Author:
TIMOTHY P. MALARKEY, ASA, MAAA, CLU, ChFC, AND STEPHAN R. LEIMBERG, ATTORNEY,
CLU
TIMOTHY
P. MALARKEY, ASA, MAAA, CLU, ChFC, is a Principal in the life insurance firm of
Lee, Burke & Malarkey, LLP, in Berwyn, Pennsylvania. He is also an
Associate of the Society of Actuaries, a member of the
This article explains the most important characteristics of
currently available life insurance products, including `No Lapse Guarantee'
policies. The authors then examine an advantageous practical application of No
Lapse Guarantee contracts.
Much of this
section of the article will involve defining the terms and characteristics of
today's state-of-the-art life insurance products. We will touch on the
generically-named products found in today's marketplace, and outline a
discrete, almost chronological progression—even though in actuality, product
evolution has been much more of a fuzzy continuum.
Although we
will focus on the products, 1
their characteristics, the catalysts for their development, and relative
strengths and weaknesses from an insurance perspective, it should be recognized
that changes in tax laws, interest rates, and equities markets as well as many
other forces shape product development and suitability for use in a given case.
Much of the commentary here will be directly applicable to life insurance
contracts that insure one life. A very similar, albeit slightly different,
product development history would be necessary to outline second-to-die
products.
Term
insurance is an appropriate beginning point. The key characteristic of term is
that the insurer assumes a death benefit risk only for a finite period of time.
Bluntly stated, term runs out. At the end of the stated term, typically, there are no nonforfeiture rights (e.g., cash values) afforded to
term policyholders. The insured must die in order for any payments to be made,
and no death benefit will be paid unless the insured dies within the specified
term. If the insured survives the specified term, absent an exercised renewal
provision, the contract expires and provides no payment of any kind.
For many
years, term insurance was sold in an “annual renewable term” (“ART” a/k/a
“yearly renewable term” or “YRT”) format. ART typically featured a premium that
increased each year to track the presumed increase in the likelihood of
mortality as (1) the insured aged and (2) time moved farther away from the
underwriting process that took place before the policy's inception.
ART was
guaranteed to be “renewable” for some number of years (rarely less than four or
five and sometimes until age 70 or beyond) as long as the policyowner paid the
next premium. The ever-increasing premiums often could or would change annually
from a stipulated initial amount, and the ultimate years' premiums were
guaranteed only to be below very high levels.
For much of
the past 15 years or so, sales of ART contracts have given way to much more
cost-effective policies that feature a level (and usually guaranteed) premium
for a specified number of years. The duration of these “level term” policies is
usually between ten and 20 years, but sometimes longer. Level term policies are
usually renewable beyond the “level” period, but the premiums will be unattractive
for those individuals who are not able to favorably pass through the
underwriting process again.
Over the past
15 years, the inherent price of these policies has continued to fall
dramatically, but recently the rate of price decrease has slowed substantially
and in some cases increased (because the NAIC clarified the amount of reserves
that needed to be set aside for this product). However, even given the
slow-down in price decrease, it is still likely that any term insurance more
than a few years old for someone who has not experienced an adverse change in
health is probably more expensive than what may be available to that client
today. So planners with healthy clients should review all
term policies more than three or four years old.
An important
feature of most high-quality term contracts is the “conversion” feature—the
ability of the policyowner to “convert” the policy to a form of cash value
insurance (discussed below) without new evidence of insurability. This
conversion takes place at the insured's attained age, and can be a very
important hedge against the risk that the end of the term coverage will occur
at a time when continuance of the coverage is desired but circumstances
prohibit the implementation of new coverage. (These circumstances could include
an insured's change in insurability or lack of time to implement a new policy
before the term policy practically or literally terminates.)
Conversion
features are usually available until a certain
duration after policy issue and/or until a specified age, and the products to
which the policy can be converted are determined by the insurance carrier.
Thanks to the design flexibility and wide product array of cash value insurance
products, the converting policyowner should be able to structure a cash value
policy to closely, if not exactly, achieve the desired
objectives of policy conversion.
Term
insurance is indicated when the need for life insurance is temporary, when the
largest possible amount of coverage is desired for a given amount of annual
cash outlay, when the need is intermediate or long-term but the buyer's cash
flow is currently insufficient to purchase the needed coverage under a higher
premium permanent policy, when the policyowner has better investment
opportunities outside the insurance policy than inside it, and as a
"rider" when additional death benefits are desired in conjunction
with cash value life insurance or "packages" of policies.
In essence,
all policies that do not fit into the category of term should be in this
category, which encompasses any life insurance that could or does have a cash
value, some or all of which is available as a nonforfeiture right if the policy
is surrendered.
Cash value
insurance (“CVI”) is often mistakenly called “whole life” but, in reality,
“whole life” is only one form of CVI. CVI is also sometimes thought of as
“permanent insurance;” however, while many CVI products can be and/or are
designed to be kept “forever” (i.e., until the insured dies), the term
“permanent” may be a bit misleading since a number of these policies can (and
are designed to) last only a finite number of years.
CVI is
indicated when the need for life insurance is intermediate, long-term, or
indeterminate—for example, when insurance is needed to provide cash for federal
and/or state estate, inheritance, or other death taxes, funeral expenses, and
administration costs, to provide funding for a business or professional
practice "buy-sell" agreement, to indemnify a business for the loss
of a key employee, to provide financing for a salary continuation, nonqualified
deferred compensation, or death benefit only (survivor's income benefit) plan,
to fund personal and charitable bequests, to equalize inheritances, to provide
the most efficient and certain method of transferring wealth and assuring
financial security to others (especially given the favorable income tax
attributes of CVI), to preserve the confidentiality of financial funding (i.e.,
to provide financial security for an individual in a manner the insured may not
want to acknowledge publicly or to provide wealth to someone in an amount the
insured does not want to become a matter of public record), and as a tool to
help recruit, retain, retire, and reward key employees.
