To set the stage in the explanation of separate account funding, an important part of any discussion on variable contracts, it should be reiterated that the obligations of an insurance company are held in the general accounts of the insurer, and consist of conservative investments which mirror as closely as possible, the liabilities and guarantees of the insurance company. An important point is that the accounts that are the foundation of the policy reserves of the company, these assets are subject to the claims of creditors. Therefore, if the company ever becomes insolvent and the assets are then subject to the claims of its creditors and policyowners—hence the conservative investment instruments.
There have been situations where insurers have collapsed because of investments in below-investment grade securities, primarily because the insurer wanted to produce higher-yielding financial instruments. As a result, the assumed rates used in variable contracts by insurers came under close scrutiny by consumers and regulators. Therefore, separate accounts should be well understood as it is such an integral part of variable contracts.
Separate accounts are simply separate accounts into which life insurance policy cash values and deferred annuity accumulations are invested. These accounts are separate from the company’s general accounts, hence their name, and are maintained only for the purpose of a mechanism so that contract owners may participate directly in the investment performance of the account. Since the returns vary according to investment performance, they provide a variable return. The policyowner’s return, plus or minus, in the separate fund is related to the performance of the assets that make up the fund. These accounts are not guaranteed by the insurer and the returns on these investments are not guaranteed.
So, what does this do? The separate account
F is a means of transferring the investment risk from the company to the
policyowner.
Since the accounts are separate from the general account of the insurer, the separate accounts are protected from the claims of creditors. Therefore, even if the company is bankrupt, the assets underlying the policyowner’s cash value are protected from creditors. However, while obvious, it must be pointed out that the assets can also be “lost” by changes in the conditions of the market.
When several insurers collapsed in recent years, the subsequent legal battles were publicized and very favorable attention was drawn to this characteristic of variable contracts. They pointed out that even though many, if not most, consumers purchase variable contracts because of the opportunity to directly participate in the invested assets, they are assured that they will not lose their share of those assets, even in the company should become insolvent.
While the protection against creditors is a major plus for variable products, there is no doubt that the greatest reason to purchase a variable contract is the owner’s participation in the investment. Since the asset performance is the responsibility of the owner, there is always the possibility of gains that can far exceed what an insurer can provide because of the restrictions on the investments of an insurer. It is almost routine for an owner to realize twice the investment return that he would get under a guaranteed rate.
The first variable contracts allowed the policyholder only three investment options in which to invest the funds, such as a stock fund, a bond fund and either a treasury or money-market fund, which were essentially mutual funds run by the insurance company and set aside as a separate account. The policyholder could put all of the funds into one of these choices or distribute the funds amount the options. Initially there usually was a minimum requirement of at least 5 or 10 percent of income funds that had to be allocated to any investment option that was selected.
The resemblance to mutual funds by separate accounts is not coincidental as both are covered under the Investment Company Act of 1940, which says:
A UIT operates like a holding company with the investors as its clients. The UIT managers usually purchase shares of other management company investments and then pass the gains and losses on to their investors, i.e., they do not actively manage their own portfolios and they do not trade securities.
A management company operates as the name implies—it actively manages the accounts. Some insurance companies, or “sister” companies, i.e., companies owned by the same holding company, etc. have their own independent management companies. Usually they offer the companies’ mutual funds as “subaccounts” within one of their own accounts. Within a single separate account, an insurer may offer as many as 6 or more subaccounts. An example could be where an insurer owns a separate account (UIT), which purchases shares in 4 funds in the insurer’s management, (such as an equity fund, a growth fund, a bond fund and a money-market fund. They also offer two funds through another independent management company (such as a balanced fund and an international fund). The second management company trades directly with the public. Therefore, the separate account allows purchase of shares in six subaccounts.
Some insurance companies have variable contracts that could offer separate accounts through either a UIT(s)—in which case the insurer is just the conduit through which the policyowner and the mutual fund can operate—or they can deal directly through an open-end investment company(s). Does one system outperform the other? Not necessarily, but clients may have a preference (and it could make a difference in a sale).
