When a permanent, cash-value policy is issued, the consumer and advisor are presented with lengthy printouts and projections known as illustrations (permanent policies include Whole Life, Universal Life, Equity Indexed Life, Variable Life, Survivorship Life, etc). These illustrations are based on a number of moving parts (components) that can and will affect the performance of a life insurance policy:
Expenses are overhead costs, such as new business costs, commissions, underwriting expenses, etc.
2. Interest/Dividend Rate
On traditional (Non-Variable) Whole Life and Universal Life policies, the dividends and interest credited are based on the overall performance of an insurance company`s managed investment account. On Variable Life Insurance products, the interest credited is based on the performance of investment sub-accounts selected by the policy-owner. Performance of any investment is unpredictable and will impact the return on a policy.
Twenty years ago, for most life insurance companies, the interest crediting rate was around 12% percent. Currently the interest crediting rate is approximately 4.5% to 5%, which was the guaranteed rate twenty years ago. Currently some companies pay a lower interest rate and most have a lower guaranteed interest rate than 4.5%. However, most companies credit at a higher rate than their guaranteed rate. On a variable policy, the return rate can be lower (perhaps 0%) depending on the policy.
As we well know, the return rate for any investment over the last couple of years has been dismal and has impacted the return on policies even more than the lower interest rates of the 1990`s and 2000`s.
Example Of Declining Interest Rates On A
Universal Life Policy
A Universal Life policy was issued with a large, well rated carrier on March 5, 1997 with a death benefit of $75,000. The annual premium of $1,172 with the assumed interest rate of 6.15% projected to endow (cash value = death benefit) at his policy age 100. In projections run on April 5, 2004, based on current assumptions, the policy will lapse (terminate) at his policy age 91. To have the policy endow (just 9 years later) at age 100, the annual premium would need to be increased to $1,379 an increase of 18%. Keep in mind that the effects of a decreasing dividend scale on a Whole Life policy will have a similar effect.
Cost of Insurance/Mortality Cost
Also known as the risk charge, these costs increase annually based a table in force upon implementation of the new policy. This is the amount applied for the pure cost of insurance.
The most noted and common impact on the performance of a life insurance policy is the interest rate. The larger and usually unknown/non-disclosed impact is a change in the mortality costs. This impact is usually unknown to the policyholder as well as the agent.
While a change in mortality costs is thought to be much rarer than a change in interest rates, an increase in the mortality rate will have much more impact on a policy than a tick in the interest rate.
As an example, a policy owner with a large, well-known life insurance company faces an extremely bad situation due not only to decreasing interest rates, but to increased mortality costs. The company was not forthcoming about the increase and finally admitted a .25% increase in mortality costs.
Here is the effect on his policy: The policy was purchased on April 16, 1991 with a death benefit of $750,000 and an annual premium of $5,661. The assumed interest rate at the time was 8% (about average at the time). According to current in-force illustrations, the policy is at the guaranteed (minimum) rate of interest at 4.5%. In order for this policy owner to continue the policy to age 100, the premium would have to be increased to $13,000+. If the premium is kept at the current annual premium of $5,661, the policy will lapse (terminate) at his policy age 81.
Over the next few years, policies are going to continue to implode due to low interest rates, usually coming as a shock to the policy owner. It is not unheard of for the premium to double, triple, or even quadruple in order for the policy to continue, especially if premium payments were missed. Missed premium payments exacerbate the issue even though this has been a key selling point for policies.
Policy loans can also cause issues. If excessive loans are taken out, then the policy can terminate. The policy owner would not only face losing the policy, he/she could also have a phantom income tax gain.
The general rule for calculating an income tax gain on a life insurance policy is to subtract the basis (usually sum of premiums paid) from the total value received (usually the surrender value and any outstanding loan).
Over the next few years, more and more policies will be terminating due to lower interest rates and higher costs assessed to the policy. The economic collapse of the last few years will have a long-range impact on an insurance company`s ability to credit higher interest & dividend rates and force the need to assess higher charges to a policy.
How a policy was originally set up really doesn`t matter. What happens after a policy is put into place is what matters. An in-force illustration is only a projection of values based on your current cash value, the company`s current interest rate/dividend scale, cost of insurance (i.e. the mortality expense), and overhead charges.
If you have a life insurance policy, you should make sure that you review your policy by ordering an in-force illustration from your agent and/or company. The longer you wait, the greater the chances of an unpleasant surprise.