Whole life. Whole life (“WL”) is the oldest form of CVI,
and for a number of years it was the only real form of CVI. WL has had many
variations over the years (e.g., adjustable WL, participating and
nonparticipating WL, current assumption WL, modified and increasing premium
WL). The form of WL that is most commonly available today is usually a fairly
straightforward version of the product. Compared with other forms of CVI, WL is
less common today than it once was, especially in the sophisticated estate
planning market.
Although
there are fewer sales of this product, WL does have specific advantages that
lead to its continued use. WL is most generally available from mutual insurance
carriers, and is suitable for those seeking the unique insurance attributes of
a mutual company (versus today's more common stockholder-owned structure).
As its name
implies, whole life is a contract designed to provide level death benefit
coverage over the entire lifetime of the insured. 2
As noted below, level or fixed periodic premiums are computed on the assumption
that the contract can be retained—assuming premiums are paid—for as long as the
insured lives. The purpose of the level premiums is to make the WL contract
affordable for as long as the policyowner wants and is able to pay premiums.
3
Policy cash values are an outgrowth and natural byproduct of the level premium
system. WL policies are issued with a table that illustrates the guaranteed
fixed cash values the owner of the contract can obtain in any given year, by
either borrowing or surrendering the policy.
The most
defining characteristics of WL are (1) a fixed premium, (2) the guarantees
available with respect to both the cash value and the death benefit, and (3)
the allocation of assets underlying the contract. The premise of a WL contract
is that if the fixed premium is paid for the “whole life” of the insured, the
death claim is guaranteed to be paid. For that fixed premium, there will be
cash values and death benefits that are guaranteed, assuming that the premium
is paid each year for the insured's “whole life” (hence the product's name).
(It is important to note, though, that the guaranteed cash values and
death benefits are often a good bit lower than the projected nonguaranteed
values [which include both the guaranteed segment and a nonguaranteed
supplement], and it is these latter amounts on which clients are usually most
focused.)
The dollars
that back a WL contract become part of the general account of an insurance
carrier, which, under heavy regulation, is typically invested in a portfolio of
mid-term bonds, real estate, and mortgage-backed securities. (Depending on the
carrier, some small allocations to the equity market place do take place.)
The fixed
premium for a whole life contract is calculated by the insurance carriers, so
that, if the premium is paid each year (and when enhanced by earnings on those
dollars), the guaranteed cash value at some point in the future (often age 100)
will equal the guaranteed death benefit. It is this relatively conservative,
cash-heavy design that sets WL apart from other products and their guarantees.
However, WL
is most typically presented and/or designed to have a premium paid, on a
nonguaranteed basis, for a finite number of years (i.e., not each year
for the insured's whole life). Rather, the premiums are usually designed to be
paid only until the accumulation of cash value within the policy, along with
future projected dividends, supports the death benefit “forever” on a
nonguaranteed basis. Nevertheless, the best performance of a WL policy can
often be achieved when the premium is continued to be paid beyond the point
where the policies are projected to be self-supporting.
In most cases, continuing to pay WL premiums results in
accumulations of cash value and death benefit that offer very attractive returns
due to the accumulation of dividends, especially given the extremely low
likelihood that the cash value would ever decrease. (Cash value in a WL
contract would be compromised only in the unusually rare event of an insurance
company failure.) In short, continuing to pay premiums into a WL contract can
offer some of the most attractive after-tax fixed-income returns, given the
deferral of the cash value build-up and the tax-free treatment of death benefits, that are available today.
The dividend
credited within a WL contract is, simply, the mechanism through which a (most
commonly) mutual life insurance carrier credits growth in value in excess of
the guaranteed level of growth back to the policy. The dividend is a function
of both the carrier's underlying asset performance (in excess of guaranteed
performance levels) and the carrier's mortality and expense experience (to the
extent these costs are less than the conservatively anticipated levels of those
expenses).
Variable life. Variable life insurance (“VL”) is
essentially a WL policy 4
that allows the policyowner 5
to select among (and typically switch annually or more often between, or
rebalance among) a menu of insurer-determined investments 6
similar in many respects to stock, bond, and money market mutual funds. 7
VL 8
provides a guaranteed minimum face amount (death benefit) and a level premium
but differs from classic WL in three important ways: First, premiums (after the
insurer charges for expenses and sales costs and mortality costs) are poured
into an investment account that is separate and legally distinct from the
general investment fund of the insurance company. The general account assets
are limited by reserving requirements to be invested primarily in bonds and
mortgages. For those policyholders who want any significant exposure to
equities, variable life is the choice. The trade-off is that contracts shift
investment risk entirely to policyowners. This means the insurer provides no
guarantees with respect to policy cash values. Instead, investment risk—and
potential growth in both cash values and death benefits—are shifted to the
policyowner. Cash values in a VL contract are determined as of a given point in
time based on the policyowner's share of the market value of the assets in the
separate account. Finally, the death benefit is variable. It may grow or shrink
(but not below a stated and guaranteed minimum) according to a formula based on
the separate account's investment performance.
The first VL
contracts appeared around 1976. The earliest forms of VL were a variation on
WL—that is, the premium was fixed, but rather than the assets backing the
contract being bound to an insurance carrier's general account, the policyowner
now had a choice to allocate some or all of the assets to a separate account,
where there is some choice of investment class.
