CHAPTER FIVE - INTEREST SENSITIVE LIFE INSURANCE

 

This chapter could just as easily be called “new products”, as interest sensitive products are relatively new.  As used in this text, interest sensitive life insurance (there are also interest-sensitive annuities, such as equity indexed annuities) is a newer generation of life insurance policies that are credited with interest currently being earned by insurance companies on these policies.

 

VARIABLE LIFE INSURANCE

 

 

The portfolio typically is a group of mutual funds established by the insurer as a separate account, with the policyowner given some investment discretion in choosing the mix of assets among such investment vehicles as common stock fund, bond fund, &/or a money market fund.  Variable life insurance offers fixed premiums and a minimum death benefit.  The better the total return on the investment portfolio, the higher the death benefit or surrender value of the variable life insurance policy.

 

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.

 

VLI was “invented” primarily to offset the effects of inflation and high interest rates on life insurance. Historically, the stock market tends to increase (when it does increase) at a rate higher than inflation; therefore these plans should provide an excellent hedge against inflation.  However, for short term investment results, sometimes inflation goes one way and the performance of investments go the other.

 

VLI has been slow to develop for several reasons, including the following:

• The policy must be registered as a security under the Securities Act of 1933.
• The agent selling it, therefore, must be registered under the SEC Act of 1934, and must pass the National Association of Security Dealers (NASD) Series Six Examination to have a license to sell it.
• Many agents have been uncomfortable selling securities, having been used to products with guarantees.

 

 

NOTE:  These topics are discussed in more detail in the section on Variable Universal Life.

 

In December 1976, the SEC introduced Rule 6E-2 which provided some exceptions from the Investment Company Act of 1940, that provided impetus for this product’s acceptance.  This rule requires that insurance companies provide an accounting to contract holders, imposes limitations on sales charges, and required that insurers offer refunds of exchanges to variable-life purchasers under certain circumstances.  Policyowners must also be given the opportunity of returning to a whole-life policy.

 

The principal part of Rule 6E-2 is that it defines VLI as a policy in which the insurance element is predominant.  Cash values are funded by separate accounts of a life insurer (not mingled with other funds held by the company).  Perhaps more importantly, the death benefits and cash value vary to reflect the investment experience.  But the policy has to have a minimum, guaranteed, death benefit, and the mortality and expense risks are borne by the insurer.

 

The policy itself is structured like a whole life policy inasmuch as there is a stated face amount at a stated age, and this face amount requires stated level premium amount.  The “variable” element is the cash value, and it rises and falls depending upon the investment results of the investment fund pertaining to that particular VLI policy.  There is no guaranteed minimum for the funds, however the fixed premium VLI policies guarantee that the face amount will not go below the face amount shown on the policy at time of issue, and the level premium is required to keep the policy in force.

 

While the original VLI policies had only a money market account and a common stock available for the investment vehicles, there are more choices today.  If the investment account(s) are positive, then the face amount of the policy is adjusted upward at the anniversary date.  However, if the account(s) are negative, the death benefit will decrease but never less than the face amount stated on the policy. 

 

Investment results of a VLI policy is affected by borrowing.  If a policy loan is taken, the equity of the underlying investment accounts is collateralized and the insurance company moves an account which is equal to the borrowed amount, from the investment account to a “loan guarantee account” which is not subject to market fluctuations.  The fund will earn less (usually 1% or 2%) than the interest charged the policyowner on the loan.  This loan guarantee account will contain these funds until the loan is repaid.

 

VLI provides against “inflation” by guaranteeing that the face amount of the policy will never be less than the stated face amount on the policy, regardless of the fluctuations of the investment account, as long as the premiums are paid.

 

 

MARKET SHARE OF VLI

 

Prior to 1998, only 3 companies sold VLI products and represented only 1% of the life insurance sold.  By 1981, there were 10 companies selling VLI and market share increased to 2.5% of the ordinary life premium.  Even though the growth of VLI was inhibited by large development costs to the insurance companies, and in particular the licensing requirements for agents and their discomfort with mutual funds products (many agents felt disloyal to the life insurance industry by marketing securities products), VLI products accounted for 6% of the market in 1991, and approximately 15% in 1993.  The Equitable reported that it has a historical net rate of return on its common stock account of over 14% per year for the over 20 years it has marketed VLI products.

ADVANTAGE OF VLI

 

The key advantage of VLI is that the contract holder has the ability to direct his/her account value to the investment that they choose, limited only by the number of investment accounts.  While VLI started with just two investment choices, they now have many choices, such as aggressive stock account, balanced funds, global funds, bond funds, high-yield bond funds, guaranteed interest accounts, zero-coupon accounts and real estate investment accounts. 

 

VLI has suffered higher expenses with the first types of VLI offered, however they have offered the highest net return available from a life insurance policy from 1976 to 1994 when invested in common stock funds

 

The policy must be sold with a prospectus which divulges more information to the prospective purchaser than provided by other traditional insurance policies or by companies marketing traditional products.

 

When VLI operates correctly, the policyowner will have life insurance protection, a “family” of mutual funds for investment purposes, and the ability to direct the investments within those funds, and there is no income tax liability as funds are moved within the contract.  The policy shelters interest, dividends and capital gains from current income taxation.  Plus:

 

 

The principal disadvantage to many people of the VLI is that once the VLI has been purchased, the policyowner may not increase or decrease the premium, as it is designed be a level premium policy.  Conversely, this can be an advantage as it is a method of “forced savings” and many people who purchase universal life policies with the flexible premium frequently use the flexibility as an excuse not to invest, with lapses as a result.