While the prospectus that is presented to each prospective variable contract purchaser will explain the nature of the fund for each separate account, there is another easier way to tell—Unit Investment Trusts will usually be named after the mutual funds that support them, while separate accounts that are actually mutual funds but owned by an insurer, will usually have the name of the insurer in the account name.
To purchase separate accounts (a.k.a. “variable accounts”) for either Variable life and/or variable annuities, the owner of the contract selects the separate accounts where they want their assets from their policy invested. If the owner does not like where the assets have been placed, usually the contract will allow the owner to transfer funds between the separate accounts once the contract has been issued. If the separate account is a UIT which invests in other mutual funds, these funds are then subaccounts of the separate accounts.
Why “Unit?” Each variable contract purchases units that represent an undivided interest in the separate account assets. The value of variable contracts are determined by simple mathematics—the number of accumulated units multiplied by the unit value on a given valuation date. “Valuation date” is usually construed to be every day that the New York Stock Exchange is open, although some contracts refine it to be only those days in which there has been enough trading in the separate accounts to affect the value of the account.
When a contract owner pays a premium, that premium is divided by the unit value as determined at the close of business that day, as follows:
First, the value of each unit is equal to the value of all of the securities in the separate account divided by the number of outstanding units. If the fund is valued at $400,000 on June 1st and there are 200,000 units outstanding, then the unit value is $2.00.
Next, the number of units that was purchased is equal to the premium paid divided by the unit value on that day. If the contract owner paid a $100 premium on June 1st, he would acquire 50 units ($100 divided by $2.00 per unit, equals 50 units.)
The next step would be to determine the value of the contract, which is the total units owned, multiplied by the unit value at the end of the business day of the valuation. If the contract owner now owns 835 units (which includes the 50 units just purchased) on June 1st, then the value of the contract on that day is 835 units times $2 per unit, which is now $1,670.
This process is repeated at any time that the contract holder wants a valuation of his contract. The prime numbers are the fund value, the number of outstanding units, the unit value and the number of units owned by the contract holder. The fund’s values fluctuate with the market, which will be reflected by the value of the contract. Therefore, every day there are changes in the number of outstanding units as premiums are paid and distributions are made.
Unit value changes are usually measured in small increments and in those situations where the cash value of the policy is distributed among several subaccounts, the total value of the contract is determined by adding the subaccount values.
Most of the regulations of investments, including variable contracts, stem from the Great Depression of 1929. A brief history of what happened helps to understand why such regulation is needed.
During the early 1900s, there were a lot of technological changes, such as electricity, the automobile, and the ability of man to fly and land in one piece. These marvelous inventions became business opportunities, and everyone was optimistic about the country’s financial future, in spite of the recent First World War. This created a “bull” market that was the longest in American history.
As the bull market grew and some investors became rich, Americans who had never invested in the market, decided that it was an easy way to make money. One of the most attractive devices to “play” the market was margin trading, which was simply borrowing money in order to buy securities. This trading reached unbelievable levels of a reported 90% or more of the stocks being bought with borrowed money. This, of course, created no problems as long as the stock prices kept growing, or at least stayed level. However, obviously, if the stock prices collapse, then the stock becomes worth much less than the borrowed funds that the investor must repay.
In the summer of 1929, stock prices continued to climb, not for business reasons such as the growth of corporations, but because of the demand created by so many buyers clamoring to buy too little available stock. After the stock reached a high in September, the stock market could no longer support these artificially inflated prices, “black September” occurred, and the rest is history.
Of course, after the crash, Congress had a mandate to make sure that this never happened again, hence the creation of laws regarding investments, investing, banking, and a multitude of regulations so that future generations did not have to go through another depression.
The Securities Act of 1933 was one of the first regulations passed as a result of the crash of Wall Street, and this Act required issuers of securities to provide sufficient information to investors so that they could make informed decisions on investments. This was to be accomplished by issuers to register their information with the federal government and to make it available to prospective investors via a “prospectus”. This was a rather hard law for the times, as it outlawed fraud, which was committed in connection with the initial underwriting of securities, but most importantly, it required that a prospectus be delivered to every person who has expressed an interest in a security.
Congress also determined that in their opinion, one of the reasons for so many banks failing was that commercial bankers were actually engaged in investment banking. Therefore, a banking act of 1933 banned banks from being in the securities business.
