Whole Life (WL) is the most complex product ever developed by the life insurance industry. Complex in the sense it cannot be broken down into its parts. It is a bundled product.
Anyone who intends to read this write should first read the “How it Works – Whole Life Box” write up. It provides a design framework that sets the stage for a more detailed discussion of WL’s various moving parts. I would also suggest reading the “WL Design Basics” and WL Guarantees” write up’s before reading this one. The combination provides a sound foundation to understand the following discussion on dividends.
INTRODUCTORY COMMENTS
The WL box story focuses on a conceptual understanding of the product. The Design Basic’s write up gives an overview of formulas and assumptions that create WL illustrations and subsequent calculation of actual values. The “guarantees” write up discusses the foundation upon which dividend based values are added. These constitute an important first step in gaining a better understanding how this ridiculously complex product works. suffice it to say, WL is not the “simple” product many who sell it seem to believe it to be.
If it were a simple product this “How it Works” series could not contain almost a dozen 20 and 30 page write-ups on the product. There would be no need for this avalanche of information.
What complicates matters with WL is the fact it is a bundled product. One where all the moving parts are obscured. No individual income or expense information is ever made available to those who sell it, or those who buy it. Only a few company executives and actuaries have access to this information.
Those who favor selling WL often base their understanding on a handful of half-truths and misunderstandings shared with them as fact by under informed or misinformed (albeit well intentioned) mentors or peers. A bold statement perhaps, but sadly one that all too often has proven to be true.
Only when a properly educated individual asks detailed questions (the answers to which they already know) does the validity of the above statement become painfully clear. Those who understand how WL works are endlessly amused (or saddened) when witnessing the floundering efforts of those who do not attempting to explain it to others who do.
Offsetting this lack of knowledge, or perhaps because of it, WL is often sold with an almost evangelical fervor. Assertions surrounding its guarantees often make the product sound as if it embodies all that is good and holy. A biblical level of enthusiasm often prevails.
Unfortunately, even those with the best of intentions and deeply held beliefs can end up making blatant misrepresentations. Which can be every bit as damaging as the falsehoods shared by those with ill intent. Or, worse since considering the level of sincerity of the person sharing the misinformation.
The WL product itself is neither good nor bad. It’s just a design developed before the advent of computers which made it possible to track every little detail of a products structure. Computers also made it possible to track and report each and every income and expense factor on an individualized policy owner basis. Imagine the challenge of attempting to do so with tens of thousands of policyholders with a manual hand based calculation and posting system.
The decade’s old design of WL allows cash values to accumulate within a policy and death benefits to be paid covering said tens of thousands of policy holders. Its design allows this to be done without the need to segregate the general account assets that support the cash values in any given individual policy. The same is true with the expenses paid from the general account.
With WL those factors are bundled together and allocated based on formulas embedded in the WL product design. This collection of interrelated formulas is often referred to as the “master” WL formula. Which differs for every individual WL product ever sold.
As with any product design WL has its plusses and minuses. What makes WL good or bad at any given point time is a function of what is, or has transpired in the real world since its sale.
So, at any given time and depending solely on economic and other realities, WL may or may not be the best product for any given person. Something that also depends on the intended use of the product and the focus of any given purchasers goals or needs.
As noted earlier, it does not require ill intent to misrepresent a products features or benefits. Ignorance works just as well. Most of those who sell WL have nothing but the best of intent. It’s just their lack of actual knowledge that creates problems. The WL product is typically sold as a product rift with guarantees that eliminate all the elements of risk. Which sadly just isn’t so.
Economic trends, in particular those pertaining to interest rates, have a tremendous impact on WL products since it is an interest sensitive product. As a result, whatever is happening with interest rates (or whatever has happened since the product was purchased) has a tremendous impact on the products ability to deliver on illustrated cash values, dividends and death benefits.
Regulations also have a tremendous impact on the value a WL product can deliver. Among a great many other things regulations prohibit investing general account funds in equities (stocks). They allow only a modest level of stock ownership which usually relates only to stock owned in subsidiaries of the company selling the WL product. Beyond this regulations also require reserves for different asset classes that can impose tremendous cost levels and capital constraints on companies selling WL products.
The reality of interest rates today could not possibly be more different than the reality of interest rates that existed decades ago in the heyday of WL product sales. In fact, the realities today are literally 180 degrees opposite.
As the number of other “How it Works” WL write ups suggests this is only one of many factors impacting existing policy holders and new potential buyers of WL products today. But it is a very important factor that has crippled the WL product for the last two or three decades.
GUARANTEES ARE WL’s FOUNDATION – DIVIDENDS DRIVE CASH VALUE GROWTH
The following comments appear in both the write up dealing with guarantees and the write up dealing with dividends. They are necessary to set the stage for the discussion of either since both are hopelessly intertwined in the WL policy design itself.