 

The amount of life insurance is fixed at its minimum level as of the date of the purchase of the policy.  If a policy lapses it may be reinstated as with other life insurance policies, with one exception:  past-due premiums collected must not be less than 110% of the increase in cash value which is then immediately available after reinstatement.  This is necessary as the reinstated policy contains values that assumed the policy had never lapsed, so the additional premium would reflect an increase in the investment account during the lapse period.

 

Policy loans are available for the amount which equals 75% or more of the cash value at a stated interest or variable interest, rate.

 

VLI policies are riskier to the policyowners than the traditional life insurance policies, and therefore are subject to more laws, rules and regulations and require more disclosure to the policyowner.  If a person’s financial planning program is built around a highly liquid and still nearly risk-free plan, VLI is a poor substitute to traditional life insurance.

 

UNIVERSAL LIFE

 

Historically, Universal Life (UL) was first mentioned as a concept in 1946 and then later in 1964 in actuarial articles in industry publications.  Regardless of its actuarial origin, the first published concept of the modern UL was presented at a conference in 1975.  The following year, a small company in Atlanta offered the first UL policy, but because of adverse tax problems, it discontinued sales.  In 1979, E.F. Hutton Life (then Life of California) offered UL, and while it was welcomed with open arms by many, others loudly and continually voiced opinions that it was (1) bad for the companies because it made them into nothing but “banks,” (2) it was not good for the consumers as it was too difficult to understand, plus a multitude of other reasons, and (3) it was not good for the agent as the commissions were going to be lower and they were going to have to be under dual regulation (insurance and SEC). 

 

As they say, “timing is everything.”  During the early 1980’s interest rates on newly invested funds were higher, much higher in many cases, that those earned on established investment portfolios.  This gave UL a head-start on the traditional cash-value products with their interest rates of 3 –3 ½ %.  However, what goes up, must come down, and when interest rates declined, so did the popularity of UL.

 

Universal Life policies offer flexibility:  flexible premium payments and adjustable death benefits.  After the first (minimum) payment, the policyowner can pay whatever they wish into the policy, and at whatever time they wish, and in some cases, can skip paying altogether if the cash value can cover the premium charges.  And to top it all off, the policyowner can adjust the death benefit with very little difficulty (with one caveat: if the death benefit increases, the insurer may ask for evidence of insurability).

 

As happens so frequently, companies geared up for the expected bonanza of increased sales and premium income.  But, again typically, many companies believed that since this product “sold itself” and there was so much administrative cost (many projections and other required consumer information) that the agents should be able to live with lower commissions, especially since they would be selling so many policies. 

 

The agents did not share the production hysteria of so many companies at that time and commissions were not dropped as much as the companies expected.  Administrative expenses were higher than anticipated by many companies.

 

As mentioned earlier in this text, UL policies are “transparent” since the policyowner can see exactly how the funds are distributed.  They are furnished with many illustrations and examples of the fund distribution and expected returns, and while the policyowner cannot evaluate the adequacy of many of the assumptions, they certainly can see where the money goes.

 

 

The movement of funds in UL follows the following schedule (Note that the term “policy period” is used, instead of typical mode of payments, such as monthly, quarter, annual, etc.  The reason is that this is a flexible contract and the premium paying period does not have to be a predetermined time period):

 

• The policyowner pays a minimum premium to the company.
• The company subtracts expense charges for the first policy period.  (This is called “front-end loading” and some UL policies do not have this charge at this time.)
• The company then subtracts the mortality charge on the insured’s age and the policy’s net amount at risk.  Premiums for any supplemental benefits (Accidental Death, etc.) are also subtracted.
• The remaining amount is the initial cash value of the policy.
• The cash value is credited with interest, which then becomes the end-of-period cash value. 
• UL policies generally have high surrender charges.  The cash value less the charge is the cash surrender value.
• The second policy period (usually this is a month) starts with the previous cash value.  The policyowner may (or may not) add additional premium at this time.  If the previous period’s cash value is sufficient to cover the mortality and expenses charges (current) then no premium is necessary.  However, if it is not sufficient, the policy lapses unless additional premiums are paid. 
• For the second policy period, the cash value at the end of the first period is increased by any premium payment, and then reduced by the expense and mortality charge, increased again by interest at the current rate.

This process continues until the policy lapses or surrenders.

DEATH BENEFITS

 

An Adjustable Death Benefit

When traditional types of life insurance are written with a certain death benefit (such as $100,000)-that face amount of the policy remains in effect as long as the policyowner pays the premium, but if no premium is paid, the insurance can terminate.  One important feature of universal life policies is that the death benefit is adjustable-it could be $100,000 at the beginning of the policy period, but it might drop down to $50,000 at some point and later rise to $175,000.  Within certain limitations, the policyowner controls these adjustments.

 

With this adjustment feature, no new policy is needed to reflect the different amount of insurance; the adjustments are made to the existing policy.  When the policyowner increases the death benefit, some insurers require proof that the insured person is still insurable-in good enough health to meet the insurer's standards.

 

Death Benefit Options:

At the onset of a universal life policy, the policyowner chooses one of two death benefit options:

OPTION A

 

The first choice, Option A, provides a level death benefit similar to traditional life insurance policies.  This level benefit is stated in the policy, but the insured still has the option to increase it or decrease it during the policy period.

 

When the death benefit is selected, the premium is determined, with part of it destined to pay for the insurance coverage (the death benefit) and part to be deposited into the cash value account to earn interest. The policyowner pays this same premium regardless of whether the death benefit is increased or decreased during the policy period. (An exception is when the policyowner exercises the premium-paying flexibility of universal life, discussed later.)  Thus, the policy provides a level death benefit and a cash value account that accumulates interest.

