In this post I want to show you how you can save an old and lapsing Universal Life policy. This is important because many of us may know someone who purchased a UL back in the late 1980s or early 1990s that is in danger of lapsing due to insufficient cash value to cover the cost of insurance.
Goal
The goal of this post is to let show you how you can preserve the remaining cash value in an old Universal Life Policy and keep it from lapsing.
Since not everyone reading this has the same understanding of Permanent Life Insurance, I’m going to begin with a very brief “Life Insurance 101” lesson[1]. I also want to provide a little history lesson to explain why these policies are in danger of lapsing. And while I’m at it, I can’t help but take the opportunity to dispel the myth that the rising Cost of Insurance is what is causing these policies to lapse.
Also, for more information on why Universal Life Insurance has such a bad rap, check out this blog post and video.
So if this sounds interesting to you, keep reading.
Life Insurance 101
There are three main things that I want to make clear for the purpose of this post:
- The cash value growth is a function of the amount of premium paid into the policy and the growth rate that cash value achieves.
- The cost of insurance increases each year, but the net amount at risk decreases because of cash value growth.
- The Cash Value is part of the Death Benefit.
It’s important to understand that the cash value represents the policy owner saving up the death benefit over the natural life expectancy of the insured. The cash value is part of the death benefit. The life insurance company knows that they will have to pay a death benefit someday. Therefore, the premium must account for the growth of the cash value and the ongoing cost of insurance.
Properly-funded Policy
The following graph is an example of a traditionally-funded life insurance policy. This policy has a death benefit of $1 million and is on the life of a male 45-year-old. The death benefit is represented by the orange line. The cash value growth over time is represented by the blue line. You can see that the blue line is growing and approaching the death benefit over time.
What you should notice in this graph is that the amount at risk to the insurance company goes down over time as the cash value of accumulates. The amount at risk is the difference between the cash value and the death benefits. This is the amount that the insurance company would need to pay if the insured passed away. The cash value would make up the remainder of the death benefit.
I want you to understand that the rising cost of insurance is built into the actuarial pricing of the policy. As long as the cash value grows at the guaranteed rate, there will be adaquate cash value to fund the policy.
Now that we understand that the growth of the cash value is a function of the amount of premium and the growth rate of the cash value, let’s look at what happens when either of these exceeds projections.
Over-funded Policy
If the cash value earns more than what was projected, the cash value will grow faster than was projected. This results in over-funding of the policy. This is illustrated by the darker blue line increasing at a steeper rate. You should also realize that the insurance company has an incentive for the cash value to grow as quickly as possible. The faster the cash value grows, the quicker their liability is eliminated.
Now let’s take a look at what would happen if interest rates dropped below the projected rate.
Under-funded Policy
If interest rates fail to meet the growth requirements of the policy, the cash value will be insufficient to cover the ongoing cost of insurance. The policy will be under-funded. If you look at the cash value at around age 100, You can see that there is still about $500,000 at risk to the insurance company. The cost of providing that additional protection will erode the cash value. The properly-funded policy (lighter blue line) looks like there is less than $200,000 at risk.
One thing I should mention is that the cost per dollar of death benefit is not changing. We know that the cost of insurance increases each year. That is from the actuarial tables. The problem here is that the policy requires more cash value to fund the increased amount at risk.
So now that you understand the problem with under-funding a policy, let’s take a look at what happened with universal life.
The problem with old Universal Life Policies
As I showed in the previous two sections, the cash value will grow faster when interest rates are higher and will grow slower when interest rates are lower. This graph shows both factors surrounding a very key date: the introduction of Universal Life.
You can see in this graph that interest rates were rising from around 1950 until 1982. These high interest rates provided an incentive to create a flexible premium life insurance policy. Just imagine if you could run projections for cash value growth at 15%as you could in 1982. This new type of policy wouldn’t need a near as much premium if they could count on higher growth.
This makes more sense when you understand that a Whole Life policy priced out at the guaranteed rate of 4%. compared to a policy showing 12% growth projections would require much more premium. UL would be extremely popular in a high interest rate environment.
But, then interest rates started to go down. You’ll notice in the graph that rates began a consistent decline from 1982 until just recently. It’s important to point out that as rates began to decline below the projected growth rates, the cash value growth was insufficient to cover the increased amount at risk in the policy. This means that policies were burning through much more cash value than they could sustain.
Do you think that the policy owners knew they needed to add more premium to make up for the lack of growth? Not likely. They just thought they were buying an inexpensive life insurance policy. They found out why it was so inexpensive.
Do you think the agents that sold the policy informed the clients that they needed to add premium? Possibly. Some probably did. Others may have not understood the problem.
Do you think that the life insurance companies themselves informed the clients? Since I wasn’t in the business at that time, I don’t know. But I do know that there have been lots of clients who’ve approached me with policies that are rapidly burning through their cash value.
So what do we do to fix a policy that is still in force and has cash value?
How to save the cash value in an old lapsing UL
Let’s just be clear upfront, unless the policy owner has the money to add the necessary premium, there is no preserving the policy’s death benefit. The cost of that high death benefit is going to burn up the cash value at low interest rates.
However, the cash value can still be saved by lowering the death benefit to the legal minimum.[2] Since both the premium and the death benefit are flexible in a UL Insurance Policy. If the high mortality costs are consuming the policy’s cash value or it looks like it may be going backward, the policy’s death benefit can always be reduced to the legal minimum in order to preserve the cash values.
However, many times an elderly client wishes to maintain the high death benefit because that has more value. If that is the case, they have no choice but to fund the policy with the necessary premium or gamble on outliving the policy. That’s not a choice I want to make. You could find yourself with no cash value and no death benefit.
Unfortunately, the time to properly fund the policy was in the early years when the policy owner was making minimum payments. Early premiums would have allowed the cash value more years of compounding to make up for the shortfall.
Conclusion
You should understand that the cash value of an old Universal Life policy can be saved by lowering the death benefit. The Death Benefit cannot be saved without adding more premium.
[1] Download the free Life Insurance 101 e-book here. You can also watch my Life Insurance 101 YouTube video here.
[2] This is more properly known as the Minimum Non-MEC Death Benefit. But if you call up the insurance company and tell them you want to lower the death benefit to the legal minimum, they’ll know what you’re trying to accomplish.