A subsequent Act (1934) created the Securities and Exchange Commission (SEC) who was given the task of overseeing the industry. The Act also regulated the conduct of those persons engaged in the secondary trading of securities, but this was amended later by the establishment of a self-regulatory body to help police the industry, with the result that the National Association of Securities Dealers (NASD) was created to regulate over-the-counter trading in a similar fashion to the way the stock exchanges regulate their members.
Therefore, anyone who wants to sell securities—which definitely includes mutual funds and variable contracts—must first be registered with the NASD. Mutual fund and variable contract sales require a Series 6 (Investment Company/Variable Contracts limited Representative) registration, or a Series 7 (General Securities) registration that is required in order to sell all levels of securities.
The National Association of Security Dealers (NASD) Conduct Rules, by which any licensed representatives – including those who sell variable insurance products –; cover a very wide range of subjects. However, any person who sells variable products needs to be familiar with these rules. There are the following nine topics covered by these rules. A summary of the contents of these rules describes the topic.
2100 General Standards. This topic defines the established standards of marketing securities and is illustrated by a number of “Don’t Do” examples. Unethical practices are described, including withholding, trading ahead, front running and intimidation.
2200 Communications with Customers and the Public. Details the proper methods of ethical communications and how to achieve full disclosure. Discusses the proper ways to use rankings, confirmations, forward materials and disclose financial conditions.
2300 Transactions With Customers. Discusses “suitability” – recommending certain products for specific situations and needs and goals of the clients. Also provides directions as to how to deal with customers.
2400 Commissions, Markups and Charges. This topic discusses discounting of securities (must not), the differences between members and nonmembers, and a discussion of charging for services rendered.
2500 Special Accounts. Handling of discretionary accounts and margin requirements by broker-dealers.
2700 Securities Distribution. Very broad discussion of underwriting terms, conflicts of interest, securities taken in trade, transactions with related persons and price disclosure in selling agreements.
2800 Special Products. Rules on direct participation programs, variable contracts, investment company securities, warrants, and options, including index options.
2900 Responsibilities to Other Brokers or Dealers. When a member of the Association has a financial interest in the business of another member, under what circumstances do they provide financial disclosure to the other member, and to what extent.
3000 Responsibilities Relating to Associated Persons, Employees and Other’s Employees. The supervision of Registered Representatives, surely bonds, etc.
The SEC has had problems with the Variable life insurance concept since it was first introduced, which is understandable as it suddenly faced the prospect of having literally thousands of new representatives and agents selling an (obviously) investment product, to the general public. So one of the first things that it decided was that all insurance companies selling variable contracts must be registered as investment companies and the agents selling the variable products be licensed as both life insurance agents and securities agents (representatives).
One of the major concerns of the SEC was the maximum compensation to agents for the sale of the product. The SEC first proposed a sales load that would not exceed 8 percent of the sale price. Since securities are usually sold on a cash-sale basis rather than on an “installment” sale basis, this created problems for the insurance companies. Eventually the insurance companies and the SEC compromised on a 20 percent load on the first year’s premium, which, according to the actuaries, is the equivalent of an 8 percent load during the lifetime of the policy.
The next major problem was in determining if insurers would be allowed to permit flexible-premium policies. The SEC would not, initially, budge from their position, so the first generation of Variable life insurance products were all fixed premium products, with the only difference between the variable products and traditional insurance was the variable investment provision where the policyowner could select among a limited number of investment choices, with the death benefit varying as a function of the portfolio’s investment performance.
The SEC requires that Variable life insurance cannot be sold without a prospectus accompanying any presentation. They require a prospectus very similar to that required of new stock issues. It is a complete, full disclosure of all of the provisions of the contract and includes expenses, investment options, benefit provisions and the rights of the policyowner under the contract. It is rather lengthy and in detail, with the result that most purchasers of Variable life are not excited about reading it, but they should, as it contains information that is not available anywhere else. It should also be noted that the prospectus for Variable life contains much more information that is available for traditional insurance policies.
The prospectus provides details on various charges and expenses, such as
The prospectus goes into great detail as to the expenses charges levied by the insurer against variable insurance contracts, including commissions paid to soliciting agents, state premium taxes, administrative charges, collection charges, and any fees for some specific future event.