The appeal of
VL was originally, and still is, largely driven by the ability to access the
potential upside of the equity markets. Also, there is a unique appeal to VL in
that, in the event of an insurance carrier insolvency,
the assets allocated to a policy—as part of a separate account—will not be
subject to the claims of the insurer's general creditors.
Variable life
is indicated where the policyowner (1) is confident he/she/it can select an
account that can significantly exceed the return and growth of the insurer's
general account, (2) desires long-term coverage, (3) wants a measure of control
over the selection of the underlying investments, and (4) needs increasing life
insurance protection.
Because
policy cash values are not guaranteed and all investment risks (and some death
benefit risks) are shifted to the policyowner, VL should be chosen only by
those willing to bear these risks in return for the potential upside gains.
Some authorities suggest that VL be used primarily as a supplement to a minimum
basic level of coverage provided by other types of CVI.
Universal life. Universal life (“UL”) is a
"flexible-premium" 9
"current assumption" 10
"adjustable death benefit" 11
type of CVI contract. These contracts are also referred to as flexible premium
adjustable life.
UL was
developed in the late 1970s and early 1980s, as interest rates soared and the
change in dividend rates of WL policies significantly lagged behind the
interest rates available in the market.
In comparing
UL policies to WL, the key difference is that UL does not have a fixed premium.
Rather, a UL contract is flexible and can accept a premium, at any given time,
from $0 to a very high level. The incredibly flexible premium of a UL policy
allowed policyholders more freedom to adapt their future cash flow commitments
to the dynamically changing interest rate world and their own financial
situations and constantly varying needs.
Mechanically,
as long as there is enough cash inside a UL policy to support that month's
charges, the policy will continue to provide full coverage for another month.
That said, the actual recommended premium for a UL policy is a function of (1)
how long the coverage is desired, (2) the number of years the owner wishes to
pay premiums, and (3) the assumed rate of interest backing the policy. As these
factors change, premiums can change; further, a policyowner can diverge from a
given course at any time. This makes UL a very flexible policy that can be
adapted to a client's constantly varying financial circumstances.
When UL was
first introduced, it also featured a practical advantage compared to WL in that
many of the new UL blocks of business were backed by a portion of a carrier's
general account that was, at the time, invested in fixed-income instruments
that were newer and, therefore, earning (and returning to those who purchased
UL contracts) significantly higher rates of return than WL owners were
receiving.
As the years
have passed, though, the insurer's assets that back UL and the assets backing
WL policy series have, essentially, grown together (driven largely by
regulation). So both types of policy can be thought of as having similar asset
characteristics—that of a mid-term fixed-income portfolio. Because of this
similarity, UL and WL contracts are commonly lumped together to make up the
“traditional” forms of CVI.
UL is
indicated in long-term coverage needs where maximum flexibility of premium cash
flow is desired, and where the insured's financial needs and cash flow are
likely to change. This makes UL suitable in the business, retirement planning,
and employee benefits fields to finance salary continuation and nonqualified
deferred compensation plans, death benefit only plans, key person coverage,
buy-sell agreements, and insurance inside qualified retirement plans.
Variable universal life. The next logical
entrant in the life insurance arena is variable universal life (“VUL”), which
combines the flexible premium design of UL with VL's ability to choose the
asset allocation supporting the contract. Sometimes called flexible-premium
variable life or universal life II, VUL is an attempt to capture the best
features of UL and VL. VUL policyowners can—within limits—determine the timing
and amount of premium payments, eliminate one or more premium payments entirely
(assuming cash value is great enough to pay current mortality and expense
charges), increase or decrease death benefits (within limits and assuming
evidence of insurability with respect to increases), make withdrawals of cash
without generating a loan against the policy and without interest charges
(assuming there is enough cash value to pay current mortality and expense
charges), and select between two death benefit options—one level and the other
equal to a level pure insurance amount plus the policy's cash value. 12
VUL contracts
represent a large portion of the insurance sold today. Whether it is because of
the many varied types of funds (especially equity-based funds) that are
available within the policies, the aspect of the “separate account” resting
outside the insurance carrier, the idea of a flexible premium, or some
combination of the above, VUL has been a major force in the CVI market for the
past decade.
The ability
to optimize these features, along with the unique tax attributes of life
insurance (tax-free death benefits, tax-free buildup of cash value, ability to
reallocate assets without taxation, and, uniquely, the ability to withdraw
after-tax basis and access gain without current taxation), can create a
powerful financial instrument that is particularly appealing to high-income,
high-net worth individuals and businesses.
VUL is
particularly indicated for estate planning and business insurance needs where
the potential increase in cash values and death benefits resulting from the
successful exposure to underlying assets invested in the equity markets is
deemed attractive or necessary. If a policyowner believes that the portfolio he
can assemble (from the available choices) underlying the policy will
significantly outperform the assets of the (tightly regulated) insurance
company's general account, then VUL can make good sense.
Further, VUL
offers the best protection of a policy's cash value from future adverse changes
at an insurance carrier, or indeed from carrier failure, thanks to the fact
that the assets are held in a separate account from the carrier. (Many
practitioners speculate that, based on past experience, some carriers may not
return to policyholders enough of the “upside” of their general account
performance in other types of CVI policies, due to future changes at carriers,
carrier consolidations/mergers, etc. The separate account feature of a VUL
insulates these contracts from some of these concerns. Even with VUL, however,
the nonguaranteed insurance charges within a policy will still be subject to
future carrier performance.)
