Life insurance purchasers who are willing to take a significantly greater risk in return for potentially greater returns can turn to Variable Life policies. The cash value in a variable policy is invested in securities, similar to investing in a mutual fund. And, like securities investments, this money is directly subject to market fluctuations with the policyowner/investor taking all of the risk. This is in contrast to traditional Whole Life policies, where dividends or interest are paid based on the life insurance company's general investments as a whole. It also differs from Universal Life policies, where the excess interest rate is determined by the insurer, based upon its investment experience as a whole. For Whole and Universal Life policies, the insurer bears most of the investment risk with only an indirect effect upon a specific policyowners cash values.
The "variable" part of a Variable Life policy is the death benefit. Like other types of insurance, the policy is originally written for a specific death benefit, and this is usually the minimum guaranteed amount that will be paid if the insured dies. But the variable feature means the death benefit could be greater or lesser depending on the return of the investment portion. Some companies stipulate a minimum guaranteed amount of death benefit and some do not. There is no guarantee, however, that there will ever be more than the original amount of insurance.
There are two primary factors that drive Variable Life Insurance:
If the policy guarantees a minimum death benefit, the cash value account operates from an assumed interest rate. This rate is the minimum interest the company determines the cash value must earn in order to cover the cost of the insurance, usually about 4% or 4 ½%. But this small assumed rate is not what makes the Variable policy attractive as an investment vehicle and a means to provide a greater death benefit.
What makes the death benefit potentially variable is what happens in the separate account. Under a Variable Life policy, the cash value account is referred to as the separate account, which is made up of the portion of the premium used to (1) pay for the insurance protection and (2) accumulate cash values that earn interest. Other portions of the premium are used to pay the various policy expenses discussed previously.
Variable policies place the entire investment risk upon the policyowner, who decides where the separate account funds will be invested. Insurers typically offer a variety of options; the most basic categories are Common stocks, Bonds, and Money market instruments
Some insurers offer very specific types of' investment accounts, such as long‑term corporate bond accounts, growth stocks or short‑term U.S. Treasury bills, to name a few possibilities. From the accounts available, the Variable Life policyowner chooses where to invest the separate account funds. Generally, policyowners may divide the cash value among two or more separate accounts if desired. Many companies allow the policyowner to switch accounts, usually with a limit on the number of such changes permitted in any one year.
The growth or lack of growth in the separate account is then directly attributable to the performance of the financial instruments selected, just as if the policyowner had invested in those stocks or bonds on the open market. Whenever the return on the investments exceeds the assumed interest rate, the excess increases the death benefit. For example, if the investment return has accumulated $15,000 in the separate account of a $100,000 Variable Life policy at the time the insured dies, the death benefit is $115,000. Or assume instead, the insured does not die until later, when the separate account investment performance has declined, reducing the former $15,000 value to $7,000 when the insured dies. The death benefit is $107,000 instead of $115,000.
If the investment return is not greater than the assumed rate, the death benefit remains level at the original face amount selected when the policy was purchased if the company has guaranteed a minimum death benefit.
Each time the separate account performance rises or falls, the variable death benefit rises or falls with it. At some point, the separate account line may remain level and so will the death benefit line; however, the death benefit never drops below the minimum guaranteed amount. So while the cash value might never be what the policyowner hopes for, there will always be insurance protection as long as the premiums are paid.
The premium for a Variable Life policy is fixed at the beginning of the contract and remains level during the entire policy period. (Newer forms of Variable Life, offering a flexible premium option and known as Variable Universal Life, are discussed later.) Like Universal Life, this premium pays any expenses or commissions and is then deposited in the separate account. The insurer periodically adjusts the amount necessary to pay for the insurance protection out of the account and the remainder is invested.
While the usual Variable Life policies require a fixed, periodic premium payment, Single Premium Variable Life, like its Whole Life and Universal Life counterparts, allows the deposit of one large premium payment at the onset of the policy. The advantage, you'll recall, is that the policyowners money goes to work earlier, rather than waiting for cash value build‑up from smaller periodic payments.
Single premium policy death benefits must be carefully set to meet Internal Revenue Code requirements to qualify as life insurance. A minimum amount of coverage is established, but the insurer also sets a maximum and the policyowner may purchase life insurance in any amount between the two. Typically, however, the maximum and amounts approaching it are guaranteed only for a limited number of years, after which the policyowner may have to make additional premium payments to maintain the higher coverage.
Administrative fees and other charges apply to single premium Variable policies. Often, sales loads are lower because the insurer receives a greater sum of money to invest initially and does not incur regular expenses to handle periodic payments.
Loans are permitted under Variable Life policies, subject to more stringent limitations than non-variable policies. Most insurers allow loans of up to 90% of the cash value and sometimes up to 100% after the policy has been in force for a certain length of' time - possibly 10 years. Some companies permit no loans in the first year or two. The policyowner pays interest on the loan.