Administrative charges usually vary between the first year of the contract and all renewal years due to the added expense of first year commissions plus charges for underwriting and policy issue, etc., and these expenses vary between $15 to $50 a month. The second year administrative charge is usually the same as the first year, and thereafter it drops to around $5 to $10 a month. If there is a maximum guarantee on these administrative fees (or not) the prospectus would reflect that.
The prospectus also specified the cost-of-insurance charge, which is the manner in which charges are made against two-asset account to cover the cost of insurance. The prospectus states exactly what rate will be used to determine these charges and specifies if there is a maximum rate above the intended rate. It also spells out the way that charges are levied against the separate account, which usually is the fees association with managing the various fund type of accounts. There can also be charges to establish and maintain trusts that are necessary in managing the assets, and these are specifically noted.
The surrender charge applicable to policy loans is plainly and clearly detailed in the prospectus—which should be known to the owner of any type of insurance, not just variable. Surrender charges are applicable only if the policy is surrendered for its cash value, or if it is allowed to lapse or, in some policies, if the policy is adjusted to provide a lower death benefit.
Surrender charges are usually levied during the first 10 to 15 policy years, and the actual number is stated in the prospectus. The surrender charge applies only to policies that are surrendered before the insurance company’s first year (front-end) expenses have been recovered. Surrender charges may be referred to in the prospectus as “contingent deferred sales charges”.
Since Variable life insurance, variable Universal Life insurance and Variable annuity contracts are forms of life insurance, states require that agents have a life insurance license in order to sell these products. States do vary as to requirements as some require a special separate variable contracts license, while others allow variable contract sales if the financial representative has a valid life insurance license and is properly registered with the NASD.
Also like mutual funds, separate accounts offer a choice in investment strategies and objectives. For instance, a money-market fund may be the right choice if the party is security-minded and the interest rates are declining, similarly for a bond fund. If the interest rates are high and the market is doing well, a contract holder may have the objective of taking more chances and receiving a higher return on their assets by investing in corporate bonds or preferred stock. It is very important that a representative marketing variable products understand what the consumer’s objectives are and that they understand the various degrees of risk.
This is called “risk tolerance” and polls have shown that the consumers consider this as a very important responsibility of the representative selling variable contracts. The client will have to make choices as to investment objectives, so determining where the assets should be invested depends greatly upon the risk tolerance of the individual, in addition to the separate account’s investment objectives. This can be difficult to determine, and companies who offer variable contracts usually can be of assistance to the representative to determine the risk tolerance of their clients.
Variable life insurance (VLI) was first offered in the U.S. in 1976 with only limited success. Equitable Life Assurance Society was a pioneer in VLI in the U.S., and suffered through four years of discussion, development and negotiations with the Securities and Exchange Commission (SEC) before the product was approved. Four years later, John Hancock, followed by Monarch Life, offered VLI products. Today, many insurers offer some versions of this policy.
There were two basic approaches to Variable life, the Equitable plan and the New York Life plan. The Equitable plan was patterned after a popular British policy and it consisted of a fixed premium from which an amount equal to the amount that is needed to cover expenses and to fund a decreasing term policy. Any excess amount is then invested in equities, such equities being held in a UIT. Annual increases in the separate account that exceeds an assumed rate of return are used to purchase paid-up additions on an annual basis. In the years when the earnings in the separate account exceeds the assumed interest return, paid-up additional are purchased, with the result that the death benefit increases in value as these paid-up additions are added to the guaranteed face amount. However, if earnings in any policy year are less than the assumed interest return, some of the paid-up additions are surrendered and their cash value is used to make up for the deficiency in the interest.
The New York Life plan does not use the paid-up additions method used by Equitable, but its policy determines changes in the variable death benefit are determined by an actuarial computation that uses the relation of the cash value to the separate account’s performance. This is the basis of most Variable life products today—any change in the cash value of the policy (increase or decrease) has a direct impact on the amount of the death benefit.
Since these policies were introduced, there have been a lot of Variable life design changes, primarily the expanding the type and number of separate account options available to the policy owners. One of the more recent changes has been the option of allowing policyowners to direct their premiums into an account where the investment decisions are made by a professional money manager.