The foundation for the WL policy design is tied to the guarantees the WL product offers. Guarantees are largely premium dependent. Premiums must literally be paid for the life of the policy for guarantees to remain active. Without fail those who sell WL tout guarantees as an essential underlying strength offered by the WL policy design versus the competing alternative Universal Life (UL) design.
Building on WL’s guaranteed foundation is the dividend fueled cash value growth above guaranteed return levels in WL products. WL’s dividend fueled cash value growth potential has long been the basis behind how WL has been illustrated and sold. Dividends accumulate in the form of additions (more on that topic later) which at a point can become sufficient to internally fund future premium payments and over time dividends can become so substantial they can also fund distributions of cash to the policy owner.
The “classic” WL illustration features “solves” designed to pin point two key points in time. The first is the point in time where accumulated past and current dividend additions become sufficient (under the terms illustrated) to pay all future premiums. The second occurs two or three decades later. This second solve calculates the potential annual maximum total possible surrender of dividend additions shown as funding distributions intended to be used as a supplemental retirement income source.
NOTE: If future dividends don’t come to pass as illustrated there is a definitive impact on how long premiums must be paid out of pocket. Dividends are not guaranteed. When actual dividends fall short of those illustrated at the time of sale the point at which the policy can become “self-funding” is pushed into the future. Meaning irrespective of what the original sales illustration showed premiums must continue to be paid out of pocket. A fact noted somewhere in the footnotes contained in the Illustration which might be twenty to forty pages long. A continued shortfall of actual vs. illustrated dividends will reduce, or potentially even eliminate, the possible future supplemental retirement income distributions originally shown. Under extreme levels of underperformance for an extended period of time premiums could literally be payable out of pocket for the life of the policy.
The fact WL illustrations continue to label accumulations in guaranteed columns as guaranteed even after the surrender of dividends are funding the payment of ongoing premiums is inherently confusing and debatably deceptive. Again, many companies attempt to address this by inserting footnotes in their illustrations triggered at the time dividends begin to fund premium payments stating the values shown as guaranteed are no longer actually guaranteed. However, labeling them as guaranteed in column headings and then stating elsewhere in footnotes they are not is confusing at best.
Rare is the purchaser of a WL product that discerns this important fact from the cursory review of the illustration typically offered by those selling WL products. Sales associates only try and help prospective purchasers grasp the intent of what the illustrations show, not every little detail pertaining to how a WL product works. Which most who sell WL are blissfully unaware of in any event.
The point is it’s important to understand what is and isn’t guaranteed in the WL product design. It would also be helpful to know how those guarantees actually work. And since the potential for cash value build up and future distributions from the product are the basis for how WL is sold it’s also important to understand what drives the illustrated accumulation levels above the guaranteed levels and how dividends work.
NOTE: Today’s economic and regulatory environment make it highly unlikely dividends on past and even on current WL policy illustrations will become a future reality. This is something those who own a WL policy and those currently considering the purchase of one need to be aware of. Those topics are addressed in additional separate “How it Works” WL write-ups.
As noted in the introductory comments, WL cannot be dismantled into its individual parts to see how it works. Absent facts on the assumptions behind illustrated values there really isn’t anything one can do to evaluate if the illustrated values are reasonable, or not. And those facts are never shared with those who sell WL or those who buy it. All one can do with WL is run an illustration and then sit back and see what the future holds. It will take decades to see what actual values accrue versus those originally illustrated.
The best one can do at the time of purchase, or thereafter, is make an effort to understand the mechanics behind how a WL policy is designed. How guarantees are structured or calculated and how the dividends that fuel the illustrated cash value growth above guaranteed levels function. While this will provide no real insight on what is likely to transpire in the years to follow it will at least impart a generic grasp of the “moving parts” that make up a WL policy design. Which in turn will allow for making some logical and educated guesses on what is likely to transpire in the years to come based on current and recent past realities.
NOTE: WL is not the right product for those who want details on product expense factors or the assumptions used to produce illustrated values. That information will never be made available. If that is a primary concern there are several variations of Universal Life (UL) products that are a better fit. The reason being UL products by design can be broken down into their parts and each and every cost element can be seen in great detail. This is not to say the UL design is better than the WL design. It’s just different. Very, very different. WL cash value growth by design is always tied to interest sensitive returns. This is required by State regulators and its design.
GUARANTEES – VS – CURRENT ASSUMPTIONS
There are actually two types, generically speaking, of assumptions being made in the WL products design. One deals with “guaranteed” elements. The other deals with non-guaranteed elements, generally referred to as the “current” assumptions the combination of which largely dictate dividend performance levels.
This write-up focuses on dividends. A separate write-up addresses guarantees.