Insurers typically pay a lower interest rate on the cash value borrowed from a Variable Life policy. For example, if the separate account investments resulted in 9% interest and the policyowner has borrowed $5,000, the insurer might pay 1% less, or only 8%. on the $5,000 that represents collateral for the loan.
FThe danger in borrowing from a Variable policy is that poor investment experience can result in the value of the separate account dwindling to the point where there is not enough value to cover the insurance cost. At that point, the policy would terminate. Insurers must warn policyowners if the separate account balance approaches that point. Such a situation could occur if both loans and interest payments were outstanding during a period of poor investment returns.
Withdrawals are also permitted, including total withdrawal‑policy surrender. With partial withdrawals, the same caveats apply concerning dwindling values in the separate account that can cause the policy to lapse and insurance coverage to cease. Withdrawals from Variable policies are subject to restrictions and charges similar to those imposed on Universal Life policies.
Because, the separate investment account contains securities, Variable Life Insurance policies are regulated in part by the Securities and Exchange Commission (SEC). The SEC requires that potential purchasers must be provided with a prospectus, which discloses certain information about the policy's underlying investments. In addition, insurance agents who sell Variable policies must be licensed as securities sales people and registered with the National Association of Securities Dealers (NASD).
One of the benefits of investing in the Variable Life separate account is similar to that of investing in mutual funds: professional account management. Investment managers employed by the insurer decide which particular securities are included in accounts made available to the policyowner. As a result, the policyowner is not required to monitor individual securities and make decisions about selling or buying. Instead, the professional managers make those decisions. Potential purchasers of Variable Life should look at the performance of the investment account based upon past actions of those managers, although that alone cannot predict whether they will make good or bad investment decisions in the future.
Insurers must allow policyowners a time‑limited option to exchange a Variable policy for a policy with a fixed interest rate. Variable policies for which the policyowner pays an ongoing annual premium must be exchanged within 24 months of purchase. For Single Premium Variable Life policies, policyowners have only 18 months to change their minds.
The National Association of Insurance Commissioners (NAIC) spent nearly 5 years developing “model” illustration regulations, and these regulations are in force in some form in nearly all of the states. The purpose of these regulations were to help consumers better understand how life insurance policies work, with particular emphasis on the differences between guaranteed and non-guaranteed life insurance elements.
These new regulations are all encompassing and pertain to policies sold after 1/1/97 (or later, depending upon the state). It includes ALL forms of individual life insurance, except those that fall under the jurisdiction of the National Association of Securities Dealers (NASD), as the NASD provide regulations for illustrations on registered policies, better known as Variable policies. The NASD has attempted to reconcile the differences between their model legislation and those of the NASD, but as of late, there has been no “joint” regulations issued.
Unknown by many, but important nevertheless, Variable Life is a unique product in respect to illustrations. It is a “registered” product, but there is NO other registered product that may use illustrations – not stock, mutual funds, individual securities or even Variable Annuities. They are specifically prohibited from using any projections of future values – for obvious reasons. In addition, a Variable Life Insurance product must not be sold without the prospect receiving a prospectus of such an investment.
As those in the insurance business – and many who are not specifically in the insurance business – are aware, using projections has caused many problems in recent years. When Variable Life, Universal Life and other interest-sensitive products were introduced, interest rates were relatively high. Therefore, projections (illustrations) assumed a higher interest rate than what has transpired. Thousands of policyholders of plans that were called “vanishing premium” plans based on high interest earnings assumptions, therefore, after a period of time – as short as 7 years in some projections – the interest earnings would take care of the premium for the insurance risk, therefore the insured would never have to pay another life insurance premium. Hallelujah!!
Now for the bad news. Interest rates did not stay as high as projected (illustrated), so now thousands of policyholders who thought that they would surely be enjoying their “free” insurance by now –are being dunned for additional premium – many of them in the thousands of dollars!! Insurance regulators did not sit still for this for long, and there are now strenuous regulations regarding illustrations, and the regulations being discussed here are the among the latest in correcting the major problems that arise because of the use of illustrations.
However, the biggest problem with the Variable Life regulations is that the allowable investment return rate used – up to but not exceeding 12% gross – is defined by these regulations as a constant average rate. To state it otherwise, whether the gross is 4% or 12%, the same rate is to be applied uniformly for all years.
According to recent published statistics, the total annual compounded return of large capitalization stocks in the U.S. has been 11% for the period of 1926 to 1998, or 12% from 1060-1968, or even for the period of 1970 to 1998, it was 13.5 %. (There is an obvious lesson in investing, but that is not for discussion here. Besides, “historical experience in no way should be relied upon as a prediction of future performance…”)
However, and this is a BIG however, even though the stock market of 12% returns is not a new phenomenon, if one would take $1,000 and use a long-term average rate of a little over 11%, after 70 years there would be over $2 million in the pot! This is an illustration of the laws of compound interest, but unfortunately, they do not apply to Variable Life Insurance.