 

It is important to differentiate between the death benefit-the insurance protection-and the cash value.  For a universal life policy to receive the special Internal Revenue Code (IRC) tax considerations that apply to insurance policies, there must always be an amount at risk until the insured reaches age 95.  (To reiterate, the amount at risk refers to the amount for which the insurer is at risk, and is the difference between the face amount [death benefit] of the policy and its cash value.  If a policy with a $100,000 death benefit had cash values of $20,000, the amount at risk would be $80,000.)

 

As the policyowner continues to pay premiums, the cash value increases while the amount at risk for the insurer decreases.  In times when earnings are high, it would be possible for the cash value and the amount at risk to be nearly the same.

 

If the cash value begins to approach the amount of insurance, the death benefit must be raised.  The Internal Revenue Code dictates a certain minimum amount at risk that must be maintained in order for the policy to continue to be treated as life insurance and not as an "investment.”  This minimum amount is often referred to as the tax corridor or the risk corridor.

 

 

OPTION B

 

The second death benefit choice, Option B, provides for an ever-increasing death benefit that is made up not only of the amount of insurance, but also the amount of the cash value account.  For example, if the original death benefit (at the onset of the policy) is $100,000 and the cash value is $45,000; when the insured dies, the beneficiary of the policy will receive a $145,000 death benefit.

 

The insured's death at any point results in a death benefit equal to the $100,000 insurance (on this example policy) plus whatever the cash value is at the time of death.

 

Because it is known from the beginning that the death benefit will increase, the premiums for Option B would be greater than for Option A so as to pay for the increasing amount of insurance protection.  An individual could choose to pay the same premium for an Option B type of policy as for an Option A type policy, but the cash values would grow at a reduced rate.

 

 

THE CASH VALUE ACCOUNT

 

CHARGES TO THE ACCOUNT

 

The Insurance Premium: Of each premium paid, a portion pays for the life insurance protection.  This amount, based upon mortality rates for the particular individual, is typically taken as an adjustment to the cash value account once a month.  Then, as previously discussed, another portion goes to the cash value account to draw interest.

 

Loading:  Not all of the remaining payment draws interest, however, because sales and administrative expenses must be paid.  This charge is called a  “load” or “loading.”

Expenses may be deducted as front-end loads or back-end loads.  In a front-end loaded policy, the insurer deducts a certain percentage from each premium payment before crediting it to the cash value account as discussed above.  If the load is 6%, and the premium payment is $1,000, $60 would be deducted, leaving $940 for the cash value account.

 

Recent universal life policies are more often back-end loaded, which means the entire premium payment is deposited into the cash value account.  The back-end loading comes into play if and when the policyowner performs certain transactions in the cash value account, such as surrendering the policy for its cash value.  The advantage of back-end loaded policies is that the cash value account has more money to earn interest in the early years.  The disadvantage is that some back-end loads are quite high.

 

Some insurers offer the equivalent of a no-load arrangement, whereby the insurance company takes a percentage of current earnings, similar to no-load mutual funds.

 

Other Charges: Insurers may also charge a flat fee to cover the cost of maintaining and servicing the policy.  This may be an annual fee or a monthly fee.  Some insurers have first year charges that apply in addition to all other policy charges.  After the first year the policy is in force, these charges no longer apply.  As examples, first year charges may be:

 

• Up to one dollar per thousand dollars of insurance coverage.
• No excess interest paid on the first $1,000 cash value, which in effect is a charge because that interest is lost to the policyowner.
• A flat monthly fee paid in addition to any other policy charges.

 

Insurers provide the universal life policyowner with an annual statement that shows exactly what transactions occurred and what charges were assessed during the year.

 

SINGLE PREMIUM UNIVERSAL LIFE

 

Like whole life policies, universal life insurance may be purchased with a single premium paid at the policy's inception.  The benefits of paying a single large premium are the same as those for whole life and could be magnified as the result of the current interest rate paid on universal life cash values.  Of course, all of the cautions about maintaining the risk corridor in a universal life policy must be observed.

 

THE ADJUSTABLE PREMIUM

 

Most universal life policies are purchased not with a single premium, but with periodic payments spread over a number of years.  At the risk of being repetitive, it is important to remember that whereas traditional life insurance policies have a fixed level premium, payable on a regular schedule, universal life offers an adjustable or flexible premium.  This feature permits the policyowner to raise, lower and even skip premiums.  However, lowering or skipping premiums is possible only if enough cash value has accumulated to pay for the pure insurance costs and any administrative charges.  If the cash value is not adequate, a payment must be made to keep the insurance in force.

 

THE IMPORTANCE OF PREMIUM FLEXIBILITY

 

When a universal life policy goes into effect, a minimum level premium payment is established.  For the policy to have any cash value, obviously, some premiums must be paid.  As stated earlier, once the cash value grows adequately, this amount can be used to keep the insurance protection in force whether or not the policyowner pays additional premiums. 

 

As an illustration of the importance of flexible premiums, assume an individual purchased a universal life policy with a death benefit of $200,000 with an annual premium of $1,000 and several years later, the cash value grew to $15,000.  At this point, the policyowner's first child enters college and the policyowner wants to skip the annual premium on the policy.  The policyowner can do so because there is adequate cash value to pay for the insurance protection.  (See the illustration on the next page.)

 

The policyowner could continue to skip payments for several years while the cash value account takes care of the insurance protection, or the policyowner could make reduced premium payments.  Of course, at some point, the cash value used to pay for the insurance protection could dwindle to the point that no additional funds would be available for insurance protection.  At that point, the policyowner must make a payment or the insurance lapses-there is no more coverage.  In addition, since the cash value account was reduced during the years, no premium payments are made, the policyowner could not rely upon those funds to be available for other purposes.

