When reviewing existing life insurance policies, there are generally three main issues that lead to increased risk of a policy lapsing prematurely;
Reason 1: Loans and withdrawals taken against the policy.
Reason 2: Premiums are not being paid as planned.
Reason 3: Overly optimistic assumptions made when the policy was sold.
The problems with these traps is that they often the things used to sell life insurance in the first place. Clients may have misguided assumptions about what they can do with their policies.
Loans and withdrawals are attractive selling features for life insurance. Because of the tax benefits within a policy, clients are attracted to the promise of using their insurance’s cash value as an “asset class.” Unfortunately, there is no free lunch and many insurance agents fail to explain that there can be long term consequences associated with loans and withdrawals.
- Taking a withdrawal from a policy will permanently reduce the cash value and the death benefit. In addition, if funds are withdrawn too early in the policy, it may trigger a taxable event.
- Taking a loan against the policy reduces the cash value and death benefit, but may also trigger interest to accrue over time. This causes the loan to grow if it is not paid back and it can erode the policy’s value over time.
- If a policyholder takes out a large loan and the policy lapses, is surrendered or the policyholder dies, the outstanding loan may become taxable as ordinary income.
If a client is considering taking money out of a life insurance policy, the first step is to determine whether a withdrawal or a loan is the most prudent course of action.
- A withdrawal up to the premiums they’ve paid is usually the smartest route because it will not trigger a tax liability. The policyholder may forfeit some percentage of the death benefit, and some cash value, but it may still be the more cost-effective choice.
- If taking a loan, the policyholder should consider increasing the premiums to structure a loan pay off or have a plan to pay off the loan in a lump sum. Doing so will better sustain the death benefit and cash value.
The second step is to request an “in-force illustration” from the carrier. This will show what the impact of a loan or withdrawal will have to the policy in the long term, and will offer an insight into whether it will create serious problems down the road.
Paying premiums as planned is necessary to maintaining a policy in the long term; this is especially true in the early years of a policy. If the premiums are not paid, a policy can become underfunded, and will not benefit the insured as intended at the time of purchase. Unfortunately, another selling tool is offering vanishing premiums or flexible premiums.
Vanishing premiums is the concept that eventual growth of the cash value will pay for the cost of insurance, rather than premiums. Conceptually, this can work – however in practice it usually fails. Products with guarantees, such as whole life and guaranteed universal life, are products where the concept works. Traditional, Variable and Index Universal Life are where the majority of the problems develop.
Policies that are not guaranteed and have ties to interest rates or market returns are subject to changes in their projected growth. In order to stop paying premiums and have a policy last to maturity, there needs to be significant over-funding of premiums. Basically, the client is front loading the policy to pay for future costs. Paying the calculated premium will usually not accomplish this.
Flexible premiums are a feature of universal life policies that allows clients to adjust their premiums. They can pay more (with limitations) or nothing and there is no notice of delinquency since the cost of insurance is always taken from the cash value. Sales tactics often promote the benefits of not being tied to a premium, but in practice clients can make poor decisions.
Missed or delinquent premiums can not only affect cash value projections, but they can erode guarantees. With guaranteed universal life, a missed premium can take years off a death benefit’s guarantee. With whole life it can trigger a loan to pay the premiums which can erode the policy values over time.
Overly optimistic assumptions are often at odds with reality. There are two common assumptions:
- Cash values will increase every year with optimistic, consistent market performance.
- Eventually investment performance will maintain the policy without premiums.
These are generally associated with variable policies, but universal life and indexed universal life policies are also subject to this kind of rose-colored thinking.
The first thing an advisor should do is dispel unwarranted optimism the client may have heard elsewhere.
This is not a reflection on anyone’s intentions, but there is no way to predict where the market is going to be, or what interest rates are going to do. The best anyone can do is offer a ballpark figure, using conservative numbers. Illustrations assume a constant rate of return – which almost certainly is not going to happen. The performance is going to fluctuate and so is the cash value. Clients should be made aware of the need to monitor these policies, just as they do their investment portfolios.
Another erroneous assumption insurance agents often make, especially with variable policies, is relying too heavily on historical data.
Typically, any 20- or 40-year S&P 500 historical chart will show average rates of return at 8% or higher. Such overly optimistic or misleading projections are part of the reason there are so many policies falling apart today. During the heyday of variable policies, from the 1990s to the early 2000s, projections were for 12-14% rates of return. These unsustainable, high rates of return were the result of the market outperforming during that time period. Now many of those policies are “underwater.”
Instead of relying on historical data, policies should be closely monitored and managed. When the market is down, people should be paying more than their premiums in order to compensate. If a policy is not monitored on an annual basis, or at least every other year, the policyholder is not going to realize that it may be lagging in performance.
The same is true for indexed products. Many illustrations show what a policy would have been credited over the past 20 years based on the market’s return. However, the caps on the policies would not have stayed constant at today’s rates. We have already seen caps fluctuate over the past four years; to assume that a 12% cap today would have been realistic during every market cycle of the last 20 years is unrealistic.
So what is the takeaway? Comprehensive insurance reviews, that include in-force illustrations to explain exactly how their policies are performing, is another way to show clients that you're taking good care of them and their finances.
Kellan Finley is Managing Director for Insurance Decisions www.in4fa.com, providing insurance resources for Registered Investment and Independent Advisors.