VUL contracts
are appropriate for key person coverage, Section
162 (executive bonus) arrangements, financing of salary continuation and
nonqualified deferred compensation plans, death benefit only (survivors' income
benefit) plans, key person coverage, buy-sell agreements, and insurance inside
qualified retirement plans.
Private
placement VUL. A variation on VUL, private placement VUL (“PPVUL”) 13
is available only as a nonregistered product to those who qualify. Generally,
the buyer is a high-net-worth individual willing to invest at least $500,000
either initially or over a relatively short period of time. PPVUL is insurance
which, as its name implies, is coverage obtained by direct (and often vigorous)
negotiation with the insurer to bargain costs and charges to a minimum. These
contracts are attractive to high-net-worth individuals and corporations because
of the income tax treatment and investment flexibility (including dynamic
hedging strategies) that make PPVUL a prime capital accumulation and wealth
transfer vehicle. 14
Advantages
include impressive internal performance through lower policy charges and
institutional pricing, surrender fees, fund asset charges, and reduced (or no)
sales loads. Special investment management design as well as a wider array of
investment options, insurer responsiveness, privacy, confidentiality, and
access to nonregistered investments (e.g., hedge funds) supporting the
insurance contract are additional benefits.
These
contracts are usually issued either as a modified endowment contract (“MEC”) on
a single premium basis or with limited payment periods to produce a non-MEC.
15
These contracts are sold as private placements by both on and offshore
insurers, and are provided on a policy-by-policy basis; thus, they avoid SEC
registration. 16
Purchasing the policy through an offshore insurer results in a high degree of
creditor protection, freedom from state regulation, and a reduction in costs
due to the absence of the insurer's obligation to pay either state premium
taxes or federal income taxes. (It is important to note, though, that in any
given case, the performance of offshore PPVUL may not be as favorable as a
contract available domestically due to the policy-specific insurance charges in
some offshore vehicles. Moreover, policy ownership structures, or laws
applicable to assets within a policy, may also provide attractive asset
protection without going offshore.)
To avoid
For all
flexible-premium insurance contracts (UL, VUL, PPVUL), in most cases the best
performance of the policy occurs when the premium is approaching, or at, the
upper limits allowable by the various threshold tests called for by government
regulation. 17
In addition, prospective illustrated performance is, in almost all cases,
heavily dependent on a number of nonguaranteed factors. Exhibit 1 shows a
comparison of UL, VL, and VUL.
As the last
significant entrant into the life insurance arena, No Lapse Guarantee universal
life (“NLGUL”) contracts were first introduced a little more than ten years
ago. In their early years, they gained only moderate momentum. But due to a
number of forces, NLGUL contracts have become common in today's marketplace.
This recent surge in NLGUL has been due to (1) absolute improvements—the
increasingly innovative and competitive pricing of these policies (largely
driven by the shadow account methodology explained below), and (2) gains
relative to other products such as UL or VUL, which have been hampered by low
interest rates or difficult equity markets.
Background of NLGUL. Before digging into
the details of NLGUL, it may be helpful to discuss more of the technical
underpinnings of UL versus WL. The economics behind a WL contract involve only
“prospective” accounting. That is, the current value of a WL contract is,
actuarially speaking, equal to the present value of future liabilities, less
the present value of future premiums and earnings. In other words, the dollars
that a carrier must have on “reserve” today to meet the promises implicit in a
WL policy must equal the difference between (1) what the carrier will someday
pay to a beneficiary (assuming premiums are paid and the policy is kept in
force), and (2) what the carrier will receive in premiums and investment
returns between now and then.
These calculations,
resulting in the policy's reserve and then, in turn, the policy's cash value,
are done only prospectively. There is no specific accounting as to the dates
premiums in the past were actually received.
In order for
the mechanics of a UL policy to work, the accounting processes were, in a
sense, “flip-flopped.” A UL accounting system, which is used to calculate a
policy's reserve and cash value, operates only retrospectively. The premiums
that have been paid, the monthly charges that have been deducted, and the
interest that has been credited—all these elements are factored into today's
cash value.
Product development. A WL policy includes
an intrinsic guarantee that if the premium is paid “forever,” (1) cash values
will be guaranteed at the promised level and (2) the death benefit will be
paid. That premium, however, if required to be paid forever to support the
death benefit, represents a fairly expensive and unattractive return in today's
marketplace.
Many of
today's buyers are focused primarily or solely on guaranteeing the death
benefit, and are willing to trade guaranteed cash value in exchange for a lower
premium. To meet that objective, following the predominant use of UL through
the 1980s, carriers began in the early 1990s to add a “rider” to some UL
policies that provided a “secondary” premium-based death benefit guarantee.
These earliest riders ensured that, in addition to the fundamental guaranteed
maximum charges and minimum interest rates of a UL policy, if the policyowner
were also to pay some (relatively low, compared to WL) model extra premium each
year, the death benefit would be guaranteed.
These early
“secondary guarantee” UL contracts essentially found a crack in the armor of
the regulations surrounding UL cash values and reserves. Because all UL rules
and regulations revolved around retrospective accounting, a carrier could offer
a prospective premium-based “secondary” guarantee without a significant change
in reserves and/or cash value. The earliest “secondary guarantee” UL policies
were fairly stringent, though. It was not uncommon to see that, if a premium
were paid a few days after a grace period, even though the policy itself was in
no danger of lapsing, the secondary guarantee could be totally lost. In other
words, there was no ability to have any kind of catch-up to re-start the
secondary guarantee that the death benefit would be paid no matter how long the
insured lived.
