Ultra-preferred non-tobacco: excellent family history, ideal height and weight, excellent blood and cholesterol levels
• Preferred non-tobacco (sometimes called standard)
• Standard non-tobacco: greater latitude on the family history, height and weight, blood and cholesterol ratios
• Preferred tobacco: excellent family history, ideal height and weight, excellent blood and cholesterol, and a smoker
• Standard tobacco: greater latitude on the family history, height and weight, blood and cholesterol, and a smoker.

The ultra-preferred insured has a lower actuarial probability of dying young, and therefore receives a lower premium. Some individuals, however, are not a standard risk, which means a higher than average probability of dying before their life expectancy. Insurance companies will generally require a higher premium to assume the greater risk of paying out a claim at an earlier date, although some carriers are more receptive to certain risks than others.

Evolution of the Life Insurance Chassis

As with any other financial product or service, purchasers of life insurance should remember the old maxim, “There’s no magic, only magicians.” The buyer should beware of fancy graphics and illustrations, which are ultimately no better than the rate book on which they’re based.

Each party to the transaction—the consumer (possibly the advisor) and the company—is trying to make the best deal for itself. Ultimately, however, there are certain costs of providing insurance protection. These costs consist of mortality charges (cost of death claims), the expenses of running an insurance company, and the interest or other earnings credited tax-free to the policy reserves/cash values. The best value can be achieved only when all parties know and disclose everything that bears on the pricing of the risk.

In order for a purchaser or advisor to make a proper evaluation of any insurance product, it is first important to understand how any policy works. A life insurance policy has two basic elements. One is the basic term insurance element, allowing it to move into the future, taking on the risk of the death of the insured. The other is the investment performance delivered to the basic insurance element to make it go for the long term, until age 100 or even beyond. Smoke and mirrors cannot enhance policy performance; only substantive improvements can enhance long-term policy performance.

Term Insurance

Originally all policies were “term” insurance, meaning the premium increased as the insured got older and the risk of dying increased. Conversely, for a fixed premium, the amount of protection reduced over time. This type of life insurance provides basic protection during the term of the contract, hence the name “term.”

Term insurance in the 21st century is designed to protect against the possibility of death in the short to intermediate period. Essentially, life and death insurance was and is an early form of derivative contract that transfers the monetary risk of an individual’s death in exchange for the premium paid. Since the probability of death in the short term is low, the premium is low.

If the potential financial loss upon death is high during a specified window of time, this risk can be hedged through life insurance. For example, if a high-net-worth individual dies before the end of the term of a grantor retained annuity trust (GRAT), the GRAT asset will be pulled back into the estate. Properly structured term life insurance outside of the estate that runs beyond the term of the GRAT can provide tax-free cash to hedge this risk. For companies, key person insurance can provide a similar protection against unexpected employee death.

The initial low cost for temporary protection, whether for personal or business needs, is clearly demonstrated in Exhibit 2, which graphs the annual premiums from age 45 to 65 on a $1 million policy for a male in the ultra-preferred non-smoker risk classification. It illustrates the annual cost of a competitive yearly renewable term contract, as well as 10- and 20-year guaranteed rate term policies. Note the disparity in premium rates beyond each initial guarantee period: this illustrates the difference between guaranteed and current assumption pricing.

This is also the point at which consumers and their advisors can make a serious error in personal or professional judgment. They assume they only need coverage for a set period and forget about what happens at its end. Such errors can be costly, because often the lowest cost (initial premium) doesn’t equal the lowest price (value of coverage). At the end of the term, policyholders may have a host of imminent questions—can the coverage be continued? under what terms and conditions? at what price?—that advisors must be prepared to answer.

Subtleties in Term Insurance

Every term life insurance policy has a number of legal and actuarial subtleties and refinements that are not always readily apparent. A policy is a legal contract, so the provisions matter. These provisions include the following:

Premium guarantee period—

• Some policies have guaranteed premiums for the full term period. This led to the “Triple X problem” at the end of 1999, when many term carriers were told that they had insufficient reserves and therefore had to raise premiums.
• Some policies have guaranteed premiums for a period less than the initial term premium period, the premiums being adjusted based upon aggregate experience. The company’s reputation in dealing with policyholders, and its fiscal solvency and integrity, should be a major concern with such contracts.
• Some older mutual company policies may use dividends to offset future premium increases.