INCREASING THE PREMIUM PAYMENT

 

If the insured’s financial condition, in the above example improves, and the policyowner wants to rebuild the cash value account.  Although the original insurance (minimum) premium was $1,000, the policyowner elects to pay $1,500annually.  By increasing the premium payments, the policyowner benefitsbecause the cost of insurance protection remains the same, as the additional paid premium goes to the cash value account to earn interest (Assuming they have not increased the death benefit.)  But remember, the so-called risk corridor-the IRS-dictated minimum of insurance protection to cash value-must be maintained in order for the cash value account to continue receiving favorable tax treatment.  At any time, the policyowner can revert to the original premium payment amount or again stop paying premiums entirely.

 

An Illustration of Adjustable Premium and Death Benefit illustrates one of many ways a universal life policyowner could adjust the premium and the death benefit over many years.  Notice each adjustment can be made independent of the other; that is, the premium can be changed without affecting a death benefit and vice versa, as long as the cash value account is adequate to make the desired adjustment.  A summary of the transactions follows the illustration.

 

 

 

At age 30, the insured purchases a universal life death benefit of $100,000 for a $500 annual premium.  This coincides with the birth of a child.  At $500per year, the cash value grows moderately.  When the insured is age 33, the policyowner receives a $1,000 windfall, which is deposited into the cash value account with the usual premium.  At age 36 the policyowner withdraws $500, but continues to make level $500payments and the death benefit remains at $100,000.

 

At age 40, the insured increases the death benefit to $150,000and begins making $900 premium payments.  At age 42, the insured skips one premium payment, then resumes paying at age 43.  At age 44, the policyowner increases the premium payment to $1,500 per year, retaining the $150,000 death benefit.

 

At the insured's age 48, the child enters college.  The insured withdraws $4,000 that year and the next year, while continuing premium payments.  At ages 50 and 51, the policyowner withdraws $4,500 each year.  At 52, after the child graduates from college the insured continues paying premiums and keeps the $150,000 death benefit, making no further withdrawals.  At age 55, the insured lowers the premium payment in anticipation of retirement and drops the death benefit to $100,000.  At age 60, the insured makes no more premium payments, and lowers the death benefit to $50,000.  At that time, the cash value is sufficient so that no further premiums are required.

 

 

USES FOR THE CASH VALUE ACCOUNT

 

Withdrawals: Universal life policyowners are permitted to make withdrawals from the cash value account.  Withdrawals of only a portion of the cash value (rather than all of it) are sometimes called partial surrenders because the policyowner is surrendering or giving up part of the policy.  The withdrawal is made from the cash value account, so that portion of the cash value is surrendered.  Most universal life policies also reduce the death benefit by the amount of the withdrawal.

 

Withdrawal Charges: While this illustration shows the cash value account reduced to $3,000, in reality it would be reduced even more because of fees charged for the withdrawal.  When a policy is back-end loaded, this is one of the situations where the expense loading applies.  Front-end loaded and no-load policies are also likely to assess a charge for withdrawals.

 

Taxation on Withdrawals: Policyowners who make partial withdrawals from cash value accounts may or may not have to pay taxes on the withdrawal, depending upon the circumstances.  For policies at least 15 years old, the portion withdrawn is not taxed unless it is greater than the amount the policyowner has put into the policy.  For example, if premiums paid total $20,000 and the policyowner takes out $20,000, there is no tax due since $20,000 represents a return of capital on which the policyowner has already paid taxes.  If the same policyowner withdraws $21,000, however, taxes are due on the $1,000, which is considered interest.

 

Policies that have not yet been in force 15 years when a partial withdrawal is made, are subject to more complex rules dealing with the specific age of the policy, how much has been paid into the policy and the amount of the withdrawal.

 

Paying and Receiving Interest: Because a withdrawal is not the same as a loan, the amount withdrawn does not have to be repaid, nor is any interest charged the policyowner for using the withdrawn sum.  From the insurance company's viewpoint, withdrawal is simply a return of the policyowner's money.  Since the money is no longer in the policy's cash value account; no interest is earned on the amount withdrawn.

 

Repaying Partial Withdrawals: The policyowner is permitted to return the amount withdrawn to the universal life cash value, but repayment does not restore the death benefit to it’s original level.  The insurance company might permit the policyowner to restore the original death benefit, but usually will require proof that the insured is still in good health and insurable.

 

In addition, whether or not the death benefit is restored, repayment of the withdrawal is considered to be a premium payment and is subject to whatever the insurer normally charges.

 

Costs of Withdrawing and Repaying

At first glance, partial withdrawals from a universal life policy might seem immensely preferable to borrowing money-whether from an outside lending institution or from the policy itself-since no interest is charged and the policyowner can return the money to the policy later.  However, careful consideration should be given to the actual costs of a withdrawal that will be repaid to the cash value account:

• Fee paid to the insurer at withdrawal. 

• Reduction of the death benefit (cost to the survivors).

• Loss of interest on the money while withdrawn.

• Charges assessed by the insurer when the amount is returned to the cash value account.

 

Even apart from the reduction in the death benefit, the other costs can be considerably higher in the long run than a loan.

 

 

 

 

 

 

 

In many cases, it will, indeed, be worthwhile from the policyowner's point of view to make partial withdrawals.  But policyowners need to be well informed about the cost of this decision.

 

Total Withdrawals

Universal life policyowners also may withdraw all of the cash value.  However, as stated earlier, payment for the insurance protection is periodically taken from the cash value account.  If the entire amount is withdrawn, no money is available to continue the insurance coverage.  Therefore, the policyowner must make another premium payment to keep the insurance in force.  Insurers are required to notify policyowners if the insurance protection becomes endangered.

 

Some insurers charge a penalty if the policyowner removes all of the cash values in the early years of the policy.  This typically involves taking back all or part of the excess interest earned during the previous 12 months.