A Variable Life Insurance policy has a cost of insurance (COI) element that comes from the policy funds (“disinvestment,” it is called), actually from the liquidation of sub-accounts, and because of the cost of the net amount of risk, the growth illustrated in the paragraph above will not occur.
Without becoming too technical, the net amount of risk of a life insurance policy is the pure cost of insurance, and when a person gets older, there is a greater chance of his/her dying, so obviously the cost of insurance increases. Because the Variable Universal Life insurance plans require that the cash value must be about 50% of the death benefit according to actuarial calculations. However (again) these types of policies fluctuate without benefit of a ceiling or a floor. What would happen if the cash value should drop as much as 20% ? The COI charge would be increased by a higher factor, with the end result that the policy will lapse in a few years or an amount equal to the loss of cash value would be injected immediately into the policy.
Again, without becoming too technical, if the actual fluctuations of the market were used in variable Universal illustrations, it would be contrary to existing regulations.
The message is that Variable Universal Life is a highly technical product (any Variable Life product is also). Regulations are being created in an attempt to alleviate criticisms of these policies, and whether this has been accomplished or not, it is still a matter of concern.
Since obviously the fact that there is a dependence on the equity returns certainly does add an element of risk to what has always before been considered as a conservative financial instrument. This risk is not simply that of not achieving the projected returns, but also includes the effect of the fluctuations in the stock market.
A method frequently used to demonstrate these fluctuations and their effect on Variable Life is to use the past returns of Standard and Poor’s 500. The second step is then to illustrate the same funding & death benefits with the S&P 500 returns inverted. By using these different patterns of return would, as expected, show quite different returns although the average annual return is the same. To some of the critics of Variable Life, this would indicate that it is an illegitimate and inappropriate cross between life insurance and mutual funds. This is incorrect because there is a significant flaw in these methods of illustrating annual returns.
The premise that a pattern that has unequal annual returns will show a different result than if the average were used throughout. For instance, if 10% is the average of uneven returns, the policy results will be different than if 10% were used each year. Most illustrations for Variable Life uses a constant assumed gross investment return, which is selected by the agent (with usually a cap of 12%) . This return, less funds fees and expenses, is used to illustrate the investment earnings on the policy cash value. If these results were graphed, this would show a smooth curve, which ends in the targeted amount of cash value.
However, in actuality, this would not be the result of graphing of the actual results, as there is a difference in annual returns from the “smooth” graphic lines indicating the assumed constant gross return, and the actual application of the monthly changes. Actually, while the difference in returns can easily be seen, the more significant factor is the effect of monthly charges.
Back to basics. Life insurance policies are actually monthly vehicles and each monthly policy anniversary (MPA) investment earnings are credited to the policy and charges against the policy are deducted. As indicated earlier, investment earnings are credited by means of the asset unit value (AUV) – which closely resembles the net asset value of a mutual fund.
To reiterate, the fund manager determines the AUV by using the value of the securities in the portfolio at close of the previous day, and divides this by the total number of outstanding shares. Since the fluctuations of the market creates changes in the total value of the portfolio, such changes are shown and reflected in the AUV, and is reported to the insurance company each day. The insurer than multiplies the AUV by the number of shares owned in the policy to determine the cash value. Fixed policy fees and expenses are then deducted from the policy through the process of liquidating or in effect, “selling” shares at the AUV for that particular month.
The effect of changes on the AUV on the performance of the policy is by means of the net amount of risk (NAR), which is the difference between the policy cash value and the policy death benefit – or to put it another way, it is the amount that the insurance company would lose in paying a death benefit under a level death benefit Universal Life policy (Option A).
Obviously, fluctuations in the AUV results in changes in the NAR. If the MPA would happen to be the day after a significant decline in the market, the AUV would necessarily be lower, resulting in a lower cash value. (For an Option A Universal Life policy, a lower cash value results in a higher NAR).
Why is this important? Half of the method used to determine the cost of insurance charges on a Universal Life policy is the NAR – the other half being mortality charges obtained from mortality tables. As also indicated previously, the NAR multiplied by the mortality rate (per thousand) created the cost of insurance (COI) for that particular month and is deducted from the policy along with other fees and expenses by liquidating shares at the AUV for that month.
Now comes the principal reason for this discourse – when market fluctuations produces a low AUV on the MPA for that month, the NAR will increase, leading to a higher COI charge. This will, in turn, result in more shares to be liquidated because (1) the higher COI charge, but also (2) the shares are being liquidated at a lower AUV.