Renewal provisions—

• After the initial term period, some policies expire contractually and cannot be renewed at any price. Any “continuation” is a new policy, subject to new underwriting.
• Some policies automatically continue as yearly renewable term policies with a tremendous increase in annual premiums, either to current assumption (nonguaranteed) or contractually guaranteed premiums.
• Some policies automatically convert into increasing premium whole life policies, where the premiums ultimately peak and cap (generating cash values) or the premiums go up to the full whole life level at the end of the term period (also generating cash values).

Revertible provisions—

• After the initial term period expires, the insurance company reserves the right to review the medical underwriting file to reprice the risk of mortality.
• If the policyholder’s health is poor, the premium goes up to the indeterminate premium level or even the maximum premium level published in the policy.
• If the health review is satisfactory, the premium level goes up, but substantially below the level discussed above. This may or may not be competitive with a new contract from a different carrier.

Convertible provisions—

• Convertibility means that the policy may be exchanged, without new physical or fiscal evidence of insurability, for a permanent form of life insurance, generally on an attained age (current age) basis. Some carriers allow for a retroactive conversion to the original issue age, with payment of back premiums and interest, and an adjustment in the reserves and cash values.
• The contract may make available specific permanent life insurance products offered by the parent company or a subsidiary.
• Some policies are only convertible for a limited number of years or until a specific age.
• Some policies are not convertible at all.

All these factors contribute to an actuary’s pricing formula. The actuary trades off certain factors in order to achieve a desirable price. A lower premium might come at the expense of not being guaranteed or not being renewable.

In Exhibit 2, note that the first year premium for an ultra-preferred non-tobacco male age 45 is $900 for $1 million of annual or yearly renewable term (YRT) coverage. The range of renewal premiums for the YRT contract shows the difference between guaranteed premium rates and current assumption pricing. Compare the YRT and 10-year guaranteed rates with the 20-year guaranteed rate of $1,830: although they are lower initially ($900 and $1,090), they are much higher later ($19,070).

Exhibit 1 shows how (on a current assumption pricing basis) the YRT premium increases through age 65. (For simplicity’s sake, the guaranteed rate and excluded rate policies are not depicted.) YRT is not commonly purchased today because after the initial few years, customers drop their existing YRT policy to buy a new one at the “low introductory rates.” Reinsurers were never able to obtain the profits scheduled later in the policy life.

To combat this, the life insurance industry devised level premium plans set slightly higher than YRT rates. The premium “crossover point” between YRT and level premium term for 10, 15, and 20 years now falls between years three and five (seen in Exhibit 2). These rates may be fully or partially guaranteed, with or without current assumption pricing. This makes it advantageous for the insurance customer to stay with the same term insurance company and stabilizes the company’s future cash flow, current assumption pricing, and profits.

As medical science enables life expectancies to increase dramatically, the long-term cumulative cost of term insurance becomes a greater concern to insurance customers and their advisors. Exhibit 3 shows the cumulative YRT payments, for both current assumption pricing and guaranteed rates, for a male, age 45, ultra-preferred non-tobacco. Cumulative premiums are summarized by decade starting at age 50, where they are only $5,260 and $17,300 respectively. By age 80—when term insurance must stop by law in New York State—cumulative premiums range between $222,610 and $880,820 on a $1 million policy. Cumulative premiums to age 100 run between $6.048 million and $10.04 million on a $1 million term policy. This leads to the question: Can a long-term financial problem or risk be solved with a short-term solution? If someone needs the life insurance contract’s cash death benefit protection when they die—as opposed to if they die within a specified window of time—is term insurance really the right choice?

Denouement of the Term Insurance Predicament

Long before most of the actuarial nuances above had been conceived, many policyholders had become disenchanted with term insurance. After they had faithfully paid their term premiums for decades, they were forced to drop their policies because the premiums were too high—just as they were nearing the age when death became likely. Then, some actuaries conceived of increasing and leveling out the premium payments to provide lifetime coverage for the same level premium. This would build up a reserve against the ultimate claim, allowing compound interest to work on behalf of the insured. In other words, they could have “level premium/level term to age 100” coverage.

Whole life was the name of the original policy form. Premiums were payable for the whole of life (hence the name) or some shorter premium paying period (e.g., to age 65 or for 20 years). Regardless of the premium paying period, a guaranteed cash value was built up such that, at the terminal age of the policy (typically age 95 or 100), the cash value would equal the face amount. Thus, as policyholders got older, the “net amount at risk” to the insurance company (the difference between the cash value and the face amount) would decline while the reserve built up tax free. The true objective was not to build up a “savings account,” but rather to create a reserve against a known future claim. This changes the contract from the “if” of a term policy to the “when” of a permanent policy.