 

Policy Loans

Like other cash value life insurance, UL policies allow policy loans up to the cash value amount.  Unlike a withdrawal, a loan is expected to be paid back and the policyowner pays interest, typically at a low rate relative to interest rates in the marketplace.  While fixed interest rates are common, some insurers offer loans at variable rates, just as other lenders.  The rates to be charged are printed in the policy.  

 

For cash values in the account that are drawing interest, insurers sometimes pay a lower rate on the amount borrowed against than on the amount not borrowed.  For example, assume there is $10,000 in the cash value account.  The policyowner borrows $6,000.  The insurer might pay only its guarantee interest rate of 4% on the $6,000 borrowed, but continue paying the current interest rate (guaranteed interest rate plus excess rate) of 8% on the remaining $4,000.

 

Other insurers may treat a UL loan as a so-called wash loan because the interest rate the borrower pays and the interest rate the insurer pays on the cash value are the same, so each rate "washes out" or equalizes the other.

 

For example suppose the current rate the insurer is paying on the cash value account is 7% and the policy loan rate 6%.  With a wash loan, the 7% rate would be reduced to 6% to match the loan rate.

VARIABLE UNIVERSAL LIFE

 

Variable Universal Life (VUL) is discussed in a little more detail than other types of policies because it is the most versatile of the life insurance products and is very popular.  VUL is a policy that has the premium flexibility and policy adjustment features of universal life with the investment options of variable life, which helps to explain why this policy is so popular.

 

From the viewpoint of a “contract,” a VUL policy is Universal Life as flexible premiums, death benefit options (A and B) and the other standard provisions of a UL policy are present in a VUL policy.  There is really only one big difference, and that is that of the variable nature of the account value of the policy.  UL account values are gathered in the insurance company’s general account and then credited with a guaranteed rate of return, or a higher value if justified by the interest rates of the insurer.  VUL policyowners can place their cash value in any of a wide variety of separate accounts or subaccounts – including a fixed interest guarantee from the company’s general account.  (At this point there would be no difference between a VUL and a UL policy, except that they could later change the investment option to a separate account.)  The accounting for the separate account unit value is the same as with variable life.

FEATURES OF THE VARIABLE UNIVERSAL LIFE POLICY

 

Even though the features and the benefits are the same as with UL policies, with the flexibility of VLI in premiums, since it is now a “mixture” of the two policies, various features and benefits should be considered.

 

As with any whole life plan, VUL policies provide lifetime insurance protection.

 

1. For tax purposes, VUL is a type of life insurance, therefore net premiums go into separate accounts where they earn a current rate of return, and earning accumulate on the same tax-advantaged basis as cash values of more traditional whole life policies.  Note, however, that if the death benefit is to be increased, the policyowner can pay additional premiums, but if the amount is above a certain amount, evidence of insurability may be required or the policy may become a modified endowment contract and lose its tax-advantaged basis.  (A discussion of modified endowment contracts [MECs] appears after the discussion of features.)
2. Separate accounts are accounts into which the policyowner’s funds are invested and are called “separate” because they are separate from the company’s funds.  These funds earn a variable return.  As with mutual funds, these funds provide returns or losses based upon the performance of the separate accounts, and they are NOT guaranteed by the insurer and the returns on the separate accounts are NOT guaranteed.
3. Policyowners can transfer funds from one account to other accounts, and to do so without charge.  The number of transfers are established by the contract, and usually are between 4 and 12 a year. 
4. VUL policies offer a multitude of account choices, often 10 or more, including a wide variety of stock accounts, multiple bond funds, managed funds and asset allocation funds.
5. The cash value in a VUL policy is constructed of premiums paid, less fees charged, less periodic deductions for the cost of insurance, plus (or minus) returns generated by the individual policyowner’s accounts.  Obviously, cash values are not guaranteed by the insurer and neither the insurer or the policyowner (or the agent) can accurately predict future earnings.
6. Death benefits are the same as with Universal Life – Option A or Option B.  While the insurers do not guarantee death benefits, many of the newer policies offer some protection against falling death benefits; some guarantee the death benefit to age 65.  Other companies offer guaranteed death benefit riders (with an additional, but quite modest, charge), and this will guarantee that the policy will remain in force even if the cash value is zero.
7. The expenses and charges of a VUL are “transparent” (or “unbundled” as some say) and take many forms.  Most VUL policies have a system whereby deductions are taken from premiums as paid, and these deductions cover marketing costs, premium taxes and other expenses.  First year deductions are shown to cover the marketing costs, which are accumulated the first year.  Deductions are guaranteed not to exceed an amount stated in the policy, but can be lower.  VUL has a reputation of having high expenses charges when compared to UL or VLI and traditional policies, but recently policy expenses have decreased so it is more “cost-efficient.”
8. A policyowner must be given a prospectus (and a buyers guide in many states) at some stage while the policy is being discussed with the prospective policyowner.  The prospectus contains the specifics of the policy and the separate investment accounts and fees to be charged.  The policyowner also receives an annual report, which provides the latest status of all policy transactions, including cash values and deductions.
9. The VUL policy form contains most of the standard provisions and options available under traditional insurance policies, such as grace period, settlement options, policy loans, etc.

 

STANDARD PROVISIONS

 

While most of the standard provisions of the VUL are the same as those of other life insurance policies, there are three provisions that differ, two that are unique to VUL, and certain riders are available.

 

Grace Period

Since the VUL is an “unbundled” policy, there really is no connection between the payment of the premium and the continuation of the coverage, but whether the policy continues is a function of the cash value.  If the cash value is insufficient to maintain the cost of insurance, the policyowner will be so notified that a premium must be paid.  From that date – date of notification – the required premium to keep the policy in force must be paid within 61 days or the policy will lapse.  Full coverage remains in force during the 61 days.

