In a world filled with people peddling products without full knowledge of the long-term risk and ramifications, it is essential to understand the pitfalls of oversold life insurance products.
Insurance comes down to risk and likelihood. Many confuse projections on paper with reality and create future problems with a lack of information.
Let’s look at the rise of the Universal Life family (Indexed Universal Life, Variable Universal Life, Universal Life).
I’ll include a glossary to support the technical jargon required for accuracy, as well as examples through illustrations.
I’ll do my best to keep this straightforward. But if you still feel this is complicated, well, it is because it is. The fact that it is complicated means that most people buy products they don’t understand. They’re sold on faulty, inaccurate numbers, unlikely to ever transpire.
The rise of Universal Life came due to fixed-income investment (CDs, Bonds) rising to double-digit interest rates (as high as 18 percent) in the late 1970s and 1980s. UL exploited a tax-free or tax-advantaged option to grow money. It was less about insurance and more about tax advantage.
Universal Life was created by EF Hutton, an investment brokerage. EF Hutton is not an insurance company, but an investment company looking for a legal tax loophole.
People funded these low-death benefit policies by stuffing them full of money to grow the cash value. The cost of insurance had less impact in those days because the rules were different, the design was different. There wasn’t much consideration for death benefit and emphasized saving tax.
This led to the government changing the rules of how much money you could allocate through a Modified Endowment Contract (MEC), limiting the amount of funding in relation to the death benefit. Otherwise, it would eliminate many of the tax benefits. Fortunately, they grandfathered the tax benefits and design to people who owned the policies before the change.
Requiring more death benefit exposed an issue with the Universal Life suite of products (UL, VUL, IUL). The cost of insurance is often higher than that of term insurance because it is easier to hide in the policy.
UL is built upon a term insurance chasse in that the insurance cost can rise over time as the policyholder ages (annually renewable[GB1] term). The word “can” is operative because the insurance cost is the difference between the cash value and death benefit, known as the net amount at risk.
As the cash value rises, the net amount at risk decreases, but the Mortality & Expense (M&E) charge increases the cost of insurance with age. Part of the insurance cost depends on the number of deaths per thousand (actual experience of policyholders) and as the policyholder ages.
So, on one hand, we have the net amount of risk going down, reducing cost (if the death benefit stays level), but the cost of insurance (mortality) goes up. When new policies with better options and opportunities are created, people in good health may roll over their cash value without tax through a 1035 exchange.…if healthy.
Insurability and testing are required. Those who have health changes are stuck in the original policy, creating a higher cost of insurance for the older policies. The people stuck in those policies have a higher mortality rate, increasing cost for the policyholders.
The insurance cost increase doesn’t happen quickly. This happens after years, even decades, as more policyholders die, and therefore is often not understood or disclosed when people purchase any type of Universal Life policy.
These initial UL policies underperformed and were a disappointment. Interest rates didn’t remain high, and they returned to single digits.
Enter the VUL (Variable Universal Life).
The big difference with VUL is the performance relies on subaccounts (like mutual funds) rather than a declared interest rate each year.
In the 1990s, there was an unprecedented bull run with the market, and simultaneously, interest rates continued to decrease. People gravitated towards VUL policies and abandoned UL due to the stock market’s upside potential.
The biggest issues with VUL are the lack of guarantees and volatility. As the market decreases, the net amount of risk increases, and as the policyholder ages, the cost of insurance increases while the subaccount value decreases.
Net amount of risk increases, increasing cost.
Policyholder ages, increasing expenses.
Lower-valued shares may be redeemed to cover these expenses.
Ouch.
Pulling out money when the shares are losing value is called disinvesting. Imagine having $100,000 and losing 10 percent. Now you have $90,000. But if the cost of insurance drags that down another 4 percent, you now have $86,000. When the market “recovers” and earns 10 percent, you only have $96,400 dollars. The losses are exaggerated.
Again, losses require the policyholder to add funds, or otherwise, the cash value is at risk as the cost of insurance redeems shares at a lower value (stock market losses), creating a higher net amount at risk and accelerating losses.
Lose, lose, lose.
Let it sink in. More shares must be redeemed to handle the higher expenses, or the policyholder must add more money to protect the policy. Adding money that isn’t necessarily buying more shares, just protecting the declining value and experiencing a “double dip” of loss (market and cost).
With VUL, there is no guarantee on the death benefit, there is no guarantee on the premium, there is no guarantee on the rate of return, and there is no guarantee on the cash value.
Substantial risk in pursuit of performance. A risk most people didn’t understand or consider, at their peril.
When returns became less predictable (economic volatility) and interest rates became anemic (1/4 or 1/5 of the peak of the 1980s), Indexed Universal Life (IUL) became increasingly popular.
The pitch: downside protection with upside potential. That could also mean “the market could go up, the market could go down, and we don’t know what will happen.” An amazing marketing story, easy to sell, even if rooted in mythology.
IUL has its own set of risks. You could pick different indexes; how the interest is credited can be different, and how much you get can vary due to Cap Rate, Spread, and Participation Rate (I’ll cover those last three here shortly).
You still have all the same issues as Universal Life with cost of insurance, but with some nuance around how your cash value is credited. There are multiple levers the insurance company can pull to reduce their risk and protect their profit.
