Universal and Variable Life Insurance

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Universal Life

Universal life policies shifted the risk from the insurance company to the consumer. Universal life was the insurance industry's answer to the extremely high interest rates that Americans experienced in the 1980s. Traditional whole life contracts have earned 3 ~ to 5 percent interest. In an effort to be more competitive, many insurers developed universal life products with interest rates that reflected the current market (prime + 1). During the 1980s these rates were attractive (l012 percent). However in the 1990s these rates have fallen to 5 -7 percent. These higher interest rates provide universal life with its distinctive characteristic-flexibility.

Universal life is basically a whole life policy divided into its two components-,death protection and cash value. In essence, the death! protection takes the form of one-year renewable term insurance and the cash value account realizes current interest rates.

The universal life policy was designed for people who need flexible coverage over the course of their lifetime. Flexibility is realized by the following factors:

• the policy owner may increase or decrease the death benefit subject to any insurability requirements
• premium amounts may be changed as long as enough premium is paid to maintain the policy
• most universal life policies are sold based on the accumulation values and tax-deferred retirement income, rather than on the proposed death benefit Policy owners often misunderstand that returns can and do fluctuate, based on investment performance and interest rates. Therefore, there is greater uncertainty.

Example: Your universal life premium is $1,000 annually for $100,000 of coverage. When the premium is paid, an amount necessary to provide one-year renewable term coverage is used to cover the death protection element of the policy. The balance is deposited into the cash account where it will earn competitive current interest rates.

Progressive Underwriting

Universal life competes in the term insurance marketplace. It can offer standard rates substantially cheaper-as much as 30 percent or more-than standard rates charged by many term insurance companies.

Some universal life policies feature progressive underwriting, which is meant to attract otherwise uninsurable consumers. These policies are usually structured so that, if policy owners pay the level minimum annual premiums, coverage wont lapse for 15 or 20 years.

Some abnormalities can be caused by lifestyle rather than medical problems. For instance, a person might take a cough medicine to treat a cold, and this might cause an abnormality to show up on tests. ~

The current guaranteed rate refers to the annual rate which is reflective of current market conditions. Thus, the current rate can change every year. The contract rate is the-minimum guaranteed interest rate which the policy guarantees will be paid. For example, the policy's guaranteed rate may be 5 percent. This amount would be credited to the cash account if the current year's rate fell below 5 percent.

There are two options regarding the death benefit payable under a universal life policy. The first option provides a level death benefit equal to the policy's face amount. As the policy's cash value increases, the mortality risk decreases. Thus, the cost of the death protection actually decreases over the life of the policy and-accordingly-more of the premium can be placed in the cash account. This is exactly the same concept which applies to whole life.

There are actually two interest rates associated with the universal life policy the current year guaranteed rate and the contract rate.

However, due to the higher current interest rates credited to the account, if the cash value increases to an amount equal to or in excess of the policy's face amount, then the death benefit will automatically be increased. Under current tax laws, if the universal life policy is to maintain its status as life insurance and thus provide a tax free death benefit, there must be a degree of mortality risk until the insured person reaches age 95. This is the reason for the automatic increase in the death benefit if the cash value equals or exceeds the policy's face amount. This buffer or corridor between the death benefit and the cash value must be maintained.

The second option provides for an increasing death benefit equal to the policy's face amount plus the cash account. Unlike the first option, the mortality risk remains at a level amount equal to the policy's face value. Thus, the policy owner will incur a higher expense for the cost of the death protection over the life of the policy and less of the premium will be deposited in the cash account.

Universal life provides for cash value loans in the same manner that whole life or any cash-value insurance policy does. If a loan is taken, it is subject to interest and if unpaid-both the interest and the loan. amount will reduce the face amount of the policy.

Many universal life policies will also permit a partial surrender or withdrawal from the cash account. This is not treated as a loan.

• A partial surrender is not subject to any interest and will reduce the total cash value in the account. If this withdrawal is later repaid, it will be treated as a premium subject to any sales load that the policy may have.

Variable Life

Variable life insurance provides death benefits and cash values that vary according to the investment returns of stock and bond funds. The policyholder can select from available funds. This allows the policyholder to be more aggressive or less aggressive.

Historically, to offset imbalances in interest paid under a standard life policy, some insurance companies made special provisions for people to purchase life insurance and still take part in any increase in interest earnings. Some variable and flexible premium policies contain provisions that guarantee you certain interest earnings, which will not ever be less than a predetermined percentage (4 percent is a commonly used figure).

Variable Life Policies cannot guarantee any return. It is possible that the policyholder will lose the cash value by selecting a fund that loses money.

