Evaluating survivorship life insurance. (includes related article on rating services)by Maisel, Melvin L.
Today, most estate planning for married couples is directed toward controlling tax liabilities on the second death by keeping assets out of the estate of the first to die. Because no one can predict which spouse will survive, Survivorship Life Insurance (SLI) or second-to-die insurance was introduced several years ago. SLI pays a death benefit at the death of the survivor of two individuals, usually husband and wife. Because it spreads the mortality risk over two lives, the cost is substantially lower than the cost of providing the same coverage on either one of the two lives. The proceeds become available at the second death when liquidity concerns or other financial needs may become pressing as a result of estate tax and estate settlement costs. It provides a solution, usually at a cost far less than the three following alternatives: liquidating assets that may subject the estate to income tax; a forced sale of prime holdings under fire-sale terms; and borrowing funds and then paying back principal plus interest. Most often, premium payments will be less than the interest cost of borrowing to meet estate liquidity needs, and no principal payments would be required.
The prime object of SLI is to have life insurance proceeds at death available to pay estate taxes. A secondary objective, an important planning feature, is to avoid gift taxes on premiums paid during the policy life.
SLI should be of immediate interest to persons with taxable estates for the following reasons: * SLI premiums are significantly less than those for conventional whole life insurance; and * Premiums on individual-term life insurance, if available, are also substantially higher than those for SLI and provide no lifetime values. Never before has a permanent life insurance program been available that both costs less than term life insurance and, after ten to twelve years, can provide for return of the total investment in cash, payable on demand.
ABOUT COMPUTER LEDGER
It is important that the practitioner understand the information needed, generally made available by insurers, to understand and evaluate SLI. The descriptive literature prepared by an insurer often contains a computer ledger illustration (CLI). But practitioners beware - a CLI showing the lowest outlay may in fact be showing the highest cost policy when all the underlying assumptions are factored in.
During the last two decades there have been illustrations prepared by insurance companies that showed an extremely favorable premium requirement. However, in some cases dividends and financial results did not live up to optimistic illustrations shown in the CLIs.
SLI is a long-term instrument. Therefore, it is critical to consider the financial where-withal of insurers when reviewing their offering literature. It is important to study past performance of insurance companies; then the prospective purchaser or advisor can discount the illustrations being presented, just as an investment banker discounts the bonds of weaker companies.
You might expect that all life insurance companies conform to the same set of rules in preparing their CLIs; however, this is not the case. CLIs are not closely regulated and may contain inconsistent assumptions. To determine that the calculations contained in the CLI are reasonable and accurate, the underlying assumptions must be evaluated.
Many companies exploit the freedom allowed and have been known to have little or no basis for the assumptions in their illustrations. At least two companies that sell SLI illustrate interest credits which, with no explanation, start at one rate and then increase in later years. There are companies that assume mortality costs will remain completely flat beyond age 85 on the theory that 95-year-olds die at the same rate as 85-year-olds. Other companies assume continuing improvement of their current actual mortality experience. There is one company that not only is lenient in its medical underwriting, but furthermore projects dividends based on 50% of actual mortality experience, thereby creating the appearance of lower premiums than the policy will actually require. Many advisors have made the mistake of assuming that CLIs represent a contractual obligation of the insurer, when in fact they are merely projections.
In evaluating an SLI, the practitioner should consider the degree that the insurer's assumptions vary from its experience.
There are three primary components to an insurance illustration: * Rate of dividends to be credited as earnings to the policy; * Mortality risk rate charged based on death assumptions; and * Expense rate charge for costs of administering the policy.
Each component must be analyzed individually. Although these components appear straightforward, their pattern varies from company to company. Even if the components can be unbundled and comparisons made, caution is still advised. A CLI is usually based upon today's assumptions; actual performance of the insurance contract will depend on the insurer's actual experience over the term of a policy.
Prior Year Data
Because new illustrations may be suspect due to the uncertainty inherent in the assumptions, it is a good idea to compare the company's past performance - over perhaps a 10- or 20-year period. Are the assumptions used in the CLI consistent with and reconsilable to past performance? In the last two decades there have been changing economic conditions and a number of product enhancements. The insurance agent should furnish supportable information about the dividends projected 10 and 20 years ago and the dividends actually paid. It is advisable to do this for more than one company. Remember the SLI is going to be in force for a long time, in some instances for 40 or 50 years.
The CLIs can be the key to understanding the choices in SLI. They can reveal much about how the product was designed.
The most important element in the design of the SLI is to factor in as many adverse scenarios as possible in developing the CLIs. Purchasers who are interested in SLI products are usually older than most insurance purchasers. The policy size is, by the nature of the need, much larger. It will likely be the most significant purchase of life insurance - and, most likely, the last one. Performance of the policy depends on so many factors outside the purchaser's control that the more departures from the assumptions that can be evaluated, the better. The ability of a product to withstand a downturn in interest, increased mortality, or an early death will determine the product's quality.