The way you can have upside potential and downside protection comes from the purchase of options. Call options allow you to get more gains when the market grows. Put options allow you to place a bet and get a return if the market goes down. Companies have an option budget to handle the upside of the policy. Sometimes, the purchase of those options is more competitive than others, leaving less opportunity based upon the options budget. The amount an option may cost depends on timing, how many options are being purchased, and the volatility of the market…just to name a few. It comes down to supply and demand.
Based upon the options budget, there are three levers the insurance company has that could drastically impact your performance.
The Cap Rate. If you have a Cap Rate of 10 percent, you can participate in up to 10 percent of return, but if the market does 15 percent, you do not get the additional 5 percent. If the market does 30 percent, you get 10 percent. You are capped. This can be adjusted up or down, often down.
The Spread. Think of it as a fee. If you get 10 percent, but there is a 2 percent spread, you keep 8 percent.
The Participation Rate. If your rate is 70 percent, you get 70 percent of the 100 percent.
Let’s look a bit further on the cost of insurance. Included at the end is an illustration highlighting guaranteed versus non-guaranteed costs with an illustration. The guaranteed side will not happen early (the maximum increase would have to happen on day one), even though it legally must be shown. It is nearly impossible to have those costs rise that fast; that typically doesn’t happen until much later, so it looks more negative initially.
One of the scariest things is if the policy lapses. As insurance costs rise, or you use the money from the policy, or miss payments, or don’t have ideal health and get stuck in an underperforming policy, you either have to add money or could lose the policy.
It can create a taxable event because the policy that creates the tax benefit is no longer in force.
Sure, you can add money if you have it. But to fund the very thing that didn’t perform doesn’t make much sense. At what cost? With what money?
There are riders to create a no-lapse guarantee…but you have to make it that long. They typically don’t kick in until 70 years old or later.
Now that you know the risks, here are some suggestions:
- Grab a complimentary copy of What Would the Rockefellers Do? and get insight into how whole life works for legacy for creating an alternative to your fixed income portfolio.
- If you aren’t sure what to do, buy a convertible term policy with a mutual life insurance company. I’d rather see someone buy term and invest the difference in index funds rather than risk everything in an Indexed Universal Life. You will drastically decrease your expenses and fully participate in the upside of the market. That is not my ultimate solution, but one with more flexibility and options than Universal Life.
In a world filled with opinion and salesmanship, I want you to have the facts. I want you to be empowered to make better choices and create a legacy that will last.
Get your copy of What Would the Rockefellers Do? and secure your financial future today!
In prosperity,
Garrett
Glossary
Universal Life (UL)
A type of permanent life insurance that offers flexible premiums, adjustable death benefits, and a cash value component that grows based on a minimum interest rate or current market rates. Policyholders can increase or decrease premiums as long as there is enough cash value to cover policy costs.
Variable Universal Life (VUL)
A form of permanent life insurance with a cash value component that can be invested in a variety of sub-accounts, similar to mutual funds. The cash value growth depends on the performance of these investments. VUL offers flexibility with premiums and death benefits but involves higher risk due to market fluctuations.
Indexed Universal Life (IUL)
A type of permanent life insurance where the cash value growth is tied to the performance of a market index, such as the S&P 500. The policy offers downside protection with a guaranteed floor (e.g., 0% growth) and an upper cap on potential returns.
Death Benefit
The amount of money paid to the beneficiaries when the insured person dies. This benefit is generally income-tax-free and can be a fixed amount or adjusted based on the policy terms.
Net Amount at Risk
The difference between the death benefit and the cash value of a life insurance policy. It represents the amount the insurer must pay from its own funds if the policyholder dies.
M&E Expense (Mortality and Expense Charge)
A fee associated with universal life insurance policies. It covers the cost of insurance (mortality risk) and administrative expenses. This fee is typically deducted from the policy’s cash value.
Cash Value
The savings component of a permanent life insurance policy. It grows over time on a tax-deferred basis and can be accessed via loans, withdrawals, or surrendering the policy. The growth method depends on the type of policy (e.g., fixed interest, indexed, or investment-based).
Modified Endowment Contract (MEC)
A life insurance policy that fails the 7-pay test, meaning premiums were paid too quickly within the first seven years. Once classified as an MEC, the policy loses some tax advantages: loans and withdrawals are taxed as income first (LIFO taxation) and may incur penalties if taken before age 59½..
Indexed Universal Life Options Budget
The portion of premiums allocated to purchase index-linked options in an IUL policy. This budget determines how much exposure the policy has to potential index gains.
Indexed Universal Life Cap Rate
The maximum rate of return credited to the cash value in an IUL policy for a given period. For example, if the cap rate is 10% and the index grows by 12%, the policyholder will only receive 10%.
Indexed Universal Life Spread
A percentage deducted from the index return before crediting the cash value. For example, if the spread is 3% and the index grows by 8%, the policyholder earns 5% (8% – 3%).
Indexed Universal Life Participation Rate
The percentage of the index’s return that is credited to the policy’s cash value. For example, if the participation rate is 80% and the index grows by 10%, the policyholder earns 8% (10% x 80%).
