Even though whole life (WL) insurance is one of the most traditional forms of life insurance, there’s an abundance of misunderstanding regarding how it works and the available dividend options. For the purposes of this piece, I’m referring to actual WL, not just permanent, cash value life insurance that many consumers generically refer to as WL. Universal life, indexed universal life, variable universal life and guaranteed universal life aren’t to be confused with WL.
Additionally, I’ll be referring to classic dividend paying WL, often referred to as “participating (par)” WL. It’s important to understand WL dividend options so you can make sure the policy is managed in the client’s best interest. Because I see so many problem policies, I understand why they’ve become problems; lack of understanding and lack of management.
What’s a WL Dividend?
A dividend is basically a return of premium over and above the amount required to support contractual guarantees. WL policies have basic guarantees regarding premium, cash value and death benefit just as many other types of policies do though sales ledgers and in-force projections generally have “current assumption” columns in addition to guaranteed columns. The guaranteed assumptions incorporate a lower interest crediting rate and higher overhead expenses and mortality charges than the current assumptions. The premiums that have to be paid into a policy must be sufficient to guarantee the cash value and death benefit in poor financial environments and if mortality experience is less favorable than expected.
However, if the insurance carrier can make more on its money than the guaranteed interest crediting and its expenses are lower and mortality experience is better than the guarantees, it doesn’t need all of the premium dollars. This is where dividends come in to play. It’s also important to remember that dividends aren’t guaranteed.
Dividends paid in cash: This isn’t difficult to interpret. Any declared dividends are paid to the policy owner in cash. If elected, the death benefit will stay level, and the annual premium will need to be paid per the contract. Premium checks and dividend checks could be passing in the mail.
Dividends to pay/reduce premium: Again, not a mystery. Any declared dividends can be used to reduce the premium or pay it entirely if sufficient. If the policy premium is $10,000 and the dividend is $3,000, the dividend can be applied to the premium, and the policy owner writes a check for $7,000.
Ultimately, the dividend can be greater than the premium and excess dividends can be used per the other options discussed here, meaning a policy can have more than one dividend option that are implemented sequentially.
Dividends accumulate at interest: Dividends don’t have to be paid out or applied to a policy. They can simply accumulate at interest with the insurance company and be used or accessed later. Because a dividend is considered to be return of premium for income tax purposes, there’s no tax on the dividend, unless cumulative dividends ultimately exceed basis in the contract, but interest earned on the dividends would be taxable.
Dividends buy paid-up additions: Here’s where plain English starts to be fleeting. It’s best to think of paid-up additions (PUAs) as little pieces of paid-up insurance. Two dollars of insurance that’s guaranteed to stay in force through policy maturity might cost a buck, so a buck of dividends buys two buck of insurance or two bucks of PUAs.
PUAs have a cash value component and a death benefit component. An insurance ledger may have separate columns for the cash value and death benefit of the base insurance policy and the PUAs part of the policy. PUAs are why many WL policies show an increasing death benefit. The PUAs are building up insurance death benefit over and above the initial death benefit. These PUAs can also be surrendered to access policy value or to pay future premiums or pay down policy loans.
Dividends buy one-year term insurance: This is sometimes referred to as the “fifth dividend option.” Dividends can be used to goose death benefit by purchasing one-year insurance. This insurance will be more expensive as the insured individual ages. This is also how some insurance carriers build a term blended WL policy to reduce premiums or otherwise build a policy for specific purposes.
Depending on the insurance company you’re working with, there may be additional options such as dividends that can be used to purchase long-term care or indexed credit options.
Why It Matters
These dividend options matter because life insurance needs to be managed. I’ll relate a typical situation:
A policy owner, Bob, is sold a $1 million WL policy with an annual premium of $20,000. The original guaranteed insurance ledger assumes the premium is paid every year per the contract. This may be a true 10-pay policy, paid up at 65 policy, an annual pay for life or some other iteration. We’ll assume our guy bought a policy that requires premiums to be paid every year through death or age 100, whichever comes first.
The sales ledger at the heart of the presentation, however, shows premiums being paid for 10 years and then terminating. The policy owner understands the policy to be “paid up” in 10 years. Most WL policy owners who see a 10-year premium ledger refer to it as a “paid up policy” after the 10 years. Remember, it might be so as actual guaranteed 10 pay WL policies exist. The likelihood though, is that the ledger is illustrating 10 out-of-pocket premiums, not guaranteeing 10 out-of-pocket premiums. It’s exceedingly important to understand that the premium actually needs to be paid every year, whether a check is cut or not, and the 10 pay ledger is only a projection. Such a policy isn’t paid up just because policy premiums aren’t being mailed in but it’s the common vernacular used by consumers and many of their advisors. This many seem innocuous but it’s the basis for many problems and policy disasters.
Many policy owners have no idea that premiums must be paid and are actually paid even when checks aren’t being cut. Here’s where understanding dividends starts to be important. We discussed that premiums can be paid by dividends. That $20,000 10-pay projection assumed that in the 11th year, the policy values could support premiums for the policy owner so Bob didn’t have to write a check. Bob may think the premiums are being paid by the dividend, but Bob might be wrong. In most policies I see, the premium isn’t paid by the dividend but rather by a loan while the dividends buy PUAs.