With whole life, the best financial performance is achieved by participating policies, which generally come from mutual companies. Companies charge guaranteed maximum premiums over a contractually agreed-upon period. These premiums guarantee the face amount of the policy for a lifetime, regardless of the company’s mortality experience, expenses, or investment return. To the extent the company has overcharged the policyowner, it pays out dividends retrospectively through the dividend formula. Exhibit 4 shows how the dividends increase the face amount and the death benefit on an ultra-preferred non-tobacco male age 45. The dividends to policyowners are based on savings in death claims through careful underwriting, savings on the expenses of running the insurance company, and earnings that exceed the assumed rate of return (generally, 4%). Historically, these reserves, or cash values, were invested in long-term, fixed-income instruments, such as bonds and mortgages.

So many factors affect the dividend formula that illustrations of only the current dividend scale can be misleading and, in the extreme, have led to class action suits (e.g., the “vanishing premium” lawsuits). Purchaser dissatisfaction with vanishing premium plans, especially with second-to-die policies, stemmed from, but was not limited to, the following:

• Aggressive interest crediting rates in the dividend formula
• Unrealistically low cost-of-insurance charges in the early years by some carriers
• Lapse-supported pricing, where carriers assumed that more policies would lapse than was reasonable, thereby underestimating future claims
• Premium rates that were contractually guaranteed to increase at some point in the future, with the hope that future dividends would offset these increases
• Blending in large amounts of term insurance, to reduce premium levels and make policies attractive to prospective customers; the term insurance was supposed to disappear over time through paid-up additional coverage purchased by the dividends.

The whole life contract is loaded with guarantees. It has a guaranteed premium that generates a guaranteed cash value equal to the guaranteed face amount at the terminal age of the policy (age 95 or 100). All insurance companies doing business in a given state have to back each other up on these guarantees, which vary from state to state. The only financial instruments with guarantees similar to the whole life contract are FDIC-insured bank accounts and U.S. government securities.

Universal Life

During the 1970s, the Federal Trade Commission (FTC) published a scathing report on the “low returns” to policyowners with traditional whole life insurance. The report failed to take into account that these low returns were tax free, meaning their effective return was higher. The FTC report spurred insurance companies to develop new products, variously called “deposit term” and “T-bill life.” Premiums were paid into high-interest T-bill or money market funds, from which the term costs (mortality and expense charges) were deducted. These products evolved into “universal life,” which is an unbundled product with charges and expenses calculated on a prospective basis. Instead of returning the mortality and expense savings retrospectively through the dividend formula, insurers bill for current charges and reserve the contractual right to reprice upwards (to no more than the published maximum rate). Both methods credit investment returns (interest) after the fact. The cost of insurance (COI) is computed by multiplying the monthly COI rate for the particular risk category by the net amount at risk (the difference between the cash value and the face amount) to determine a monthly mortality charge. Interest is added to the net premium (gross premium paid less the COI and expense charges). The floor interest rate used in making the actuarial computations is generally around 4%; better performance is derived from the excess interest.

This particular policy form is very flexible in that premiums can be increased, decreased, or even skipped. This is also one of its main drawbacks, because many policyholders fail to properly fund their policies, which can lead to disappointing long-term performance. Early purchasers of universal life policies discovered that the high interest rate environment which existed when these policies were purchased did not last. This led to policies performing below what had been illustrated and meant that many contracts were going to die before the insured did—another cause of consumer dissatisfaction.

Universal life has three basic death benefit models:

• Option 1 is a level death benefit with an increasing cash value (like whole life), so that the monthly COI charge is assessed on the net amount at risk.
• Option 2 pays the face amount plus the cash value, so there is never a decrease in the net amount at risk. This allows for heavy premium funding levels while preventing the policy from becoming a modified endowment contract (MEC).
• Option 3, which is the least common, pays the face amount plus cumulative premiums paid; this is useful for returning premiums to an employer under a split-dollar arrangement.

Premium levels in a universal life contract have a wide range:

• The minimum premium level generally guarantees the death benefit under current assumption or guaranteed pricing for some modest period, such as three years. After that, the benefit depends upon the premium placed into the contract and the returns thereon.
• The target premium is the maximum level of fully commissionable premium, and is often set at 60–75% of a comparable whole life premium. Even this level of premium, however, may be insufficient for long-term policy performance; extra cash may be needed to sustain the policy long term.
• The MEC premium is the maximum amount that can be stuffed into the policy (generally Option 2 is the best choice) without making it an MEC. It ensures that money can be pulled out tax free on a first-in, first-out (FIFO) basis.

