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Digging Into the Black Box of Life Insurance

By scratching under the surface, smarter decisions can be reached.

Referring to life insurance as a “black box” goes back a long way, but just because life insurance may seem like a black box to you or your clients doesn’t mean it has to be. Some people understand it. It may not be healthy to foster an “us versus them” mentality, but it’s most certainly not healthy to ignore reality. When individuals don’t understand something, they seek out an advocate to ensure they have the information they need to make decisions in their best interest. Life insurance shouldn’t be any different.

Real-Life Case

Here’s a case that came across my desk recently. A couple was presented a proposal that totaled tens of millions of dollars of death benefit and would be committing to a seven figure premium. Their attorney wasn’t confident they knew what they were getting into, so he brought me in.

This was an indexed universal life or IUL contract, and when I received it, on the surface it looked like just any projection I might see in a given day. It didn’t look to be built any better or worse than what’s typical. That was the first hint of an issue.

One piece of the transaction was a $15 million death benefit on the husband, who was about 50 years old. It was built on a limited pay basis with premiums going in over five years. The policy projected to accumulate millions of cash value and consistently be on an upward trend through policy maturity.

The first thing I did was to recreate the proposal so I could look at and share the expense pages that had never been provided to the client or advisors. Of the $328,790 annual premium, $115,077 per year is taken out as a premium charge. In the first 10 years, there are an additional $201,325 of administrative charges. Insurance/mortality charges are another $172,000 for a total of $949,033 of the $1,643,950. This is 57.73 percent of the premium in the first 10 years.

The point of this piece is not to argue if this is good or bad. It’s only to dive into a typical transaction. After the first 10 years, there are no premium charges if an additional premium isn’t paid, and administrative charges are only $180/year. Mortality charges are the only real expense within the contract. This is exclusive of charges of the mechanics regarding the ultimate crediting rates.

By the 28th year of the contract, the total proposed expenses equal the premiums paid. Of course, the cash value has hopefully been earning the proposed return. This particular proposal is assuming a 6.28 percent return, which is the maximum allowable under the AG 49 regulations for this product. Reasonable minds will differ on whether this is a reasonable assumption.

By the husband’s actuarial 50 percentile life expectancy, aged 83, the expenses are a bit over $2.5 million. By his 85 percentile life expectancy, aged 92, they total about $4.8 million. At aged 100, the number is $8.2 million. Doing the easy math shows you the nine years between ages 83 and 92 totals $2.3 million, and the last eight years before aged 100 have a total mortality charge of $3.4 million. It’s important that the cash value has grown by the projected rate, because there needs to be a lot of it to support hundreds of thousands of dollars of mortality charges per year at that point. If performance relative to projections is off, then the entire transaction may be in jeopardy, as the mortality expenses may be much higher. Experts who understand how these things work understand how important it is to perform some independent modeling and stress testing.

Modeling and Stress Testing

First of all, this insurance ledger, like almost all ledgers, assumes a static return forever. This isn’t going to happen. Dynamic returns will affect the transaction more than most people can comprehend. It’s more than frustrating that these deals are put together and decided upon based on assumptions that have a literal impossibility of occurring. The fact they’re sold and bought the way they are is close to unconscionable. 

When I take the specifics of this contract and input them into Dick Weber and Chris Hause’s Historic Variability Calculator, this thing isn’t going to last. How sensitive might it be? If we layer in an up-and-down market over time that did, in fact, recreate historical market returns through Monte Carlo modeling, the policy would rarely make it to life expectancy, let alone aged 100. That’s not reassuring. 

What about stress testing on the carrier’s own software? If the assumed level rate is lowered from 6.28 percent to 6.20 percent, a single basis point difference, the policy doesn’t make it to aged 100. The contract burns through the $7 million of cash value originally projected to be in existence at aged 100, assuming 6.28 percent and lapses. Did you know it could be that sensitive? If you did, would you move forward?

Then I called up my industry associate and friend, Barry Flagg of Veralytic, and asked him to run a Veralytic report. The report indicates, among other information, that the costs of insurance is particularly low, and the premium charge is particularly high. At least the COIs being low is good, right? Maybe, but this also allows the carrier to increase them significantly down the road (as a number of carriers are doing today) if they end up being off base. It also tells me that the benchmark for all policies would fail if funded at the same level as the proposed contract. I want a good deal as much as the next person, but are the COIs in this contract too aggressive? Wouldn’t you want to know if you were headed into a contract that everyone else thought was “too good.” You’d hope for the best, but would want to be prepared if things got off track.

I was with Richard Harris recently and brought this up. He said, “I was working on a case with the same carrier and their other product is going to work a lot better.” Again, how would you know that?

If the performance is off a bit, and the policy needs additional funding, this is a flexible premium product so the grantor may contribute more. That’s great, but at any point in the existence of this policy, there’s a 32 percent premium charge. Start paying $100,000 a year to firm this deal up, and $32,000 of each payment comes off the top.

A Better Solution?

I’m not trying to beat up on this particular product or the carrier. It’s just the one that came across the desk. The agent brought other options to the table, but recommended this one. Why? I can’t be sure, but the other one that looked very competitive had a fraction of the commission built in. I’m not anti-commission by any means, but it may be worthwhile digging a little to discover why certain decisions are made.

Even this carrier’s portfolio may have products that are better suited, and I know factually this particular policy could be designed more effectively and efficiently. There’s a reason the policy has to be in force for 14 years before the cash value is projected to be equivalent to the total premiums, which matters even in death benefit-oriented transactions in which cash value isn’t the goal. In this situation, cash value was theoretically a part of the design. 

Killing deals isn’t my goal. I come in, if possible, to make them better and increase the chances the original goal of the plan is fulfilled. In this case, I recommended some design changes and increased funding levels. The client had the resources to do so, but less cash flow is better, right? I put together the following overly simplistic decisions tree to illustrate. It doesn’t seem that complicated.

Beyond all of this, my understanding is that current assumption universal life (UL), guaranteed UL, whole life and variable polices, whether convention or private placement, were never brought to the table. Why not? This is the most basic part of the process to be incorporated into the work of any transaction.  It’s like the assets allocation and risk tolerance aspects of investment planning; a pretty important piece. With this amount of premium, the world is your oyster. You can do some fun stuff. Urge your client to treat this like he’d treat a business acquisition, a real estate transaction or a private equity deal. The numbers are worth it, and the advice is available. This isn’t where he should cheap out.

The point of all of this is to help consumers and their advisors see that by scratching under the surface, seeing behind the curtain or penetrating the black box, whatever you want to call it, a lot can be learned, and smarter decisions can be made. 

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