Extra quality has a cost. Lack of quality also has a cost that will be paid at a later date, possibly at the wrong time when the damage cannot be reversed. Those with a goal of retaining family wealth accumulated over a long term and of caring for surviving heirs, should not be so short-sighted as to think that a life insurance premium is the only relevant factor.
Many SLI policies now in existence will not perform as anticipated. If the premium does not vanish - become completely payable from earnings in the policy - as projected, will the surviving spouse be able to cope with the loss of 50% of the annual joint gift tax exclusion? When the surviving spouse is elderly, dependent on savings, and severely limited in the ability to properly fund the policy, how will the premium be paid?
Does the CLI state that the values represent a continuation of the company's current expense, mortality and investment experience? The footnotes must be studied carefully. They can reveal that anticipated results rather than historical results are used; this may be misleading. If a practitioner is not satisfied that the assumptions illustrated are consistent with current conditions and past experience, he or she should not recommend the policy.
Does the insurance company pay the same dividend interest rate to all policy owners regardless of when the policy was purchased? Or does the company throw old policyholders to the wolves in the race for sales volume? Does every policyholder who buys today automatically become an old policy owner?
Everybody seems to want a product that has the lowest outlay to carry the largest possible death benefit. On its surface that seems like a fairly simple matter to analyze. But the annual premium is not the policy's cost. The policy cost is not known until the death claim is paid or the policy surrendered. There are many factors involved. Which is a better deal - a policy that has a low premium or one that has a higher premium? That depends on the death benefit that develops and on how long that premium has to be paid, as well as what happens if interest rates drop or mortality experience changes adversely over the life of the policy.
A Vanishing Premium
Most people think the feature of a vanishing premium is attractive. They like the fact that at some future point, the internal build-up of values will offset the annual premium resulting in no more out-of-pocket payments. But most people have never really considered the true reason it is so attractive.
A vanishing premium is possible because there are dividends. A major component in the dividend is the return of investment income in excess of what is guaranteed by the contract. In other words, if there's no excess interest, the premium will never vanish.
Changes in Interest and Dividend
Currently illustrated interest rates used buy most companies are a result of economic events at the beginning of the last decade, a period during which interest rates were as high as 21%. Recently, articles have appeared predicting that as the major western democracies begin to balance budgets, the U.S., Japan, Great Britain, Germany, and others will dramatically reduce their demand for debt financing. Demand for securities would then drop and long-term interest rates could drop to the 5% to 6% range. Today's economic conditions are driving interest rates toward that level.
Remember that in 1971, interest on Treasury Bonds was 3%. According to Salomon Brothers, over the last 19 years, long-term interest rates have been 7% or lower in 37 a total of 76 quarters - just about half the time. This has interesting implications for several life insurers, especially those that guarantee 7% interest rates in their contracts.
Many insurers sell plans that use very high interest rates to create guaranteed cash values. That's what creates relatively low premiums. But remember, premium alone is not the policy's cost.
One problem with using a high guaranteed interest assumption is that it makes a policy more sensitive to changes in dividend rate. To understand why, consider the following simple example:
Table : Guaranteed Interest Assumption and the Effect of Changes in Dividends
Note that "excess" interest refers to the difference between the guarantted rate and the current dividend rate.
If dividends are reduced by 200 basis points:
The effective change in dividends paid is - 66.66% -33.33%
When the guaranteed rate is high and there is a reduction in dividend, the reduced dividend most likely will not support the vanish at the date projected. Furthermore, the reduced dividend may not support the increased term cost. If these lower interest rates are then combined with an early first death causing an increase in the cost of the term insurance, the outlay can far exceed the initial annual premium.
It is because of this critical stress point, not visible in a CLI, that some companies will not prepare illustrations at a scale lower than current dividend, while others allow for a decrease of up to two or more percentage points. It is essential to look at and compare CLIs from the same company that assume a two-point reduction in dividends and the death of one of the insureds after the fifth and tenth years. This comparison is necessary to determine whether a surviving spouse will be able to meet premium payments in a market where interest rates are declining. There are companies that will make it extremely difficult to obtain a CLI both with a reduced dividend interest rate and a first death. Any carrier confident in the quality of its product should provide this information quickly. Even if the dividend rate has been reduced for illustrative purposes, you should ascertain whether the CLI indicates Terminal Dividends (TD) and has the dividend interest rate for the TD been reduced? Inclusion of TD can be grossly misleading. Terminal dividends are additional dividends that are payable when the contract terminates.
An analysis of a CLI with the first death in the 12th year and a dividend decrease of 2%, reveals a substantial increase in the term cost. As a result, the vanished premium reappears. A 2% decrease in the dividend rate, coupled with the death of one insured in an early year, may cause the vanish to take place in triple the projected time.
Beware of a CLI showing a two-point reduction of dividend and no appreciable impact on the vanish. An actuary may have found a way to compensate for the reduction in earnings. The extent of this difference may prove to be costly. Also be leery of a policy that has two sets of term rates, one before and one after the first death. In all probability it will make the policy especially sensitive to a reduction in dividends; additional premium may be required.