 

Reinstatement

If a VUL policy should lapse, it may be reinstated at any time within a stated period of time (usually 2 years), subject to specified requirements and conditions:

1. An application for reinstatement must be sent to the company, signed by the policyowner.
2. The policy must not have been totally surrendered; i.e. it must not have been surrendered for its net cash surrender value.
3. The company may require evidence of insurability, and if so, it must be provided to the company.
4. Premiums which, with interest, are sufficient to keep the policy in force for a stipulated period of time (3 months usually).

Free-Look Provision

As required by law, after the policy is issued, the policyowner has a stipulated period of time (usually 10 days after receipt of the policy by the policyowner, or 45 days after the application has been signed) to return the policy to the insurer and receive a full refund of all premiums paid, no questions asked.  In some states, the refund will reflect earnings or losses in the cash value accounts, due to investment(s) performance, for the period of time that the money was in the control of the insurer.

 

Conversion Privilege

Unique to VUL policies, the VUL allows policyowners to exchange the VUL for a comparable non-variable plan, or they may transfer all values in the subaccounts of the VUL to the general and fixed account within 24 months after issue of the VUL.  The new policy, if the VUL is exchanged, will have the same effective date, same issue age and the same underwriting classification as the VUL.

 

Annual Report

At the time the policy is issued, it is impossible to project what the cash values will actually be because of the fluctuations of the investment accounts.  The SEC also requires “full-disclosure,” so for these reasons, the policyowner is sent an annual report that explains the current status of the policy, in full detail.  The annual report will contain the following information:

1. death benefit;
2. total cash value, by account and by percentage allocated to each account;
3. net cash surrender value;
4. total premiums that were paid since the previous report;
5. policy loans and interest charged on loans made during the previous year, if any;
6. partial surrenders made since the last report; and
7. the transfers of funds among the accounts.

 

Semiannual reports are also sent to the policyowner, which show the 6-month performance of the cash value accounts in which the funds of the policyowner has invested, and a complete listing of all investments in the policy.

 

Riders & Options Available

The same options that are available for Universal Life and some traditional products are generally available for VUL policies.  Following is a list of those that may be included:

1. Waiver of Premium in case of disability;
2. Cost of Living Riders (COLA) which may be either a rider or part of the policy and may or may not have a separate premium;
3. Accidental Death Benefit;
4. Accelerated Death Benefit;
5. Term insurance rider;
6. Family Insurance rider; and
7. Guaranteed Insurability Rider (GIR), or option, which allows the increasing of the specified amount on each option date, without evidence of insurability and at standard rates.

 

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. 

 

Using a MEC

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 of the IRS 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, then it is imperative that they consult a tax professional. 

 

 

 

 

TAXATION AND REGULATION

 

 

Even though it is regulated as a Security, it still retains its originality as a life insurance policy for taxation purposes. 

 

Obviously, premiums are not tax deductible.  Cash values accumulate free of current income taxes (but the legal guideline corridor ratio between cash value and death benefit must be maintained within the policy).

 

Death benefit proceeds are tax-free, and lump-sum benefits paid to a beneficiary are excluded from the beneficiary’s gross income for tax purposes.

 

Policy loans are viewed as a debt of the policyowner, and not as income or a taxable distribution.  Interest paid on a loan (for non-business purposes) is not tax deductible.  Also, if a policy fails the “7-pay test” it then becomes an “MEC” and loans and withdrawals are then subject to current income taxes plus a 10% penalty if the policyowner is under age 59 ½.  (See discussions of modified endowment contracts, MECs.)

 

In some cases, surrenders and withdrawals and the right to change death benefits options, can have tax consequences.  For instance, upon total surrender, any amount received by the policyowner that is in excess of the total premiums paid into the policy, is treated as ordinary income and is taxed as such.

 

In total, taxation of the VUL has created a very appealing product to many persons, particularly those who are in a higher tax bracket.  As an example, individual life insurance doubled from 1986 to 1996, but over the same period of time, variable life insurance (including VUL) grew from approximately $65 billion, to $591 billion.

 

In order for a VUL policy to meet the definition of an insurance contract and obtain the favorable tax treatment, there are three tests that must be met:

 

1. Cash Value Accumulation Test

 

When the cash value of a permanent life insurance policy exceeds the single premium that would pay for all future benefits, at that point the policy no longer meets the IRS definition of life insurance.  If a policy does not meet this cash value accumulation test, the policy is “disqualified,” with the disqualification retroactive to the policy issue date.  All income credited to that policy becomes taxable to the policyowner.

 

Since the insured or the insurance company’s producers do not have access to the mortality tables and the present value tables necessary to make this “test,” the insurance company’s home office will provide the necessary expertise to make sure that the policy meets the test and is considered as life insurance.

 

2. The Corridor Test

 

All VUL contracts contain a provision that defines the minimum of pure insurance protection in comparison to the cash value amount.  This minimum amount, technically guideline minimum sum insured, is the amount that is necessary to prevent the policy from violating the IRS Corridor rules.

 

To further make this complicated, the IRS considers the minimum sum insured by using a published ratio between the face amount of the policy and its cash value.  (See table below)  For example, for those under age 40, the death benefit must be 250 percent as great as the cash value at that age.  The ratio decreases each year, eventually reaching 100 percent around age 95, at which time it is said to “mature.”

 

In the previous discussion of Universal Life, the illustrations show how the face amount increases after the cash value grows to a certain point, and after that point, the “amount at risk” continues to grow, with the “corridor” between the cash value and the death benefit.  The reason for the corridor is that if a policy matures before age 95, under the IRS Code it is no longer considered as life insurance.  So, in order to maintain this ratio, insurance companies reserve the right to refuse additional payments of premium if they would cause the cash value to increase beyond the upper limits relative to the death benefit.  If the policy fails to meet the corridor test in any year, the policy is disqualified from inception and all income credited to that policy becomes taxable income to the policyowner.