Regulations
and product development over the last half of the 1990s changed somewhat
dramatically (by insurance community standards). Regulations known as XXX and
AXXX, and responsive product development, led to the concepts of the “shadow
account” and “No Lapse Guarantee” UL policies. In short, these NLGUL policies
have the same retrospective accounting as any UL policy (with a cash value
resulting from premiums, historical charges, and interest-to-date). The primary
guarantees within the policy are that the monthly charges will never go above a
certain level and the interest rate will never go below a certain level. These
primary guarantees have an ultimate effect on both the death benefit and the
cash value of the policy.
For a No
Lapse Guarantee (“NLG”) policy, the accounting of premiums, interest, and
charges results in the regular cash value, and the primary guarantees govern
the worst-case performance for the death benefit and cash value. At the same
time, the death benefit (and the death benefit only) is also subject to a
secondary “no lapse” guarantee. This new form of secondary guarantee is a
result of the retrospective accounting done “on the side,” in a “shadow
account,” and it factors in actual premiums paid to date, a level of charges
better than the worst-case guaranteed charges, and a level of interest at or
higher than the worst-case guaranteed interest rate.
The result of
the shadow account calculation is that, if the shadow account is sufficient to
keep the policy in force, the death benefit will not lapse. In this manner,
most carriers are addressing the danger that the guarantee might be lost
because of the client's failure to pay premiums on time. So, while the UL
policy may have what appears at first to be typical current interest rate
performance, its death benefit (but not cash value) is also protected by the
shadow account. Thus, the shadow account offers a built-in premium catch-up
mechanism to prevent a loss of the death benefit guarantee.
The end result. The “bottom line” of today's NLGUL
policies is a type of CVI that perhaps should be thought of in its own
insurance asset class. WL and UL offer interest-rate-based performance while
VUL is generally used by those seeking equity-based performance. In all three
of those cases, policy attractiveness is measured by both the
cost-effectiveness of the death benefit as well as the performance of the cash
value.
In the
opinion of many, the NLGUL asset class is unique. It features (relatively
inexpensive) permanent death benefit guarantees at the expense of cash value
performance. Analytically, NLGUL policies typically offer very attractive guaranteed
death benefit internal rates of return (“IRR”) up to, and a bit past, life
expectancy. (It is not uncommon to see these death benefit IRRs approach, and
exceed, an after-tax rate of 7% even beyond life expectancy.) WL and UL death
benefit returns may be (or may not be, depending on the case) projected to be
as favorable, but the illustrated WL and UL death benefit returns will
assuredly carry the assumption of performance risk by the policyowner.
Some argue
that it is prudent to think of NLGUL policies as largely illiquid. The reason
is that it is unlikely that these contracts will have a cash value that is
attractive for any other possible uses in the future—due to the projected
underperformance of the cash value. The lack of a significant cash value is
clearly a disadvantage if a cash value that can be rolled over to another new
product innovation is desired in the future. Nevertheless, most who use NLGUL are not uncomfortable with the illiquidity,
given the relatively certain shifting of permanent death benefit risk to the
insurance carrier. Further, proponents argue that, in many cases of trust-owned
insurance, the existence of a notable cash value is, at best, a secondary bonus
to a family, given that the cash is likely to have been tied up in trust
anyway.
On the other
hand, the lack (or non-existence) of cash value within an NLG contact creates a
“last stop on the train” phenomenon—that is, the policyowner's options to
perhaps make a change in the future will be very much limited, if not precluded.
The policyowner needs to be permanently comfortable with those death
benefit returns of the NLG policy—because once the policyowner gets on this
train, the reality is that he can't (economically) get off.
NLGUL also
bears the solvency risk of the carrier issuing it, especially because the low
cash value and attractive guarantee of the death benefit create a situation
where the policy's risk is less likely to be transferred elsewhere in the
future. Those advisors who are comfortable with this point out that this risk
does—to at least some degree—exist with any insurance, and there are some
protection mechanisms to mitigate the risk. Some authorities, however, argue
that these policies increase the solvency risk of carriers that issue them,
particularly those insurers that have underpriced their NLG products. 18
The greatest risk to policyholders is the possibility that in an insolvency, the rehabilitator would "reform the
contract." Most state guarantee funds only provide that limited death
benefits and cash value will be paid. This risk is more than theoretical;
contracts were reformed in the several large insurance company failures.
Finally, the
last potential disadvantage of NLGUL is that, while the death benefit is likely
to have relatively little downside, NLGUL is also less likely than alternative
contracts to have a notable performance upside in the event of rising interest
rates, or bull equity markets (which could positively drive the WL/UL and VUL
markets, respectively). Those who favor NLGUL would counter that the lack of
upside is a fair trade-off for the very attractive “locked-in” IRR at death.
Obviously, an NLGUL contract is most appealing and appropriate for clients
seeking to assure the financial security of future generations through the most
cost- and tax-effective and economically certain wealth transfer mechanism
possible.
Aside from
the issue of proper reserves (which in itself is a complex, difficult to
determine, highly controversial, and very important issue), planners should
give special attention to (1) suitability (e.g., is the client better served by
a product that is flexible enough to meet life's inevitably changing
circumstances than by the features of a policy that guarantee the sufficiency
of the premium?) and (2) fitting this type of contract to a buyer's
circumstances. It is essential that clients be informed—in writing—of how those
products really work, what's required to maintain the guarantee, and what
happens to the product if the client fails to meet those requirements.