Then by actuarially calculated methods, the insurance company will also guarantee that you will make a certain percentage of the current interest rate should that iriterest rate go above the 3 percent or 4 percent interest that you need to earn. This additional interest percentage is the excess interest over the minimum guaranteed interest.

Example: If the insurance company is earning 7 percent on an investment, you will earn the guaranteed 4 percent. But if the insurance company earns 11 percent, you may earn an additional 3 percent on the current interest rate. Therefore, the combined interest earnings will be 7 percent.

An insurance company's general investment account usually consists of safe, conservative investments such as high grade bonds, real estate, certificates of deposit, etc. The premiums from a traditional life insurance contract are placed in the general account and the entire contract is fully guaranteed by the company. But these conservative investments may lose value during periods of high inflation. Traditional mutual companies' policies have hedged against inflation whereas, stock company products have not.

Variable life is a risk investment without guarantees. It may be a good vehicle for a sophisticated investor, but not for the novice.

Historically, during periods of inflation, the stock market usually has kept pace with inflationary trends by increasing in value. In recognition of this fact, an insurance company selling variable life establishes a separate account which consists primarily of a portfolio of common stock and other investments.

The premiums from a variable life insurance contract are placed in the company's separate stock market account-so, there is considerable investment risk to the policy owner and few guarantees. Due to this element of investment risk, the federal government has declared that variable contracts are securities and are thus regulated by the Securities and Exchange Commission (SEC), the National Association of Securities Dealers (NASD) and other federal bodies.

Variable life policy owners have voting rights. Under federal securities law; the policy owner is allowed one vote for each $100 of cash value. And the policy own~ must be permitted to convert to traditional whole life insurance within 24 months of policy issuance.

Federal laws require a mandatory 45-day free-look provision from the. date of policy application for a variable life contract.

At the time of solicitation, variable life illustrations or projections may not be based on assumed interest rates greater than 12 percent. This prevents both the agent and the policy owner from assuming excessive and unrealistic rates of return.

There are basically two types of variable life insurance: scheduled premium variable life and flexible premium variable life. Scheduled premium variable life requires that a periodic level premium. be paid to keep the policy in force. Because a specific premium will be paid, this type of variable life provides a guaranteed minimum death benefit equal to the initial face amount of the policy. The excess death benefit may be paid depending on the performance of the policy's separate account. The scheduled premium is not guaranteed. If mortality expenses increase or investment return decreases an additional premium may be required.

If the portfolio of common stock in the separate account does well, then the variable life policy will perform well. However, the policy owner is guaranteed a minimum death benefit regardless of the performance of the separate account.

In most other respects, the scheduled premium variable life contract is very similar to traditional whole life. Flexible premium variable life is basically variable universal life. Variable universal is a universal life policy that allows the policyholder to select investment risk.

Although this insurance may provide a minimum guaranteed death benefit, most often there is no guarantee of death benefit or cash values. It is very difficult for an insurance company to provide a guaranteed death benefit when the amount of the premium you will pay is unknown. Therefore, the performance of this kind of policy is solely based on the performance of the separate account.

Target premiums are fixed' in the first year but policy owners, because of the flexible nature of the products, are not contractually bound to pay those amounts in subsequent years.

Mortgage Insurance

Life insurance to cover the costs of your mortgage is a good idea. However, the mortgage insurance sold by lending institutions or mortgage brokers isn't always a good deal. You are often better served by purchasing a regular policy-term or cash value-in the amount of the mortgage from a separate insurance company.

Among the reasons to avoid mortgage insurance sold by lending institutions:

• the lending institutions' policies are designed to guarantee the bank gets paid instead of your survivors
• the policies appear to be priced competitively-but usually contain clauses that restrict options
• decreasing term policies usually give the insurance company the right to automatically reduce your insurance

Group Life Policies

Employers generally offer group life insurance as an employee benefit. This kind of insurance is usually written as one-year term insurance.

The legal requirements of group insurance are uniform throughout the majority of states and include the following basic characteristics:

• Most states define a true group as having at least 10 people covered under one master contract. Some states make allowance for even smaller groups.
• Coverage is generally available without individual medical examinations.
• The policy is issued to the employer, trust, union, or other association. Certificates of insurance are issued to the individual insured.
• The insurance cannot benefit the employer, trust, union, or other association. It must benefit the covered employee or member and any dependents.
• Premiums are based on the experience of the group as a whole.
• Premiums can be paid entirely by the policy owner or jointly by the policy owner and the insured employees. If the premium is paid entirely by the policy owner, it is a noncontributory plan and all eligible employees or members must be covered. If premium is paid by both the policy owner and the insured employees, the plan is a contributory plan and at least 75 percent of all eligible employees or members must be covered.
• Employees can be deemed eligible or non-eligible according to any legitimate occupational distinction (salary or hourly status, staff position, time on the job, etc.).

