In this article, I am going to debunk one of the most pervasive myths regarding Indexed Universal Life (IUL). The myth is that the rising cost of mortality is going to cause an IUL to lapse. Understand that as an independent life insurance agent, my goal is simply to make sure that my clients get the best possible product to fit their needs. I certainly don’t want to sell a life insurance policy that could potentially lapse someday.
It’s important to realize that this myth is absolutely wrong. This means that agents repeating this myth really don’t understand how life insurance works. In this paper I will guide you through the inner-workings of a life insurance policy to illustrate this. You should understand that ALL permanent Life Insurance policies face rising costs of insurance as the insured ages. Because insurance companies understand mortality risks, there are mechanisms in place to make sure that policies will not lapse. I’m also going to show you why the risk in an IUL is actually lower than the risk in a Whole Life. Keep reading if you would like to take a look under the hood of a permanent life insurance policy to debunk this myth.
This article is going to be fairly technical, so you may want to checkout my Life Insurance 101 download. This article has much more detailed background information.
What exactly is the Cost of Insurance/Mortality Cost
We need to start by defining the cost of insurance. The best way to do that is to cover some of the basics.
The easiest way to get your arms around what is going on in a permanent life insurance policy is to put yourself in the position of the insurance company. When an insurance company sells a permanent life insurance policy, they KNOW that they are going to have to pay a death benefit someday.
Because they know they will have to pay a death benefit someday, part of every premium goes into a savings reserve so that the policy owner will essentially save up the death benefit over the insured’s lifetime. That is the Cash Value. The insurance company also needs to make sure that they can pay the death benefit if the insured passes before they reach their life expectancy. Insurance companies handle this risk by pooling. All insurance works by pooling and sharing of risk. The insurance companies use actuarial tables that allow them to understand the risk of a 45-year old, non-smoker dying at that age, for example.
Pooling of Risk
The “Cost of Insurance” is the amount of money that the insurance company needs to pool. The pooled money is used to cover the death benefits that will be paid out. The Cost of Insurance is also known as “Mortality Cost”. This money either comes from the premium dollars or from the cash value if no premiums are paid. Most of that money will be paid out in claims if their actuarial tables are accurate.
Mortality risk increases as people age. The cost of insurance has to increase each year to account for the increased mortality risk. More money needs to be pooled to cover the increased mortality risk.
Net Amount At Risk
This graph illustrates the death benefit and the cash value growth over the life of the insured. The Death Benefit is $1 million and is illustrated by the orange line across the graph. The blue line represents the growth of the cash value over time. The brackets are showing the “Net Amount at Risk” to the insurance company. It’s important to point out that the cash value is part of the death benefit. So the net amount at risk is the Death Benefit minus the cash value.
The Net Amount at Risk goes down over time and the risk is gradually reduced for the insurance company. The bracket on the left side shows how the risk to the insurance company is greatest at policy issue. At this time, there is no cash value and the risk of paying the $1 million is borne by the insurance company. The bracket in the center shows that by the time that the insured has reached age 79, the policy owner has saved up about one-half of the death benefit.
Both IUL and Whole Life Face Increasing Cost of Insurance
Here is the part that the people spreading the myth don’t understand. Both Whole Life and IUL work the same way. Keep in mind that everything you’ve read thus far applies to both Whole Life and IUL. It is very important to understand that a universal life policy is simply an unbundled Whole Life. The insurance company makes explicit those costs that are not shown in a whole life.
The more important thing here, however, is the reduction in the net amount at risk. The graph shows the rising cost of insurance being offset by the reduction in Net Amount at Risk. While the cost of insurance is increasing, the net amount at risk is decreasing. As the insured nears their life expectancy, the net amount at risk is very low. But the cost of insurance is very high.
Policies run into trouble when they don’t meet the actuarial growth expectations. The “Guaranteed Rate” is actually the rate that the insurance company used to price out the policy. It is the rate necessary for the cash value to close the gap with the death benefit over time.
The cash value needs to grow at the actuarial rate. If it doesn’t, then the higher cost of insurance and net amount at risk put the policy at risk. But conversely, if the cash value growth rate exceeds the actuarial rate, then the risk is eliminated more quickly.
An IUL has LOWER risk than a Whole Life!
Yeah. I said it. I want to show you why an IUL actually has less risk in it than a whole life.
Insurance companies have an incentive for the cash value to grow as quickly as possible. THAT is what provided the incentive for insurance companies to introduce IUL. They do this by hedging with options on the market indices. This allows them to earn a premium over what they would have credited as a dividend. The result is faster growth of the cash value. This reduces risk in the policy.
This graph shows how an increased growth rate will shift the blue line up and to the left. The cash value would reach the death benefit by the time the insured reaches age 83 in this example.
Maximum Over-funded Policies
Everything I’ve mentioned so far in this article has dealt with Traditional life insurance policies. These are policies where the priority is to get as much death benefit as they can for the money. The insurance company doesn’t collect any more in premium than it needs for the policy to perform. The cash value just needs to stay on the growth track illustrated above.
It’s important to realize that those policies are minimally-funded. This means that as long as the cash value grows at the actuarial rate, the policy will perform as designed. If the policy grows faster than projected, it becomes “over-funded”. This means that it has more cash value than necessary to meet its obligations. Clients can also add additional premium into policies to over-fund them.
You should be aware that if a policy is “Over-funded”, then it is not at risk of lapsing. By definition, it has more than enough cash value to keep up with the rising cost of insurance. A Maximum Over-funded policy is a policy that is funded right up to the legal limit. The law requires that there be some minimum amount of risk in order to meet the definition of life insurance.
This graph shows that the death benefit is kept to a minimum at all times. The net amount at risk is as small as it can get. This keeps the fees and expenses to an absolute minimum, which you can see in this next table.
Expense Ratio Doesn’t Increase
This table shows the expenses in a policy. The shaded section on the left shows the itemized charges. The shaded sections on the right show the ratio of charges to premium and charges to cash value. If you look at the lower right corner, you’ll notice that the ratio of charges to cash value remains relatively constant. While the table only shows the ratio through the insured’s age 74, I want you to know that this ratio will continue to remain constant through Age 120.
The point I am trying to make is that the amount of cash value that must be spent on death benefit is relatively constant. Some small percentage of the cash value must be spent on “Risk” in order to meet the legal definition of life insurance.
It is important to understand that the rising cost of insurance doesn’t matter because the insurance company will only buy as much of it as they can get with their fixed budget.
The rising cost of insurance IS NOT going to cause a maximum over-funded policy to lapse.
Let’s wrap things up. There are two main takeaways that I want you to get out of this article. The first is that I want you to be aware that both IUL and Whole Life work the same way. Both face the same rising costs of insurance over time. A Universal Life is simply and un-bundled Whole Life.
I also want you to understand that an IUL has a lower cost of insurance than a similarly designed whole life. This is because the cash value will grow at a higher annualized rate of return, the IUL
And, finally, understand that a maximum over-funded policy is MAXIMUM OVER-FUNDED. By definition, it has more cash value than is necessary to cover the rising cost of mortality over time.
The idea that the rising cost of insurance will cause a maximum over-funded policy to lapse is complete nonsense. Anybody who repeats this myth doesn’t understand how life insurance works.