It is also
essential that the products being considered for purchase are compared with a
current assumption product and tested for relative premium flexibility, cash
values, and potential to benefit from higher interest rates. In other words,
would some other type of product be more suitable for the client's particular
facts and circumstances? It's essential that the client be presented with an
array of choices that allow an informed decision.
At the “end
of the day,” the tried-and-true principle of diversification—not one but two or
three different life insurance contracts, across more than one carrier—may
provide the best answer to the question of product selection. For some clients,
the assurance of a death benefit at a certain level with no future
volatility—especially in the face of an otherwise well-diversified financial
picture—could make a heavy concentration of NLG desirable. But because of NLG's
illiquidity and consequent lack of flexibility, in most cases clients will be
best served by using NLG as a relatively modest portion of an insurance portfolio
that is carefully diversified across carriers, products, and cash value/death
benefit performance projections.
Future. Natural evolution is likely to lead to more
carriers entering the NLGUL market, and those that are already in it may
further enhance their contracts. Opposing forces, however, are likely to be the
pressures caused by the regulatory bodies that may further tighten carriers'
ability to offer these policies, as well as the hardening reinsurance marketplace
that most carriers use to enhance product competitiveness.
We have begun
to see notable product development of NLG Variable UL, and the
development of this hybrid will assuredly continue in the near term.
Fixed annuities. Although a description of the general
annuity marketplace is beyond the scope of this article, 19
a bit of background may be useful. The annuity universe can be divided in half
from two different perspectives. First, there are “fixed” and “variable” annuities.
The former rely on a declared interest rate and are backed by an insurance
company (similar to UL and WL). On the other hand, “variable” annuities allow
the contract owner to choose the assets that back the policy from among a
number of different funds or asset allocations (similar to VL and VUL).
Second,
annuities can also be divided between “immediate” and “deferred” contracts. The
former call for payments to the annuitant to begin now and continue for some
period of time (tied to the annuitant's life, a guaranteed period, or some
combination thereof). Alternatively, “deferred” annuities are simply vehicles
where dollars rest while (hopefully) growing until the point of “annuitization”
(i.e., when payments to the annuitant begin).
In all cases,
annuities enjoy one of the tax-favored aspects that characterize CVI—the
ability for dollars to grow (assuming cooperation from the underlying assets)
without current taxation. Unlike life insurance, however, when money comes out
of the annuity contract, any gain in excess of after-tax premium deposits will
always be taxed as ordinary income.
The rest of
this article will focus on the use of “fixed immediate” annuities (“FIA”).
These are contracts under which an amount of money (i.e., premium) is
transferred to an insurance company in exchange for the insurer's promise to
immediately start to pay to the annuitant a stream of dollars consisting of
principal and interest. Embedded within the calculation of the stream of
annuity payments is an assumed internal rate of return declared by the
insurance company (as opposed to market-based performance that the annuitant
controls). The level of this internal rate of return will drive the competitive
differences between different annuity products.
As has been
the case in the life insurance marketplace, FIAs have improved over the years
due to declining expense levels and market competition. On the other hand, at
this time, FIAs face one of the same great challenges confronting any interest
rate-sensitive product—the low yields in the current interest rate environment.
Annuity pricing. Despite the low interest rates in the
FIA market place, annuities can still provide an attractive return on an
initial premium in absolute terms (and a very attractive return in relative terms)
if the annuity stream is tied to a life that extends beyond life expectancy.
The periodic
(usually monthly or quarterly) payments from an FIA will be at a maximum level
if the payment is tied to a single life, with no guarantee feature. Simply put,
the annuity will continue as long as the annuitant is alive. These FIAs are
called “life only” payouts. Such “life only” payments provide the maximum
annuity payouts because the risk to the annuitant is greatest, and,
correspondingly, the least risk is passed to the insurance carrier. At the
extreme, with a “life only” annuity, if an annuitant were to die soon after
paying the initial premium and after receiving only a few (or potentially no)
periodic payments, the insurance carrier will have significantly “won” and the
annuitant will have experienced a complete loss of principal.
Depending on
the client's age and the product/pricing structure for a given carrier, other
FIA payment options could be selected instead of “life only.” These are
typically (1) “life with refund” (resulting in payments that continue for life,
but if the total aggregate payments at death don't exceed the initial premium,
a refund of the balance is made), or (2) “life with x-year certain” (payments
for the greater of life or × years). Payments can also be tied to more than one
life (i.e., “joint-and-survivor annuities”).
Because all
these FIA variations pass more risk from the annuitant(s) to the insurance
carrier, the level of each periodic annuity payout will decrease, for a given
single premium, versus the individual “life only” option. And, because the
periodic payments will be lower, the rate of return delivered to an annuitant
will be less than it would have been, given the same life expectancy, under the
“life only” option.
Transferring
wealth with an annuity tied to an NLG life insurance contract. Clearly, an FIA will
deliver an optimal return under a “life only” option if the annuitant lives
beyond life expectancy. But in reality, while an annuitant can clearly choose
the “life only” option, it is not so easy to simply elect an extended life
expectancy.
We can
mitigate, and in essence hedge, the economic risk of the annuitant's premature
death, if we synchronize a life insurance contract with an FIA. This concept is
not new; it has been a part of pension-based planning for many years. (In
advising someone about a pension payout choice, the discussion is quite similar
to choosing, or not choosing, the “life only” annuity option in an FIA
discussion.)