 

3. The Seven-pay Test

 

Another test!  However, if a policy fails the 7-pay test, it still remains as a life insurance policy, even though it loses the tax advantages of policy loans and withdrawals.  This has been mentioned previously, during the discussion of MECs. 

 

Basically, the test considers that if the total amount a policyowner pays into a life insurance policy during its first years, exceeds the sum of the net level premiums that would have been payable to provide paid-up future benefits in 7 years, then the policy is a MEC.  Once a policy is an MEC, it will always be an MEC.  And, to repeat the earlier discussion of MECs, if the policyowner receives any amount from a loan or withdrawal, that amount is taxed first as ordinary income, then as return of premium.  Plus the 10% penalty if the policyowner is under age 59 ½.

 

One other point on taxation of VULs.  If interest accrues after a date of death because of a delay in settlement, the interest may be taxable.  If the interest-only settlement option is chosen, the tax exclusion does not apply, and it does not apply to any option selected by the beneficiary.

 

 

 

 

 

 

 

 

 

 

 

NASD CONDUCT RULES

 

An outline of the NASD Conduct Rules were indicated earlier.  At this point, it would be advantageous to discuss some of those rules in a little more detail, as they are very important to the marketing of Variable Universal Life.

 

1. Advertisements and all sales literature must not attempt to mislead investors, in any fashion or in any way, and must be filed with the proper department of the NASD.
2. Any discussions or communications with customers or potential customers regarding securities must be done in good faith, which means that there must not be any misleading information, omission of key information, exaggeration or other such guarantees, particular when comparing funds or accounts.
3. Any recommendation given must be reasonable, and if the representative has an interest in any security’s or product’s success, this interest must be fully disclosed.
4. The firm or the individual representative may not advertise in any other identity or name, or anonymously, and the firm must display their name prominently on all advertising and sales literature.
5. If the product’s name does not adequately identify it as a variable life insurance product, the representative must fully describe what the product is.  Further, an agent should never suggest that VUL policies or their separate accounts, are mutual funds.
6. As explained earlier, every prospect must be furnished a prospectus, either at the time of the first presentation, or mailed to the prospect in advance.
7. Under no circumstances should the agent suggest, or even imply that the any variable product, including VUL, is a “short-term” or “liquid” investment.
8. Obviously, the agent must be extremely careful about representing as to what is “guaranteed” and as to what is not, under a VUL or other variable product.
9. Even though separate accounts are, for the most part, patterned after mutual funds –  an agent must not represent or indicate that the separate accounts are mutual funds.  However, it is deemed proper to use the experience of a mutual fund invested in the same products as the separate account, so as to be shown what did occur with the mutual fund.

 

ILLUSTRATIONS

Because the variable products are rather complex and the outcomes are not readily and accurately forecast without considerable explanation and assumptions, it is extremely difficult to describe to the average consumer exactly how a VUL functions.  However, the life insurance industry has a checkered past in using illustrations as a sales tool, so the insurer’s representative or agent must be extremely careful and must always tell the prospect that all illustrations are hypothetical and based on assumptions, and are certainly not a guarantee of cash value accumulations.  A statement to the effect that the prospect understands that the illustrations are not guarantees, etc., are required to be signed by the prospect by some insurers as a precaution. 

 

Illustrations may use any combination of returns up to a maximum gross rate of 12 percent, but only if the present market conditions warrant such expectations and an illustration with a “0” return is also provided.  The major difficulty suffered by insurers today with existing blocks of Universal and other interest-sensitive life products is that the interest rates have declined recently, to levels beyond the comprehension of most people just a few years ago.  Many illustrations were shown with a return of a level 10% interest rate. 

 

All illustrations must show that separate account returns are what determines the cash values as well as the death benefits, and they must show maximum mortality and expense charges. 

 

It is NOT appropriate to compare one policy to another based on hypothetical performances.  Further, a hypothetical illustration can only show the relationship between the cash value and the death benefit value, not whether it is “better” than another policy.  Illustrations comparing VUL to the “buy term and invest the difference” strategy is considered as appropriate, provided that the hypothetical returns are identical and other such stipulations are met.

 

SPECIAL NASD CONDUCT RULES REGARDING VARIABLE CONTRACTS

 

Variable contracts have special rules as part of the NASD rules and they apply mostly to the construction of the policy and not specifically to agent’s conduct.

 

Obviously, when the values of a contract can change daily, it is necessary that the value must be determined at a specific time, in this case when the payments have been received - they are considered to have been received when the application has been received.  This further emphasizes that all applications and premiums must be submitted to the insurance company’s home office promptly.

 

A representative may not sell contracts through another broker-dealer unless the other broker-dealer is also a member of the NASD.  This also means that an agent cannot sell a product that his broker-dealer is not licensed to sell or does not have a valid sales agreement. 

 

Sales charges may not be excessive and the NASD Rules set forth what is considered as “excessive.”

 

When a sales charge has multiple payments, they cannot exceed 8.5% of the total payments due in the first 12 years of the contract or for total length if the contract length is less than 12 years.

 

If the contract has a single payment of the sales charge, the maximums are 8.5% of the first $25,000 (of the purchase payment); 7.5% of the next $25,000; and 6.5% for any amount over $50,000.

 

Section 2300 of the Conduct Rules addresses “suitability” which is the recommending of products for customers only when the product suits the customer’s needs.  This is addressed to some degree in the following section discussing the uses of VUL.

 

 

USES FOR VARIABLE UNIVERSAL LIFE INSURANCE

 

“Suitability” under the NASD Rules is a difficult prerequisite because of the changing economic climate in the U.S.  VUL can be “used” in many different ways and all the ways that it can be used, whether “suitable” or not for a particular situation, is beyond the scope of this text.  A few of the uses for VUL are addressed below.