Variable Loan Rates
Interest sensitivity can come in another flavor. It is called "npon- direct recognition" with a variable loan rate. In this scenario, the policy loan interest in an SLI is tied to Moody's Index of Seasoned Corporate Bonds. The dividend rate paid under the policy remains constant, even after policy loans are made.
When these arrangement were first illustrated the policy loan rate was higher than the dividend interest credit, with policy loans having some cost to the borrower. For example, if the interest credit was 12% and the loan rate was 14%, the insured was discouraged from making policy loans because of the net cost of 2%. The problem developed when Moody's Index fell below the crediting rate. If the loan rate determined under the Moody's index fell to 10% and the crediting rate set in the policy remained at 12%, the company is subsidizing loans at 2%. That's a good deal, if it really happens over the long haul. But in reality, the subsidy cannot be retained for very long. One company is currently illustrating a 10.5% credit against a 9.5% loan rate; a subsidy of 1%. This is an attractive illustration, but the company cannot permanently subsidize policy loans.
A procedure used by some insurers to accelerate the point at which the premium vanishes is to pay the premium by borrowing against the cash values. However, the internal borrowing may not be apparent in the CLI. A way to spot internal borrowing is to compare guaranteed cash value with actual cash value on the CLI. Because the internal borrowing will have reduced the actual cash values, they will be lower than the guaranteed amount. When you see that, immediately request an expanded CLI with the borrowings. If there are policy loans and the policy is surrendered, taxable income may be generated, but without the cash to pay the tax.
There are companies that print out aggressive illustrations using the current dividend scale and the assumption that both insureds live forever. Unfortunately, in the world of illustrations, that is usually the way a product is presented. The practitioner must demand real-life assumptions by requesting illustrations showing how the contract operates when the first death occurs in years one, five and ten.
In addition to knowing whether the insurer is capable of delivering a check at the second death, it is important to recognize additional characteristics of SLI: * In the event of a divorce, what happens to a policy that insures both husband and wife? * In the event of a repeal of the Unlimited Marital Deduction or a substantial decrease in estate tax rates, what happens to a policy that insures both husband and wife?
The driving force behind SLI products is utilizing the unlimited marital deduction. While there is nothing looming on the horizon, it is altogether possible that change will be made during the life expectancies of the purchasers.
If an SLI need is changed to a single life need, or if the property must be distributed in a divorce, the only option is surrender of the contract. There is no tax-free exchange available, because there can be no "like to like" exchange. If the policy is surrendered, there is either a gain or a loss; gain means taxes will be due. If new insurarnce is needed, the insured will have to requalify at attained age and health. At best, purchasers will have to pay a higher premium because they're older, and have to pay acquisition costs again. At worst, they won't be able to buy life insurance. It is important to know that products exist with a Split Option feature. This permits a policy to be split into two individual policies, retroactive to date of issue. Not all companies have the same provisions in event of divorce or changes in the estate tax law. This information is not noted on a CLI, but is an essential feature.
Other questions that require specific answers in writing are: * Is SLI available in the state where the purchasers reside? * Is evidence of insurability required? * Are all underwriting risk classifications eligible? What is the cost? * Is there more than one cost? If so, how much? * Can the term insurance element be split or converted?
WHAT TO LOOK FOR
A purchaser is in a better position to request alternate CLIs if the following additional questions are answered: * Does a company favor new policyholders to old policyholders? When does a new policyholder become an old policyholder? * Does a company make available product improvements to all existing policyholders or does it discriminate against old policyholders? * How does a mortality increase or an interest rate reduction affect the date when premiums are expected to vanish and to what extent are additional premiums required? * If the illustration shows a reduction in the number of years for the premium to vanich because of internal borrowing, can significant premium payments reappear than can cause the product to fail its objective? * Why doesn't the CLI continue beyond the number of years being illustrated? * What effect will the firstr death have on insurance premiums? Will they increase or stay level? * To what extent will the policyholder in an insurance company with a higher guaranteed interest rate and lower premium be adversely affected when dividends are reduced? * Does a company's past financial history support its projections? * Does a company use unrealistic mortality assumptions to illustrate its product? * Will funds from a policy purchased to cover a substantial tax liability be available when that liability becomes due?
Exhibit 1 describes information about insurance companies compiled by well known rating agencies. It is absolutely vital to consider the financial health of the insurance company issuing the policy.
Accountants and their clients should understand that CLIs are merely projections and are not guarantees. No matter what a life insurance company projects, they can only pay what they actually earn. Many insurance buyers are being sold not a better product, but a better CLI. Therefore, accountants should advise their clients to buy from the best rated life insurance companies. Top rated life insurance companies with conservative investment portfolios and sound underwriting practices will probably be around for a long time. These characteristics will enable them to deliver their promises to all of their policyholders.
Creative tax planning is essential and requires careful guidance in order to keep together that which people have put together. Uncle Sam does not want I.O.U.s - Uncle SAm wants the final tax in cash on demand.
Melvin L. Maisel is Chairman, First National Bank of Stamford, Vice President, National Pension Service, Inc., and President, Stabilization Plans for Business, Inc., White Plains, New York. Mr. Maisel is the author of numerous articles and other material dealing with pension and estate matters.
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