A “new” twist
on this planning technique arises from the recent product development and
popularity of NLG life insurance contracts. In the traditional setting, if a
person chose a “life only” annuity (or pension) option, and wanted to hedge
that risk by purchasing a life insurance policy, there still may be some
noteworthy risk that will be borne by the annuitant/insured. That is, if the
interest rate (for WL and UL buyers) or equity (for VL and VUL buyers) markets
don't perform well, the “life only” annuitant will have traded the risk of a
premature death for the risk of a poorly performing life insurance policy.
With the
option of using the relatively inexpensive death benefit guarantee offered by
an NLG contract, in conjunction with an FIA, an annuitant/insured has the
opportunity to “lock in” a guaranteed return. For a given single premium, an
annuitant will get a fixed “life only” annuity payment for as long as he or she
lives, and the economic risk of premature death is then hedged by using part or
all of the annuity payments received to purchase and maintain an NLG life
insurance contract that has a guaranteed death benefit for a given annual
premium. Further, because the timing of payments from an FIA is predictable and
fixed, they will dovetail well with, and will address, the premium-timing
sensitivity that can exist with an NLG contract.
On the other
hand, although the return is “locked in” and guaranteed, the policyowner and
all advisors must be comfortable that the return is, in absolute terms,
attractive. Again, the NLG contract is best thought of as a last stop on a
train from which the client can't easily or inexpensively get off, and there is
assuredly a risk that the NLG/fixed annuity locked-in return could be
lower—perhaps significantly lower—than the returns available in the marketplace
in the future. So, this strategy is appealing for those who think the locked-in
return is an attractive number, but will be unappealing for those who think
they might be able to find a higher return in the future.
Quantitatively,
it is not uncommon today for an annuitant, who would qualify for a favorable
life insurance classification, to be able to buy a single premium FIA and then
use the after-tax periodic FIA payments to purchase a life insurance contract
to “fully guarantee” a net return of 7%, or more, at—or a bit beyond—life
expectancy. (The term “fully guarantee” is realistically threatened only by the
ability of the insurance carrier[s] to deliver on its promises. While this risk
is hopefully negligible, it should not be overlooked.)
For an
example with real numbers, a $400,000 single premium from a healthy 65-year-old
individual could fund an FIA stream which, after paying tax on a portion of the
annuity payments, could purchase a guaranteed death benefit of more than $1.4 million.
If the annuitant died at age 83, the return on the initial premium is more than
7.2%. With a death at age 83, the 7.2% return was truly guaranteed 18 years
earlier because the annuity will pay all the premiums over the intervening 18
years, and because the NLG contract guarantees that the death benefit premium
will not change during that time.
As with any
insurance-based solution, if a premature death occurs, the return will be even
higher. On the other hand, if death occurs well beyond life expectancy, the net
return may still be in the 4%-5% range. These returns, compared with others in
today's interest rate market, are attractive, especially considering that they
are after-tax returns (the ultimate payment of the life insurance death
benefit, if structured properly, will be income tax-free).
This
technique can be made even more powerful if some relatively simple estate
planning techniques are used. If (1) the initial would-be lump sum annuity
premium were in the client's otherwise taxable estate, (2) the ultimate NLG
contract were owned by, and payable to, a device outside the estate (such as an
irrevocable trust), and (3) the periodic annuity payments were transferred out
of the estate by way of tax-free transfers, then the leverage created by using
an asset (which would otherwise be significantly taxed in the estate) to “lock
in” a 4% to 7% return, or more, on an after-tax basis, is significant. In
comparing this method of wealth transfer to other strategies, consider that
here there is no probate or administrative cost or other "slippage"
that can reduce the value passing to the named beneficiary.
Similarly,
suppose that a healthy person already holds an appreciated deferred annuity in
his estate. If that deferred annuity will be unused and therefore will be
subject to both income and estate tax at his death, purchasing the most
competitive FIA (via a tax-free Section
1035 exchange) and an NLG life insurance contract will assure a much more
favorable result than will the previous taxable strategy.
Finally, if
an annuitant has a history of health problems that could shorten his life
expectancy, there is a chance that even greater leverage may be created thanks
to underwriting “arbitrage” available in the marketplace today. If an annuitant
can legitimately demonstrate to some insurance carriers that his life
expectancy is likely to be materially shortened (i.e., if the insurer can be
convinced that the annuitant is not a "standard" risk), the client
may be able to purchase a “rated” FIA, which will increase the payout of a
“life only” option.
On the other
hand, despite the person's medical history, it may still be possible for him to
obtain a favorable NLG contract because of another life insurance carrier's
current aggressive underwriting practice (some of these are called “table
shaving” programs). With this confluence of facts, the effective “guaranteed”
return of the FIA/NLG combination can be even greater (especially considering
the possibility of a sooner-than-normal life insurance payout).
Caution. Anyone marketing any UL, VUL, or NLGUL
policies—especially in conjunction with an FIA—should consider the tax
consequences if the insured lives beyond the policy maturity date (e.g., age
100). Different contracts and different states may have entirely different
rules concerning the cash value and the death benefit of the policy after the
maturity date. Obviously, this is a greater concern in the case of very elderly
insureds. Certain contract provisions may cause uncertain tax results for the
policyowner and should be reviewed by tax counsel.
At no time in
recent years have practitioners had as many cost-efficient options to (1) help
clients "match the product to the problem," (2) better address
clients' changing circumstances, and (3) accomplish estate planning objectives.
This unprecedented opportunity is accompanied by a responsibility and
professional obligation to work with competent insurance specialists to learn
more about the pros and cons of currently available life insurance products and
how they can be used to meet clients' needs and goals.
Feature UL VL VUL------- -- -- ---Death Benefit Yes Yes YesGuaranteed WhilePolicy in Force?
