This post is about understanding life insurance guarantees. Whole life insurance is built upon three primary guarantees: A Guaranteed amount of life insurance, Guaranteed annual premiums and premium payment period; and Guaranteed increases in cash value. And as you begin to consider putting your money to work in two places at one time, you may begin to wonder if the guarantees are imperative. We are most concerned with the Cash Value when it comes to using a life insurance policy for real estate investing. And as we explore the guarantees on life insurance cash value, you will discover how life insurance guarantees relate, or do not relate, to maximum over-funded life insurance policies.
Why Do We Have Guarantees?
Life insurance is an industry built on trust. We have life insurance guarantees mostly for regulatory and marketing reasons. How would you feel if insurance companies, any insurance company, auto, health, etc. took in billions of dollars of premiums, but did not honor their claims?
So from a strictly consumer protection standpoint, you can see why regulators would want to ensure that insurance companies maintain strict reserve requirements in order to ensure their ability to pay claims, right? And, in this world of Bernie Madoffs and The Wolf of Wall Street, you can see why life insurance companies would want to tout their guarantees to separate themselves from their competition.
But, since one of my goals is to separate the reality from the hype and BS, I want to show you that, realistically and practically speaking, the guaranteed rate is really nothing more than a worst-case scenario used for planning and pricing purposes. The insurance company is statutorily bound to maintain minimum reserve requirements. The guarantees and the reserve requirements are roughly synonymous.
These worst-case scenario rates are used to ensure that the life insurance company is collecting adequate premium to maintain sufficient reserves to pay claims and honor policy commitments such as cash surrender value.
As we move on you will see, guarantees are not as important for people utilizing maximum over-funded policy designs for The Double Play and other private banking strategies. In a maximum over-funded life insurance policy, the policy has much more cash value than is necessary. There is very little risk of not being able to pay claims.
Now, if on the other hand you are purchasing a policy strictly for death benefit protection, you should be very concerned that the insurance company, in its efforts to keep premiums as low as possible to be competitive with other companies, has accurately estimated the growth that they need to maintain adequate reserves to pay claims.
Policy Design Impact on Guarantees
Minimally Funded Policy Designs (Typical)
Let’s start our analysis by taking a look at my familiar chart of a minimally funded life insurance policy:
This is representative of a typical Whole Life or Universal Life policy as well as the “Base Policy” that would be utilized in a maximum over-funded Whole Life policy design. Now if we imagine that the growth rate of the cash value was the Guaranteed 4%, then the blue line would represent the necessary reserves that the insurance company must hold in order to allow the policy to perform at any time over the insured’s lifetime. The premium must be enough to cover both the mortality costs in covering the gap between the death benefit and the reserves at any given time and it must be enough to insure that the gap is closed over the insured’s lifetime.
Both of those factors go into the determination of the Guaranteed Premium that the insurance company must collect on the policy.
Now let’s think about what would happen if the Insurance Company’s investment performance was actually much better than the Guaranteed Rate.
If the reserves grew at 6% rather than only th 4% guaranteed rate, then the money would grow much more quickly and the cash value would intersect with the death benefit well ahead of the worst-case projection. By the same token, if the company over-estimated actual growth of their reserves, then the growth would be much slower and the cash value reserves would intersect with the death benefits long after the client would have passed away.
In this case, the policy would likely not have adequate reserves to pay claims if the insured passed away. The mortality cost of covering “The Gap” would consume the cash reserves.
Maximum Over-funded Whole Life and Guarantees
As we explore even further now, it is very important to consider that maximum over-funded whole life policies are a blend of a small base policy, a significantly large term rider to increase the overall policy death benefit, and Paid-Up Additions. The term rider inexpensively increases the death benefit which allows for more cash, in the form of Paid-Up Additions, to be put in policy.
Understand that while the base policy and the paid of additions both include guarantees, the term insurance does not. The base policy is a typical minimally funded policy. The Paid-Up Additions are Guaranteed Paid-up Insurance. So if the agent leaves the client with the impression that the total death benefit is covered by The Guarantee, the client may be disappointed in the future when they realize the policy will require more premium to maintain the initial death benefit. The premium on that term policy must be paid in order to maintain that level of death benefit.
Have you heard the myth that “The rising mortality costs in a Universal Life will cause the policy to lapse as you age”? Can you see here that mortality costs rise in a Maximum over-funded whole life policy too? If the client wants to keep the high death benefit initially issued on the policy, which includes the term rider, the premium for the term matter must continue to be paid in order to maintain the death benefit protection. The cost of the death benefit protection in the term rider is going to increase each year as the insured ages. The policy’s total death benefit is dependent upon the payment of the non guaranteed elements.