 

1. A person does not need a variable insurance policy unless they need life insurance – obviously.  Therefore, those who have legitimate life insurance needs can usually benefit from VUL.  Those that choose VUL are generally those with above-average incomes.

 

1. VUL is an important vehicle for those who use insurance to build or transfer their estates.  Life insurance is the best vehicle for transferring wealth with fewer hurdles, and the VUL product allows them to transfer their business interests to family members or to business partners.

 

1. The VUL allows an insured to reduce (or skip) premiums when cash flow of the insured is reduced, and to channel excess dollars into the plan where earnings will be tax deferred.

 

1. For an executive bonus plans, the VUL allows more flexibility so that a bonus does not need to coincide with a fixed-premium schedule, and the employee can determine how much coverage they wish and how the cash value is to be invested. 

 

1. For buy-sell agreements, the potential of growing cash values and death benefits makes the VUL an attractive funding mechanism.  As the business value changes, so can the coverage without having to lapse or create a new policy.  Additional premium dollars can be put into the plan to help fund lifetime buyouts if desired.

 

1. For split-dollar plans, by using VUL, the premium can be reduced in the early years because of the creation of an immediate cash value.  And, when the employer receives values as repayment of cash-value matching-funds, these values can grow through investments that the employer selects.

 

1. VUL can also be used for deferred compensation.  It has the advantage of an above-average accumulation of funds which helps the employer to meet the promise to pay future benefits.  Since these agreements are generally renegotiated periodically, the coverage can be updated easily.

 

1. If a person has securities or securities-based accounts, the VUL offers stability, and if a person already has life insurance, it would probably be better for them to add a VUL policy to their insurance portfolio, instead of surrendering old policies. 

 

THE ATTRACTIVENESS OF VUL

 

Variable Universal Life has a variety of attractive features to consumers, but probably the most attractive feature is that of flexibility.  As any good financial planner can attest, few financial plans continue in a “straight line,” but fluctuate as circumstances change as they always do.  VUL gives the policyowner the ability to fluctuate or remain static, depending upon the situation.

 

1. VUL is also noteworthy because of its ability to compensate for financial difficulties, as the policyowner can skip or reduce premiums if things get “tight” financially, and there would be (usually) funds that would be available in case of an emergency.

 

1. Policyowners not only control the amount and frequency of premium payments, but they also determine how the net premiums and cash values will be invested

 

1. Americans are becoming more and more sophisticated investors and appreciate the value of professional fund management.  This professional fund management of the separate accounts is a very attractive feature, particularly if the individual has suffered through a period of making wrong choices in investments without professional guidance. 

 

1. When the overall financial and economic conditions change – as they have in early 2001 – the separate accounts can change to meet these changes as the policyowners will make their investment choices based upon their personal and present objectives and the current performance of the fund(s) that they choose, with the knowledge that they can change funds as the situation changes and can adjust to economic swings.

 

 

 

 

STUDY QUESTIONS

Chapter 5

1. An insurance policy that is actually a whole life policy that provides a return that is limited to a portfolio of securities, is

A. Universal life insurance.

B. Equity Indexed Annuity.

C. Variable life insurance.

2. A Variable life insurance policy

A. has fixed premiums and a minimum death benefit.

B. is a risk free investment.

C. is a combination of term insurance and a securities account.

 

3. The sale of one fund and purchase of another within a Variable life insurance policy is

A. a taxable event.

B. not a taxable event.

C. not permitted.

4. With a Universal life insurance policy

A. there are flexible premium payments.

B. has no guaranteed death benefit.

C. with adjustable death benefits, a new policy is needed to reflect the different amount of insurance.

5. Universal life insurance policies

A. usually are purchased with a single premium.

B. like traditional life insurance policies require a fixed level premium payment.

C. allows the policyowner to skip some premium payments.

6. Withdrawals from a Universal life insurance policy are

A. not permitted.

B. called partial surrenders.

C. do not effect the death benefit.

7. A withdrawal from a Universal life insurance policy

A. is treated the same or a loan from a traditional life policy.

B. does not have to be repaid.

C. can be repaid and the death benefit restored to it’s original level.

8. A total withdrawal of the cash value in a Universal life policy

A. may cause the policy to lapse.

B. cancels the death benefit of the policy.

C. can be accomplished without costs to the policyowner.

9. Variable Universal Life insurance policies

A. can be sold by any life insurance agent.

B. are flexible.

C. do not require a prospectus.

 

10. A Variable Universal life policy

A. can be exchanged for a comparable non-variable plan.

B. does not have “riders” available.

C. does not have a grace period because there is no connection between the payment of premium and the continuation of coverage.

11. The Variable life insurance policy primarily is used to

A. offset the effects of inflation.

B. give stability to the interest earned in the life insurance policy.

C. allow the policy owner the flexibility to vary the premium payments.

12. The Variable Life insurance policy

A. leaves the risk of investments to the insurance company.

B. must be sold with a prospectus.

C. allows the policyowner an opportunity to increase or decrease the premium.

13. Will a Universal Life insurance policy

A. the death benefit can change.

B. the death benefit is fixed at a stated age, and a level premium is required.

C. the insurance company can charge the death benefits.

14. Most Universal Life insurance policies

A. are purchased with a single premium.

B. do not allow the policyowner to skip a premium payment.

C. provide that of each premium paid, a portion pays for the life insurance protection.

15. With a Variable Universal Life insurance policy

A. the premiums are tax deductible.

B. withdrawals are taxed as ordinary income.

C. the policyowner controls the amount and frequency of premiums payments.

 

 

 

Answers to Chapter Five Study Questions

1C    2A    3B    4A    5C    6B    7B    8A    9B    10A    11A    12B    13A    14C    15C