When we review existing life insurance policies for the clients of our advisor firms, we find that certain plans are failing and at risk of lapsing prematurely. There are generally 3 main causes for this:
Reason 1: Loans and withdrawals taken against the policy.
Loans and withdrawals are attractive selling features for life insurance. Premiums paid into a policy grow tax-deferred over time and that money can be accessible through either loans or withdrawals without paying tax on the amount taken out. Because of this feature, many view these policies as cash accumulation vehicles, putting money into them with the intent of funding college educations, or even supplementing retirement plans. Unfortunately, many insurance agents fail to explain that there can also be negative consequences associated with using policies for this purpose.
- Making a withdrawal from a policy permanently means there is no intention of ever putting it back in. Problem: Taking money out of a policy may permanently reduce its cash value, and the death benefit. And if funds are withdrawn too early in the policy, it may trigger a taxable event.
- A loan is when a policyholder borrows against the cash value of the policy. Problem: Loans accrue interest over time, so the outstanding loan amount gets significantly larger if it is not promptly paid back. 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.
Before a client decides whether to take a withdrawal or a loan on a policy, you will want to request an “in force illustration.” That will show the hypothetical impact to the policy long term, and will offer an insight into whether or not it will create serious problems down the road. You should also be sure to consult a qualified insurance expert to discuss the impact of taking money out of a policy before doing so.
Reason 2: The premiums were not paid as they were supposed to be.
When someone buys a life insurance policy, the amount owed in premiums is determined based on a combination of several factors. The most significant considerations include:
- Policyholder’s age, gender and health
- The type of product being purchased
- The assumed economic growth of the policy over time
Problems arise when premiums are not paid as initially planned. It is important that policyholders stay true to the planned premium, especially in the beginning years, to ensure their policy’s continued solvency. If the premiums are not being paid, a policy can become underfunded, and will not benefit the insured as it was intended to at the time of purchase.
The 3 most common types of plans and the problems that can result if premiums are not paid into them regularly:
- Variable universal life policies: Many of these were written in the 1980s and 90s. Because of prosperous economic times during those years, very optimistic assumptions regarding the market and interest rates were made, and unfortunately many of these factors have not panned out nearly as well as expected. Policyholders had been told that they did not need to make premium payments and the market performance would maintain their values – or even provide growth. Given the actual performance of these policies, in addition to the 2008 economic crisis, many are underwater with clients being forced to pay additional premiums to maintain them.
- Guaranteed universal life policies: These have been very popular over the last 5 to 8 years. People wanted death benefits that were guaranteed, without having to worry about external matters such as market fluctuation. The problem is that the guarantees are dependent upon premiums being paid on time and as planned. If a premium is missed, the policy guarantees may be compromised. If a policyholder with one of these types of plans has missed premiums, he or she may still be able to “catch up” with the payments and restore the guarantees in their policy. The longer they wait, however, the more expensive it will be to accomplish this.
- Whole life insurance policies: Premium issues with these often surprise people because they think that whole life policies are not “flexible premium” products, meaning that you have to pay your premium or the policy lapses. This can be true, but many of these policies have a built in APL (Automatic Premium Loan) which means that if a policyholder fails to pay the minimum premium within 60 days from the due date, the premium will automatically be deducted from the cash value of the policy, in the form of a loan. Of course, this loan accumulates interest, eating into the policy’s cash value and death benefit if not promptly paid off. And in fact, some people don’t even realize that they’re even taking these Automatic Premium Loans, even though it has been happening for multiple years in a row. Fast forward 10 years down the road, and they suddenly discover that their policies are underwater.
Advisors should be telling their clients to pay premiums on time, every time. In addition, at least once every 3 years, clients should review their policies to make sure their plans are still meeting the financial expectations in place at the time they were purchased.
Reason 3: Assumptions that were made when the policy was sold were too optimistic.
Many clients recognize the benefits of using life insurance as an investment, but they can be sold on this premise with optimistic assumptions – which are often at odds with reality.
- Cash values will increase every year with optimistic market performance.
- Eventually premiums can be discontinued and investment performance will maintain the policy.
Those assumptions are made primarily when dealing in variable policies, but universal life and indexed universal life policies are also subject to this kind of rose-colored thinking. 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 to offer a ballpark figure. Illustrations can only assume a constant rate of return on a variable policy – but even with a conservative course of action aiming for a 5% return every year, but there is no chance that person will realize this return, every single year, for many years. 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 will show average rates of return at 8% or higher. Such overly optimistic are part of the reason there are so many policies falling apart today. During the heydays of variable policies, from the 1990s to the early 2000s, they were being projected to have 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.”
Another popular investment-based product in the insurance industry is index policies. Index policies typically feature a cap and a floor. For example, a policyholder may get a 0% floor, which means that he or she cannot be credited anything less than 0 – so it essentially protects from down markets. However, it does not guarantee a client will never lose money. There are still fees and expenses being drawn from the policy, and during down markets, cash values can decline.
Once again, assuming historical data for these contracts is unfair. Many illustrations show what a policy would have been credited over the past 20 years based on the market’s return. However, it is unlikely that the current caps on the policies would 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.
It is vital that clients review their insurance policies for all of these reasons. If the client puts more money into the policy when the market is down, when it does rally, those increased payments will make up for it. It is important that an RIA’s client knows how important it is to not be overly optimistic with their assumptions, or everything built on that assumption risks falling apart.
All three of these common mistakes are completely avoidable with right guidance and policy monitoring. It is another reason why advisors must incorporate insurance into their practice.
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