There is very little difference between Variable life insurance and traditional whole life insurance in respect to how they function. Both of them are permanent policies and both have a stated face amount consisting of the net amount at risk (NAR) and the cash value of the policy. The policies mature usually at age 100, but the IRS’s definition of life insurance states that policies may not mature or endow earlier than age 95, so many companies do not use age 95.
Both policies have a cash value loan provision and the contract owners can borrow from the cash value (unless the policy is a modified endowment contract as described below), and do so with favorable tax ramifications. Variable life does limit the amount of the loan to an amount less than the cash value, ranging from 75% to 90% of the cash value.
Like traditional life insurance, the policyowner has access to the cash value by way of the policy loan but a policy loan affects the earnings on the cash value. The policyowner accrues indebtedness at the interest rate as stated in the policy, which is the yield that is applicable to the assets that are proportional to the cash value offset by the outstanding loan, so when the policy loan interest rate is lower than the investment earnings on the portfolio, the insurer has a lower effective investment return. The only time that an insurer can have a financial gain from policy loans is when the policy loan interest rate is more than that earned by the portfolio backing the policies.
Policy loans can be repaid in part or in full at any time, but there is no requirement that the loan be repaid in cash at any time during the policy period, but any portion of the loan not repaid will have compounding interest. Just like traditional insurance, when the outstanding loan plus accrued interest is equal to the remaining cash value, the net cash value becomes “zero” and the policy is terminated.
In discussing loans from contracts, this would be an opportune time to discuss TAMRA and regulations regarding “modified endowment contracts.”
Congress enacted the Technical and Miscellaneous Revenue Act of 1988, commonly referred to as “TAMRA,” and which revised the definition of a “life insurance contract” for tax purposes. One of the principal purposes of this act was to discourage the sale and purchase of life insurance for investment purposes or as a tax shelter, and by doing so; they created a new class of insurance, known as modified endowment contracts or MECs.
Life insurance has traditionally had a very favorable tax treatment, but if the policies do not meet the qualifications set forth in TAMRA, then the policyowners will not receive this favorable tax treatment.
Basically, if the policyowner makes a loan or withdrawal from the policy, the amount that is loaned or withdrawn will be taxed first as ordinary income and then as return of premium – if there is a gain of more than premiums paid. In addition, there is a 10% penalty tax imposed on this amount if the policyowner is less than 59 ½ years old.
So as not to be classified as an MEC, the policy must meet the “7-pay test” (discussed in detail later). Briefly, this states that if the total amount paid into a life insurance contract by the policyowner during its early years, exceeds the sum of the net level premiums that would have been payable to provide paid-up future benefits in seven years, then the policy is an MEC—and it can be an MEC at any time during the first 7 years—and it will remain an MEC during the duration of the policy.
Sound complicated? It is! Therefore, the determination as to whether a policy is an MEC is the responsibility of the insurance company and its actuaries.
The potential for abuse or misuse particularly exists with single-pay life insurance policies, limited pay policies and Universal Life policies, especially since many consumers purchase these policies for tax benefits instead of protection. Therefore, insurance companies and their producers must be aware of this law and its implications.
Even though the modified endowment contract loses, some of the tax advantages of a life insurance policy, it still retains the death benefit and in certain situations, this can be worked to the policyowners advantage.
If the problem for the policyowner is Estate planning, a VUL MEC can be used to an advantage as the policyowner can pay one (or several) large (usually very large) premiums and then later contribute more premiums should the policyowner find it helpful or if the need should arise. The policy still has the security-based growth, and when the policyowner dies, the funds go directly to the beneficiaries without going through probate first. The VUL becomes a valuable planning tool!
However, no one should ever recommend such a plan without discussing the tax consequences to the prospect and if there is the slightest indication that the prospect does not completely understand the situation, it is imperative that they consult a tax professional.
Both require that premium payments of a specified amount on a scheduled basis be made, otherwise the policy may lapse. Note: Universal Life does not have a specified premium amount or schedule of payment.
Most of the standard provisions are the same, such as the 2-year incontestability clause, exclusion for suicide and cash value nonforfeiture options.