Of course, if the market fluctuates upward, then just the opposite occurs and the NAR will decrease which means a lower COI charge, requiring fewer shares to be liquidated at a higher AUV. Makes sense.
Theoretically, because of the volatility and the fluctuations in Variable Universal Life policies, the policyowner actually sells low. If there is not a premium payment, shares would have to be sold every month with - more shares sold if the market is depressed than when the market is high.
When these factors are all considered, it is apparent that life insurance illustrations do not effectively demonstrate this effect because, as stated earlier, they are usually based on constant annual returns, and even if they were based on a fluctuating annual return which is equal to the constant annual return, the illustration still would not reflect accurately the effect of the fluctuations every month. And to make matters even worse, any illustration based on such assumptions would not be accurate; actually, there are innumerable monthly return patterns that could be assumed, with each having a different outcome. This is the flaw in the illustrations that was stated earlier in respect to using illustrations with the S&P 500 chronologically illustrated, and then illustrated in inverse order. This method actually only uses two of the innumerable patterns of return, and then draws a conclusion based on this very limited sample of data.
Is there a solution to this problem? Well, yes, as originated by Gabriel R. Schiminovich and discussed in a recent article in Life Insurance Selling. The system that produced the closest to actual returns was produced by generating multiple patterns, each of, which was likely to happen because they matched the variance of the domestic equity markets. This system is quite complicated. For instance, a baseline illustration was run through a random return illustration 10,000 times to produce a meaningful large sample of likely results!
A result of this study simply supports the conclusion that the fluctuation of the market creates a wide range of returns, each of which is equally likely to happen. They discovered that two clients of identical age and health, if they purchased identical policies, funded identically on two different days of the month, each of whom achieves the constant assumed investment returns – guess what? They would likely achieve different policy results because of the fluctuations of the market.
Basically, all this proves is that the volatility of the stock market has a tremendous effect on Variable Life Insurance, and much more than is obvious from the limited studies of the S&P results plus inversion. This does not, in any way, negate or reflect adversely on Variable Life as an excellent financial tool.
Further, this does not undermine or negate the usual Variable Life insurance illustration’s value as a tool to reflect a “reasonable” expectation of the policy investment performance. The point is that producers must be aware of the effect that the market’s fluctuations has on the performance of the policy, particularly long-term. Reporting investment returns alone is certainly not sufficient to measure the effect of the fluctuations as the actual policy values must be closely monitored. This information must be furnished to the client on a regular basis, and if this is furnished to the client regularly, both the agent and the client can rest easier.
CHAPTER 3 – STUDY QUESTIONS
1. What makes the death benefit potentially variable in a Variable Life policy?
A. The amount of premium.
B. The assumed interest rate and the separate account.
C. The size of the insurance company.
2. When the return on the investments in a Variable Life policy, exceeds the assumed inter-est rate, the excess
A. increases the death benefit.
B. decease the death benefit.
C. is paid to IRS in taxes.
3. A Variable Life insurance policy with flexible premiums is known as
A. a flexible premium Whole Life policy.
B. an Interest-Sensitive Variable Life policy.
C. a Variable Universal Life policy.
4. In order to sell Variable insurance products an insurance agent must
A. be bonded for $1,000,000.
B. be licensed as a registered representative with NASD.
C. forfeit their insurance license.
5. If the accumulation of cash in the separate account of a Variable Life policy falls below the cost of life insurance, the policy would
A. terminate.
B. continue because it cannot happen by law.
C. have cash added by charging back on the agents commission.
6. Investments in a Variable Life insurance policy are made through an account that is known as
A. Variable account.
B. Insurer portfolio.
C. Separate account.
7. Variable Life insurance companies are regulated by
A. Federal Deposit Insurance Corporation.
B. Securities and Exchange Commission.
C. National Association of Insurance Commissioners.
8. The asset unit value (AUV) of Variable Life insurance policy is determined by
A. using the value of the securities in the portfolio, at the close of the market and divided by the number of outstanding shares.
B. using the total portfolio of the insurance company and dividing it by the total number of policies in force.
C. using the value of the securities and dividing by the number of shareholders.
9. The value of a Variable Life illustration is
A. to reflect a “reasonable” expectation of the policy investment performance.
B. that it accurately demonstrates the guaranteed growth of the cash values.
C. that it is based upon the fact that the agent’s commission is a function of the asset value.
10. The main advantage to a Single Premium Variable Life policy is,
A. by paying a lump sum, up front, the policy owner is guaranteed a definite death benefit.
B. the policy owner’s money goes to work earlier rather than waiting for cash value build-up from smaller periodic payments.
C. by paying lump sum, up front, the policy owner is guaranteed a specific interest rate over the life of the policy.
ANSWERS TO CHAPTER THREE REVIEW QUESTIONS
1B 2A 3C 4B 5A 6C 7B 8A 9A 10B