Maximum Over-funded Policy Design
A look at a graph of death benefit and cash values in a maximum over-funded life insurance policy tells us everything we need to know about the value of guarantees.
This graph shows a 45 year old putting $100,000 of Premium per year into a policy for 10 years. At the end of 10 years the death benefit is being reduced to the Minimum non-MEC in order to drive the costs out of the policy.
At the end of the 10th policy year when the death benefit is reduced to the minimum non-MEC, you can see that there is only a very tiny sliver of actual death benefit protection in the policy. The Guarantee provides no additional value. The growth of the cash value over time is completely dependent upon the ability of the insurance company to invest its assets universal life to use the interest on those assets to provide funds for hedging purposes to capture additional movement in the market indices.
When you utilize a maximum life insurance policy, this decision needs to be made based on your assessments of the returns on the underlying investment accounts of the life insurance company. Life insurance guarantees do not play an important role because they are unlikely to ever play a role in your policy.
The goal here is to keep the death benefit to an absolute minimum at all times to keep the load on the policy to an absolute minimum in order to preserve the cash values. You can see that there is very little risk to the insurance company beyond the 10th year of the policy. This is the type of policy design you need for a life insurance retirement plan (LIRP) or for The Double Play.
Implementing The Guarantee
So one thing that is apparent in an Indexed Universal Life that you cannot see in a whole life, is that the interest and dividend crediting does not involve an actual transfer of physical cash. The word crediting implies that some allocation of the life insurance company’s reserves or general fund is credited on paper to the policy. No physical cash is actually held in an account for the Policy Owner.
People who own an Indexed Universal Life policy, for example, often note that even though the policy includes a 2% guarantee, the policy’s interest crediting is still dictated by the cap and floor of the interest crediting strategy that they selected. For example, an interest crediting strategy based on the one-year change in the S&P 500, might have a floor of 0% and a cap of 10%. People often mistakenly think that since the policy has a guarantee of 2%, that they will earn 2% and not 0%. That is not the case.
The way that The Guarantee works in an Indexed Universal Life is that if, for example, after 10 years, the policy’s cash value had not been credited with at least 2% year over year growth, then the guaranteed value would be paid out upon a surrender. The policy owner will get the greater of the actual cash surrender value or the guaranteed surrender value. But that guarantee is not shown in your surrender value each year and you not do not have access to the cash value either from loans or withdrawals.
As you can see, for all practical purposes, The Guarantee in an Indexed Universal Life is offers no real value because we can be pretty certain that the market is going to perform better than 2-3% over a long period of time. And, for that matter, the same is true with the guarantees in a whole life because the return of the company’s general fund is going to well-exceed their guaranteed rate as well. And the guarantees don’t apply to the non-guaranteed contract elements.
You don’t buy a maximum over-funded life insurance policy, whether whole life or Indexed Universal Life, for The Guarantee. Focus on the proper design and funding of your policy and select a policy with the best potential for future growth. You have to understand what the life insurance company is doing with reserves and make your decision based on the expected return.
A minimum non-MEC policy design is in no real danger of lapsing for anybody who is in good health and has no rated risk factors.
The idea that a universal life insurance policy is going to lapse because of rising mortality costs is a pervasive and incorrect myth. If a policy is properly designed, and the death benefit is reduced to minimum non-MEC at the end of the premium paying period, then a mandatory minimum percentage of the cash value is going to be spent on mortality expenses. If the cost of mortality increases, it just means that the same dollars are buying less death benefit protection. But the ratio of expenses to the cash value is going to remain constant.
You can actually see this in a life insurance illustration if you look at the alternative scenarios. for example, most Indexed Universal Life insurance policies include an alternative three and a half percent interest credited rate projection. If the policy is properly designed, and the death benefit is minimized at all times, you will find that even at only three and a half percent growth over time, the policies cash values continue to grow your after year. The rising cost of mortality does not in fact cause the policy to lapse over time.
To be fair, if the percentage of the cash value that must be spent on analyzing illustrations, then that one quarter of 1% represents a much larger percentage of 3.5%. so the cash value growth is impacted by the higher insurance costs, but not at a level sufficient to cause the policy to lapse. Since that three and a half percent assumption is less than the guaranteed rate of most whole life companies, we can be fairly confident that an Indexed Universal Life is a safe policy selection.