Here is a difference—Variable life insurance has a guaranteed face amount, however it may fluctuate above the amount guaranteed, whereas the traditional whole life policy has a guaranteed level face amount.
While both types of plans have cash values, the traditional whole life has guaranteed cash values, variable insurance does not have any guarantee. This is the main difference in the policies.
Policy premiums under variable insurance contracts are often subject to an administrative charge with the balance of the premium going into the cash value account.
With Variable life insurance, the premiums are invested in separate or subaccount(s) and can be identified as the investment or “property” of the contract owner, while traditional whole life insurance requires that the premiums be invested in the general account of the insurance company, and thereby losing it’s identity with the policyowner.
With both plans, however, the insurer’s liability reserves are maintained in the general account of the insurer.
At the risk of being redundant, the big difference is the method by which the cash value is determined. As explained earlier, the assets that make up the investments of the Variable life and other variable products, are kept separate—segregated—from the other general accounts and other assets, and are managed in separate accounts. This way the performance of the invested assets is passed on to the contract owners. Neither the interest rate nor the cash values are guaranteed with variable products.
This means that the cash value of a variable contract directly affects the death benefit and the ability of the policy to deliver “living” benefits in the form of surrenders or loans. To be succinct, a variable contract allows the contract owner to enjoy both insurance protection and investment opportunity.
STUDY QUESTIONS
1. The investment risk in a variable policy or deferred annuity is transferred from the cash value/annuity accumulation by means of
A. the separate account.
B. mutual funds.
C. direct transfer from the insurer’s general accounts.
D. certified check.
2. One of the advantages of the account being separate is
A. the insurer has total control of the assets.
B. there is a commission paid on the securities transaction that is more than the insurance commission.
C. the assets never go down, they always increase.
D. that they are protected from claims of creditors.
3. A entity that operates like a holding company with the investors as its client is
A. a management company.
B. a Unit Investment Trust.
C. a separate account.
D. an insurance company.
4. When an insurer offers a single separate account, typically
A. they may also offer a maximum of two subaccounts.
B. they may offer as many as 58 subaccounts.
C. they are not allowed to offer “subaccounts.”
D. they may offer as many as 6 or more subaccounts.
5. Each variable contract purchases units
A. that represent an undivided interest in the separate account assets.
B. which are basically death benefit net amount at risk for the face amount.
C. of stockholder’s shares in various industrial corporations listed on the Exchange.
D. of a special fund consisting of premiums paid by the insured which never vary.
6. Any agent who wants to sell securities, which include variable contracts
A. must first be registered with the NASD and obtain a series 6 or 7 registration.
B. must establish a separate corporation or LLC for securities sales.
C. must first contract with a major securities dealer and void his insurance license.
D. must take a minimum of 30 hours of classroom education in securities, plus obtain a professional designation from the American College.
7. It is very important that a representative marketing variable products understand what the consumer’s objectives are and that they understand the degrees of risk; this is called
A. client interrogation.
B. client preparation.
C. risk tolerance.
D. consumer orientation.
8. The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) discourages the sale of life insurance for investment purposes or as a tax shelter, and by doing so they created a new class of insurance,
A. Modified Endowment Contracts.
B. Single Premium Variable Life Insurance.
C. Special Variable Contracts.
D. ERISA contracts.
9. If a VUL MEC is used for estate planning, one of the advantages would be
A. the VUL MEC has the full tax advantages of any other life insurance policy.
B. the commissions are much higher for a VUL MEC, than just for a VUL.
C. the VUL MEC would then have a guaranteed level death benefit.
D. the funds in the plan after the death of the policyholder, goes directly to the beneficiary without having to go through probate.
10. Another difference between Variable Universal Life and Whole Life policies, is
A. a security dealers license is necessary to market whole life, but not VUL.
B. VUL has a 1-year incontestability clause, whole life has 2-years.
C. VUL has a guaranteed face amount, whole life has a flexible face amount.
D. Whole Life plans have guaranteed cash values, VUL does not have any such guarantee.
ANSWERS TO STUDY QUESTIONS
1A 2D 3B 4D 5A 6A 7C 8A 9D 10D