Premium Amounts Yes No YesFlexible?
Policyowner No Yes YesChooses HowPremiums Invested?Policyowner Can Yes No YesVary Frequency orAmount ofPremiums Paid?Policyowner Can Yes No YesIncrease orDecrease DeathBenefits?
Death Benefit Yes No YesOptions A and BAvailable?
Cash Values No * Yes YesFluctuateDepending onPerformance ofUnderlying Asset?Interest Rate on Yes No NoCash ValuesGuaranteed?Partial Withdrawals Yes No YesAllowed FromCash Values?
Cash Value Grows Yes Yes YesTax-DeferredAnnual Statements Yes No YesDetail MonthlyDeductions forCosts and C.V.
Growth?
Considered a No Yes YesSecurity?
* The current interest credited to cash values of UL contracts fluctuates withthe performance of the insurer's general portfolio, but cash values, once
accumulated, do not fluctuate in value with fluctuations in the market value
of the assets in the general portfolio. Table courtesy of Tools and Techniques
of Life Insurance Planning (800-543-0874).
See Leimberg and Doyle, Tools and Techniques of
Life Insurance Planning (800-543-0874), and Zaritsky and Leimberg, Tax
Planning With Life Insurance (800-950-1216), for
more specific guidance as to life insurance products and their taxation and
use. See also Baldwin, New Life Insurance Investment Advisor
(McGraw-Hill Trade, 2001);
There are many types of whole life contracts. The
oldest and most common is ordinary level-premium whole life, more commonly
known as ordinary or straight or traditional or continuous premium whole life.
During the early years of the contract, premiums charged
are greater than necessary to provide a pure insurance death benefit equal to
the “face amount,” the amount promised by the insurer in the event of the
insured's death. This excess amount, together with earnings on policy values,
is held in a reserve and gradually “used up” during the years when the
insured's probability of death is more likely and therefore the cost of
providing the agreed-upon amount of insurance is higher than the money received
from the policyowner, and the level premiums are no longer sufficient. In
essence, there is an “overcharge” in the early years of the policy to
compensate for an “undercharge” in later years.
Most of the key legal benefits of a WL contract are
also contained in VL. These include guaranteed maximum mortality charges,
nonforfeiture values, a policy loan provision, a reinstatement period, and
settlement options.
See the Estate Planning Newsletter Archives in Leimberg
Information Services, Inc. (http://www.leimbergservices.com) for the latest
information on Section
817 , which covers the taxation in this area.
Because variable life contracts are considered
securities, a prospectus must be provided to prospective buyers. This
prospectus sets forth information on the insurer, including certain financial
data, the way the insurer will use the policyowner's premiums, the investment
characteristics of the policy, and most importantly, extensive information
about the contract's expenses, fees, loads, and rights of the policyowner.
Some insurers offer a wide choice that might include
foreign stock funds, bond funds, GNMA funds, real estate funds, zero-coupon
bond funds, and even funds that specialize in specific areas (such as small
capitalization stock funds), market index funds, or funds that focus on sectors
of the economy (such as utilities, high tech, or communications).
Rybka, "A Case for Variable
Life," J. Am. Soc'y of CLU & ChFC (May 1997), and Black and Skipper, Life
Insurance (13th ed., Prentice-Hall, 1999).
Under a flexible premium contract, the policyowner
can, within limits, decide how much he, she, or it wants to pay and even skip a
payment entirely—as long as there is sufficient cash value in the policy to
cover current policy charges.
Additions to policy cash values are determined by
current interest rates, current mortality costs, and current expense charges.
A policyowner of an adjustable death benefit contract
is allowed to lower policy death benefits or, assuming he or she is able to
prove insurability, increase the policy's death benefit.
These two death benefit options are typically called
Option A (or I) and Option B (or II). The death benefit stays level under A just as it would in a classic WL contract.
See Harris, "Due Diligence Tips for Private
Placement VUL,” Nat'l Underwriter (
One cost of the underlying investment options is a
much reduced liquidity, which results in unique problems and challenges for
both the policyowner and the insurer. For example, policy values are not
determinable on a daily basis. Moreover, limited liquidity complicates the
processing of recurring monthly charges—a problem often solved by a requirement
that some level of liquidity be maintained to cover those charges.
The trade-off here is that the internal rate of return
(“IRR”) on surrender is greater with a MEC than with a non-MEC because a MEC
provides less life insurance and therefore lower costs while a non-MEC provides
a higher net amount at risk—i.e., more insurance and greater liquidity but
greater consequent insurance charges and lower cash values. Therefore, many
individuals try to obtain the minimum face amount that will still satisfy the
Guideline Premium test.
Theodore, "Introduction to Private Placement
VUL," Product Matters, p. 22 (Nov. 2002).
Regardless of whether the policy is issued on or
offshore, if the policyowner is a
See Rybka and Jones, "Guesses, Projections,
Promises & Guarantees," 59 J. Soc'y Financial Service Professionals
No. 4 (July 2005). Mr. Rybka notes, "While secondary guarantees constitute
an unequaled marketing success, they have triggered growing concerns among the
industry's leading pricing actuaries and rating agencies. They caution that
some companies having large blocks of secondary guarantee products may, in some
circumstances, cause long-term financial impairment to their reserves and
create risk for those very policyholders who were seeking the safety of
guarantees."
For more information on annuities, see Tax Planning
With Life Insurance (800-950-1216), and Tools
and Techniques of Life Insurance Planning (800-543-0874). See also Leimberg
and Gibbons, “Annuities and Estate Planning,” 29 ETPL 360 (July 2002).
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