Inadequately Funded Life Insurance
In the mid-1980s, when prevailing interest rates were as high as 14%-15%, there were only two types of Life Insurance contracts: Term Life Insurance, in which a specific dollar amount of life Insurance was guaranteed to remain in force for a specific period of time at a specific guaranteed premium; and Whole Life Insurance, which was guaranteed to remain effective for the entire life of the insured. These Whole Life contracts contained an accumulation account known as Cash Value, which was typically earning 3% annually. The Cash Value was available to be withdrawn and used for any purpose, so long as the owner paid a contractual 5% interest charge on the money that was withdrawn.
In a Whole Life contract, if a person had an accumulated Cash Value of $50,000 earning 3% interest, the owner had the ability to borrow the money at 5% and then place those dollars in a money market or savings account, where they could have earned 14%. Thus, without any additional risk, the owner would be able to earn an additional 9% on their $50,000 of Cash Value.
Due to the competition from banks’ significantly higher interest rates, the insurance industry watched billions of dollars in their Cash Value coffers being withdrawn and transferred to the individual bank accounts of the people it insured. In order to stop these outflows, the life insurance industry created a new product called “Universal Life Insurance”, which paid an interest rate based on prevailing market interest rates instead of a fixed rate, as had been the case in Whole Life contracts. If interest rates rose, then one’s insurance coverage would, become less expensive or last for a longer period of time as a result of the larger amount of accumulated cash value. What was not as clearly understood, however, was that if interest rates decreased, then the length of time the coverage would remain in force would consequently be reduced, or a greater annual premium deposit would be required to prevent the earlier expiration of this coverage. In other words, the Universal Life contract provided no guarantee as to how long it would remain in force. If interest rates maintained their projections everything was fine, but if interest rates fell below their projections there would be a problem.
The problem faced by many Insured’s today materialized because of the steadily, steeply declining interest rates following the higher interest rates of the mid-1980s. This resulted in 30-35% of today’s Universal Life coverage on pace to expire years earlier than originally projected. When Universal Life was first offered, agents and brokers would ask their clients how long they wished the coverage to remain in force. Clients would typically respond that they wanted the coverage to last until age 92-95. Next an average interest rate was then assumed for the 20-30 year period it took to get to the specified age after the policy was issued and that interest rate was plugged into a computer. The resulting computer illustration would provide the anticipated premium needed to keep that particular amount of Life Insurance in force for the desired period, but that time period was not guaranteed, only assumed.
While this interest-sensitive product stopped the tremendous outflow of monies from the insurance industry’s cash value coffers to the banks, the solution was not a long-term fix because it created other problems that have just began to surface over the last 5-6 years as a result of today’s record-low interest rates. Let me explain. In the late 1980s, when interest rates were 14 -15%, many assumptions were made that interest rates would remain in the 10-12% range for a long period of time. Even the more conservative agents and brokers were projecting 7-10% rates. Although those assumptions seemed perfectly reasonable at the time, our staggeringly low interest rate environment has decimated Universal Life contracts with even the most conservative projections. As a result, the original assumption that a life Insurance contract would last until the person was age 92, has been shortened by as many as 8-9 years. While Universal Life has received most of the blame in the Insurance Industry it needs to be pointed out that double and triple A rated Insurers are now beginning to also feel the effects of low interest rates as their Whole Life contract holders are being asked to either reduce their death benefits or increase their premiums as a result of poorly performing dividends which are not guaranteed.
The combination of a low interest rate environment and the fact that the octogenarian demographic is the fastest growing segment of the population is a ticking time bomb for the Life Insurance industry.
In the 1980’s Universal Life products provided additional funding flexibility for insured’s, but as interest rates soared, many of these policies were purchased with the expectation of receiving very high policy crediting rates over the life of the policy. The resulting false expectations have created a glut of policies that are going to lapse, resulting in no death benefit to the beneficiaries.
A actuarially based policy review examines the actual interest rate return earned each year since the policy was purchased and actuarially determines exactly how long the contract will last based on (1) the historic actual return, and (2) the current age of the insured, and (3) any outstanding loans. Many individuals and trustees neglect to request this historical projection, and are not aware that as a result of a poorer than expected performance, their contracts are now in danger of expiring earlier than originally expected. The more advance notice an insured or trustee has about a potential shortfall, the less additional monies are needed to adjust the coverage back to its originally projected level. The hidden risk of premature expirations of coverage shortfalls in Universal Life contracts has often been referred to as the insurance industry’s “dirty little secret” because there was not sufficient disclosure initially provided stating that this new product was Not Guaranteed to last for one’s lifetime.
Another set of false expectations were set in the 1990’s using non-guaranteed Variable Life products during a rising stock market and creating the same disastrous effects. Fortunately, the industry has created a new generation of “guaranteed mortality” contracts, but the negative effects from 20 years of setting unrealistic expectations is just beginning to take its toll.
1: Lower Interest Rates
*Between 1982 and 2006, carrier non-guaranteed ‘current’ crediting rates for in-force universal life policies have declined from the 12% level to the 5% level
*Source: 2006 TOLI Portfolio Statistics, Fiduciary Advisor Series 5, January 2007.
2: Longer Life Expectancy
*The U.S. Census Bureau reported in 1990 that 37,306 centenarians — people who have reached age 100 — lived in the United States. As of 2010, that number had boomed to roughly 72,000
*Source: Krach and Velkoff
3: Inadequate Funding
*45% of policies intended for lifetime protection, are inadequately funded to reach maturity
*Resource Insurance Consultants, Inc.
4: Lacking Competitiveness
"*There is as much as an 80% variance between poorly priced offerings and the best available"
*(Source: Tillinghast Towers Perrin study)
5: Insufficient Guarantees
Most policies written prior to 2006 do not have lifetime guarantees and were originally sold using illustrations that relied on unsustainable interest rates
6: Policy Loans
Outstanding loans can negatively impact policy returns and lead to inadequate funding issues
7: Carrier Issues
When a carrier drops its ratings, it can impact reserve requirements and policy performance
8: High Policy Lapse Rate
*80% of All Life Policies Lapse Without Any Payout