Group policies must contain provisions relating to the following:

• Evidence of insurability. Individual~ insurability must be proven if the employee or member joins the plan after the enrollment period.
• Conversion. An employee or member must have the right to convert to an individual policy when the group coverage is terminated because of termination of employment or the elimination of ac1ass of insured people.
• Termination of master policy. An employee or member must also have the right to convert to an individual policy because the master policy has been terminated.
• Individual certificates. These must be issued as evidence of coverage under a master policy.

It is possible for people in poor health to receive group insurance benefits because there is no medical underwriting. All eligible participants obtain coverage. But underwriting, the risk selection process, does occur. Insurance companies will consider the risk factors posed by employees as a group, and price the insurance accordingly.

Example: Coal miners will pay more for group life insurance than office wolkers. Nevertheless, there are many advantages of purchasing this kind of life insurance. The most important of these include:

• Underwriting is frequently guaranteed or very easy.
• Price per $1,000 of coverage is frequently the same for all employees regardless of age. Clearly, this is a much better deal for older employees than for younger employees.
• The convenience of being able to purchase insurance without a medical exam, having payroll deductions and minimum paperwork makes it very attractive.

Some employers offer employees the option to purchase' additional insurance through the group plan. This can be a significant opportunity for people who would otherwise have trouble getting insurance. If this is the case for you, buy all of the group coverage you can.

To lessen this disadvantage group term policies must include provisions to provide for conversion to individual coverage. They may also include continuation of insurance provisions, and waiver of premium provisions. Some employers continue group term insurance at reduced amounts for retired workers.

Association Group Policies

Many professional associations (the American Medical Association, CPA Society, State Bar Associations, Engineering Associations, etc.) offer association group term to their members. The quality of these programs is mixed-so it is not possible to generalize, except to caution about certain .common problems (which may apply generally to all group insurance plans):

• The price of the association group life insurance is comparable to individual policies. Therefore, despite good advertising by many associations, price is not a real basis for choice.
• The underwriting may be lax. If you have had medical problems, you may get favorable underwriting from association plans.
• Association membership is usually a pre-condition of having the insurance. If you think you may not continue your membership or will cancel it upon retirement, you may no longer be eligible for insurance.
• The right to convert the group policy to an individual cash value plan is an important benefit. If the conversion option is not available, it may be wise to pursue an individual plan with conversion rights.
• Quality of insurance company is important. It is wise to demand the same high financial ratings of a group carrier as you would from an individual carrier.
• The insurance company can cancel the group at any time. While the company cannot usually cancel an individual policy, it can-and frequently does-cancel an entire association.
• You may have to requalify medically if the carrier cancels the group. At tat time, you may not be able to qualify and therefore, could be ineligible for insurance.
• Your rates aren't guaranteed, since the carrier can increase the rates or cancel the group.

l Order Insurance

You see the offers on late night television and in senior magazines: An aging celebrity talks assmumingly about cheap life insurance available to older people, veterans or those who don't qualify for standard coverage.

There is no reason to consider mail order insurance. It is virtually impossible to determine the price, product, contract, caveats and exclusions in such plans", without first purchasing the product. If you 7choose to purchase .insurance through these channels, apply as many principles contained in this book as you can-and good luck.

Economic Pressures Are Intense

A last caveat: As actual interest rates fell below projections during the late 1980s and early 1990s, consumers became wary of interest sensitive policies like universal life. As aggressive assumptions were proved wrong, consumers found their vanishing premiums didn't vanish and their level premium policies required more money.

Some insurance companies concluded that they had to carry out the illustration war in the arcane invisible world of undisclosed assumptions. They began to manipulate mortality assumptions and lapse ratios. These changes can have a big impact on pricing and projected cash values-yet are virtually impossible to debunk because they're undisclosed in compliance documents.

A small reduction in mortality can create a major lowering of premium. Suddenly, companies that have no history of extraordinary performance are able to out-illustrate everyone else. Other companies then jump in with even more aggressive assumptions.

Conclusion

Although universal life policies and other variations were developed to provide flexibility in the type of protection that you choose, these policies are sometimes accompanied by a degree of uncertainty and increased risk. They may provide attractive alternatives, but it is important to focus on how these products perform when compared to other alternatives. In the next chapter, we will examine these alternatives further and discuss how to go about choosing the life insurance policy that best suits you.