“There are worse things in life than death.
Have you ever spent an evening with an insurance salesman?” – Woody Allen
For most people, discussing the working parts of a life insurance policy probably isn’t captivating after-dinner conversation. But a recent report concerning the current state of the life insurance industry in the United States reveals some basic information that even Woody Allen might find worthwhile.
The Recession Hits Life Insurance Companies Too…
While life insurance companies remain some of the most solid financial institutions in the world, sales of life insurance have been affected by the downturn in the economy. According to an August 31, 2009 report released by the Life Insurance Research and Marketing Association (LIMRA), annualized premiums are down 23% for the first six months of 2009, the greatest six-month decline since the second half of 1942.
Considering the declines in employment, housing and the stock market, it’s not surprising that the recession would affect life insurers as well. People may want life insurance, may want to keep the life insurance they already have, but some just don’t have the money to pay premiums. But the surprise is that certain types of life insurance have experienced great decline in sales while others did not.
The LIMRA report divided life insurance into four broad categories: Term, Whole Life, Universal Life and Variable Life. Here is the year-over-year change in sales for each type:
- Term – 03%
- Whole Life – 04%
- Universal Life – 29%
- Variable Life – 72%
In light of the broad-based recession, a decrease of 3% or 4% (for term and whole life) doesn’t seem too bad. And in fact, the LIMRA report noted that 40% of the companies in the evaluation were reporting increased sales compared to the first six months of the previous year.
But the numbers for universal and variable life are a different story. And the story is about what can happen when the assumptions for life insurance don’t match reality.
The Nuts and Bolts: Who assumes the risk? (This is the part Woody Allen probably won’t read)
A life insurance policy is comprised of three elements: the cost of insurance, the operating expense of the company, and the investment return generated from the collected premiums.
Term and Whole Life policies are designed to provide a high degree of contractual certainty in regard to these three variables. With level term, the premiums are established for the period of the term, and typically guaranteed not to change. There are no cash values. If the insured dies during the term, a benefit is paid.
For Whole Life, a level premium delivers both a guaranteed lifetime cash value accumulation and a death benefit. If the insurance company’s performance exceeds the contractual guarantees, this surplus/profit is passed on to policyholders in the form of non-guaranteed dividends. Paying the base premium always assures the policyholder that the guaranteed benefits will remain in place.
In both Term and Whole Life policies the only requirement of the policyholder is that the premium be paid. All other financial responsibilities are shouldered by the insurance company.
By design, Universal and Variable Life are contracts that offer a lesser spectrum of guarantees, potentially lower out-of-pocket costs and/or greater investment return opportunities to the policy owner, and more risk to the policyowner.
Universal life gives policyholders the option of flexible premiums, some of which may be much less compared to whole life. Because the owner isn’t required to pay as much premium on a regular basis, cash value accumulation will also be less certain. And instead of dividends reflecting “over-performance” based on guaranteed assumptions (as in a whole life policy), the interest rate credited in a Universal policy may be designed to bolster or extend the initial costs of the contract. In this way, a policy guaranteed to last until age 65 may also project to remain in-force for the rest of one’s life.
Essentially, the Universal Life policy owner assumes responsibility for some of the future costs of insurance. If at some point the dividends aren’t sufficient to pay the costs of insurance, the policyholder will either have to increase premium payments, decrease benefits or surrender the policy.
In a Variable Life policy, the policyholder is given the option of investing cash values in the stock market, usually through participation in the underlying investment funds within the policy. The cash values placed in these investments are not guaranteed; they will fluctuate in value according to the performance of the underlying funds. With Variable Life, the policy owner assumes responsibility for the performance of the underlying investments.
What Happened?
When Universal Life first reached the marketplace in the 1970s and 1980s, it was not uncommon for policy illustrations to project a dividend rate of 10-12% or higher. Over the next two decades, when these historically high dividend projections did not come to pass, many policy owners faced the unwelcome prospect of higher premiums or diminished benefits. What was once projected to perform like a stripped-down “leaner” version of a whole life policy now became an expiring term policy unless the premiums were increased. Similarly, Variable life policies suffered when the underlying investments did not perform as anticipated.
If the purpose of insurance is to manage risk, universal and variable life policies obviously place more of the risk management responsibility in the hands of the policy owner. And as best-selling financial author Garrett Gunderson, who is a friend of our, is fond of saying, “self-insurance is really no insurance.” Considering the events of the past two years, it’s logical that individuals would be more risk-averse and less likely to gamble on any financial decision – including their life insurance program.
During three decades of explosive economic growth, financial risk management sort of got lost in the euphoria. But as recent events indicate, there are no shortcuts. There are legitimate uses for Universal and Variable Life insurance, but the plain vanilla versions of life insurance – Term and Whole Life – provide a strong level of risk management for most people.
Do you have Universal or Variable Life Insurance policies? If so, now might be a good time to find out how much “risk” is in your contract.
“The path of least resistance is the path of the loser.”
- H.G. Wells
“If you are not willing to do some homework, plan on getting messed up sooner or later.”
- Errold F. Moody, Professor and Expert Witness for life insurance