Still with me? If Bob stops paying the premiums out of pocket and the premiums are paid by an internal and automatic policy loan after the 10th year, 20 years after that the policy might have a million dollar loan. Believe it or not, I regularly meet with people who have no idea there’s a loan on their policy. This default action chosen on the original application is often chosen by the agent with no input from the client. There’s often a reason for it, and it’s not necessarily bad. This allows the full policy to stay in force in the event a premium is missed. The alternative may be something like a reduced paid-up policy or extended term coverage that might defeat the purpose of the insurance.
This also might have been perfectly supportable under assumptions at play when the policy was initiated. The dividend could have been 10% with a loan rate of 8%. Now the dividend is 5% or 6% with the same 8% loan rate. That’s not so supportable in all cases. In another 20 years, the loan could be well over $5 million and tanking the policy.
Because the cash value of the policy is collateralizing the loan, the insurance company will never allow the loan to exceed the cash value. With a loan growing faster than the cash value (and we have to remember that the cash value doesn’t actually grow at the dividend rate), this is often unsustainable. If the loan does grow too high, the carrier will cash out the policy, collect their marbles and go home. But why should a policy owner really care?
What Can Go Wrong?
If a WL policy is in this situation, the policy owner will get what I call the insurance equivalent of a margin call. The policy is about to collapse so the insurance company sends an invoice for the premiums and loan interest due to stave off the problem. This number can be astronomical because the insurance company generally won’t force the issue until the policy is on the brink of disaster. It’s like not putting money into your retirement account for 40 years and then trying to save enough a year before you want to retire. It can’t happen. When the policy collapses, the entire net cash value plus the loan is taxable income at ordinary rates over and above the basis in the contract. In our situation, this will be millions of phantom gain on receiving nothing. Why? It’s treated as forgiveness of debt, and forgiveness of debt is taxed at ordinary rates. Because the taxable income will be millions of dollars when the policy collapses, it will be at the top rates.
As an aside, and I realize this will draw howls, those premiums on WL policies consumers generally understand to be guaranteed aren’t always really guaranteed. When a policy owner’s $40,000 premium jumps overnight to $400,000 because $360,000 of loan interest was due to keep the policy from lapsing, an agent isn’t going to get much of a sympathetic audience from a client when he attempts to distinguish premium from loan interest. All the policy owner cares about is the size of the check required. Similarly, when a client with a $150,000 annual premium sees his amount due grow to multiple millions per year because of the increasing cost of the term rider in an underperforming term blended WL contract, parsing what’s WL premium versus term premium is an exercise in futility. All these people know is that they bought a WL policy. Regarding the premium, if it looks, walks, smells and sounds like a duck, dammit, it’s a duck.
What should have happened years ago? If this policy was being managed properly, the agent would have come to Bob and suggested he start paying premiums out of pocket again, start paying loan interest, change the dividend option or a combination of some or all. What’s the point of buying more insurance through PUAs when the loan is spiraling out of control? The dividend should have been changed from buying PUAs to having the dividends pay premiums so the loan wouldn’t grow as fast. At some point, dividends may be high enough to pay the premium and have something left over. When the loan was smaller, the dividend might have been able to pay the entire loan interest in addition to the premium. Yes, you can do this. It might have been able to do so and also start paying down the loan itself.
You can sequence dividend options. For example, change the dividends from buying PUAs to: (1) dividends pay premiums, (2) dividends pay loan interest, (3) dividends pay down loan principal, then (4) dividends buy PUAs or another option. I’ve implemented policy rescues by doing this but only if they’re caught on time. Otherwise, premiums and loan interest have to start coming out of pocket. Some policies have more than one loan option with a certain rate for fixed loans and another for variable rate loans. It can be very worthwhile to evaluate this. Additionally, a policy owner who would never dream of moving forward with an 8% home mortgage may very well have an 8% policy loan and not look at options to refinance from external sources.
It’s also important to understand that there’s nothing inherently magic about life insurance policy loans. Contrary to popular belief, one isn’t actually borrowing from oneself and subsequently paying oneself back. The loan from the insurance company is separate from the policy but is collateralized by the policy. If I had $250,000 on deposit at Community Bank and then borrowed $50,000 on a line of credit or home equity line from Community Bank, I’m not borrowing from myself. I may be collateralizing myself, and there may be efficiencies in management and reporting, but I’m definitely not borrowing from myself so when I pay back loan interest, I’m not paying myself back.
There’s blame enough to go around regarding the lack of education and management. Policy owners need to ask more questions, agents need to better educate and manage and carriers need to have better training, oversight, systems and alerts. All the fluffy marketing and advertising meant to make you and your client feel like the only reason for the firm’s existence is to serve you too often goes dormant after the policy gets to a point that it ceases to be profitable to the agent and/or insurance company. Beyond lack of understanding, willful misrepresentation at the point of sale leaves many policy owners with a specific misunderstanding of how these policies work.
Bill Boersma is a CLU, AEP and LIC. More information can be found at www.oc-lic.com, www.BillBoersmaOnLifeInsurance.info and www.XpertLifeInsAdvice.com or email at [email protected].