In a typical universal life policy, the cash value is invested in short to intermediate fixed-income investments; the returns will fluctuate more widely than the longer-term bonds and mortgages that underpin a whole life policy. This interest component made these policies more investment-oriented, especially during the ’80s, when shorter-term rates were in double digits. Current universal life crediting rates range from 5.5 to 6.5%. Beware of the fairly common 0.5% “bonus” interest crediting rate hidden in the supplemental footnotes which may not actually be paid; it is completely at the company’s discretion after the tenth year.

Variable Life

Variable life allows the policyowner to invest the cash value portion of the premium (reserve) in a number of subaccounts offered by the insurance company. The basic policy is generally either the whole life form or the universal life form, although some hybrid products use features of both.

Initially, some insurance companies offered proprietary products exclusively, while others outsourced the fund management to outside managers. Today, products offer a whole array of investment options and strategies—index funds to small-cap funds, global funds, precious metals, bonds, even hedge funds—from both in-house and outside managers. These investment options can significantly improve the real policy performance of single life or second-to-die coverage.

Over the years, many financial advisors have taken the position that high-net-worth individuals should “buy term and invest the rest,” because they can invest better than a life insurance company. The following are reasons to consider the other side of this issue:

• As a practical matter, most people never invest the difference; they spend it.
• The tax-sheltered returns under TEFRA and DEFRA, including capital appreciation in a variable contract, are inside the life insurance contract; this makes them more tax effective, because the pretax returns can pay to run the policy.
• Using FIFO treatment, tax-free withdrawals can be made from the cash values (assuming the contract is not a MEC under TAMRA), including the cost of the term insurance element. The separate investment approach would not provide for the return of the term element.
• Policy loans on investment returns beyond the cost basis (cumulative premiums paid) are also tax free, repaid to the carrier income tax free upon death.
• Death benefits paid under IRC section 101(a) are income tax free to the beneficiary, thus converting tax-deferred investment returns into income and capital gains tax-free returns (they receive a stepped-up basis at death and will continue to do so even after the return of carryover basis in 2010).
• Life insurance cash values and death benefits are accorded a form of creditor protection that is unique and superior to any other financial instrument.

Investment options are offered through prospectuses that contain information regarding fees and expenses; policyowners are urged to read them carefully before investing. Variable life policies and their investment options are typically registered with the SEC. Life insurance, by its very nature, should be viewed as a long-term financial instrument, directed toward the long-term potential benefit to beneficiaries; although stocks will fluctuate in the short term, they have historically provided the highest potential long-term investment. Nonetheless, policyowners should purchase coverage appropriate to their personal risk profile.

Intelligently Shopping for Insurance

Because the purchase of life insurance will very likely provide protection benefits for decades before coming to fruition, it should not be viewed as a commodity and judged solely on price. It is hard to measure a policy’s price, because it means much more than just its premium. Newer investment-oriented insurance products perform even better when loaded up with cash, increasing the price of the premium—and further complicating the decision-making process.

There are numerous issues to be reviewed and resolved while shopping for life insurance before making an intelligent purchase. Who is best equipped to review the alternatives? Who can explain the differences between illustrations from the same company for the same policy form, same premium amount, and same amount of coverage? What about tax issues?

The most informed responses to the questions above will not be obtained from the typical mail-in response or 800 number, nor will they come from the Internet, the relative, the banker, the stockbroker, the fee-only planner, or even the CPA. The most knowledgeable responses will come from well-qualified life insurance professionals with years of hands-on experience and professional credentials: the chartered life underwriter (CLU) or chartered financial consultant (ChFC). Many such advisors will also possess other advanced credentials, such as an MBA, JD, or CPA. Many have also created strategic partnerships with CPAs, bankers, and property and casualty firms.

These insurance professionals will be members of the National Association of Insurance and Financial Advisors as well as the Society of Financial Service Professionals, just as lawyers will belong to their state and local bar associations and accountants to the AICPA and state societies. The more sophisticated insurance advisors will be members of the local Estate

Planning Council and will provide satisfied client references. Going with a newer agent is a less risky choice if working jointly with a more seasoned professional.

A final word on agents, brokers, and advisors. The truly professional insurance advisor may have a primary company or relationship, but should not represent just one carrier. Today’s advisor must have relationships with multiple companies and access to a wide variety of products. A single purchase may comprise a variety of products from several companies. The carriers should have solid financial ratings and a long-term commitment to the life insurance industry and its products.

A professional insurance advisor does not just sell a policy. Bringing their personal experience to bear, they advise and counsel, they review policy forms, options, costs, benefits, structures, tax implications, and nonfinancial considerations as they relate to the prospective purchaser, both at the time of purchase and in the future.