CURRENT ASSUMPTIONS – ILLUSTRATED AND ACTUAL DIVIDENDS
It’s fair to say there is little or no clarity relating to how the non-guaranteed elements of the WL product are administered or how they operate in practice available to the public; including the calculation of:
- illustrated year by year base policy premium driven credited dividends,
- dividends relating to prior accumulated additions and
- dividends to be credited on paid up additions (PUA) rider payments (a topic to be discussed in another write-up).
Non-guaranteed WL policy values collectively are referred to as “current assumption” values, or simply “current” values. The most important of which is the illustrated and subsequent actual level of “dividends” credited into any given “in force” WL policy.
The term “credited” refers to the portion of general account earnings that actually find their way into any given WL companies inforce book of WL policies. That is based on a decision made solely at the discretion of the WL companies Board of Directors.
The amount credited to policyholders may not have any direct relationship to the yield on invested assets (earnings) in the general account, which is generally referred to as the company’s “dividend scale”. A totally misleading term that is completely misunderstood by most of those who sell WL products in that it implies a direct relationship to dividends credited.
It is the crediting of dividends into a WL policy that creates “current” cash values above guaranteed levels. Credited dividends accumulate in the form of “additions” inside the policy. Additions have both a dollar value and a death benefit value. The dollar value is equal to the dividend dollars credited.
There can and would be a different dividend credit pertaining to base premiums versus prior year additions already credited and the “up front” immediate purchase of Paid Up Additions (PUA’s) with added premium funds paid in above the required base premium level. The reason being “additions” are immediately available in the form of cash values that can be accessed by the policy holder.
As a result these values cannot be invested in the general account for the longer term (which creates principal risk) and therefore they typically earn a lower rate of return than asset values resulting from the payment of base premiums (which are illiquid due to a formula driven surrender penalty factor; the subject of a separate write-up).
Base premiums can be and typically are invested for a longer term than general account assets supporting additions based cash values. The greater the spread between shorter term bonds and longer term bonds the truer this statement is.
NOTE: If $100 in dividends is credited think of it as creating 100 additions, each with a one dollar immediate and accessible cash value. Then think of each of these dollars of additions as a separate “mini” life policy with its own level of death benefit. The death benefit value of a $1 in additions might range from a low of few dollars to a high of eight to ten dollars. Generally, the older the insured the lower the amount of the death benefit value “per dollar” of additions. The death benefit value is above the guaranteed base policy death benefit created by the payment of base premiums.
Dividends are the result of an extremely complex combination of factors tied to the very same formula categories and myriad of assumptions that combine to represent any given WL product. For purposes of this write up most of the discussion pertains to dividends created by the payment of base premium dollars but they pretty much apply equally to additions related dividends.
The reference “base premiums” refers to premium dollars that create the “normal” amount of guaranteed death benefit being purchased which is stipulated in a table built into the WL policy disclosures for any given age, sex or tobacco use status. It is also possible to pay an amount above the base policy premium. That added amount creates immediate “paid up additions” (PUA’s) value that can be accessed by the policy owner at any time.
NOTE: These formulas and assumptions that combine to make up a WL product are discussed in great detail in the “design basics” write-up. As such, they will not be repeated in this write-up.
Generally speaking, it is the combination of actual results substituted for the initial product design assumed formula assumptions and factors that determines the degree to which actual credited dividend values exceed or fall short of originally illustrated dividend values in any given year. The further behind the actual values fall over time, versus the originally illustrated values, the less likely it is that future policy values will ultimately equate to originally illustrated levels.
Logically, one would assume the actual results pertaining to general account earnings, death benefit payments and overhead expenses paid with general account funds should be the three factors that have the greatest impact on dividends credited into a company’s inforce WL policies. Logic aside, this this may, or may not be the case. The reason being two other factors must be considered by a company’s Board of Directors. They are asset reserve requirements imposed by regulators and both mandatory and optional capital needs considerations.
- Reserves: Regulars require WL companies set aside funds to protect against downward swings in value of various types general account assets. The more illiquid, longer term the asset and the lower the credit rating the greater the required reserve amount. The funds required to fund reserves must either be deducted from premiums paid by policy holders or come from general account earnings. Unfortunately, the highest earning asset classes (illiquid, longer term or lower rated) require the highest reserve levels. Which may well discourage a WL company from investing in those types of assets to avoid the need to fund said reserves. A decision that results in lower paying assets being held in the general account. While this may reduce reserve funding needs it also lowers general account earnings and possible dividend crediting. A roughly similar end result.
- Capital: Regulators and creditors require companies maintain specified capital levels. Ratings agencies determine financial strength ratings based on the holdings in the general account and levels of offsetting reserves for those deemed to impose a level of risk of loss. To do so insurance companies must either raise capital from outside sources (stockholders) or retain a portion of general account earnings to address these capital needs. Mutual companies have no stockholders so in theory they have no external sources of capital (although some forms of borrowing are allowed to be called capital by State regulators). The only other sources available to mutual companies are premiums paid by WL policy holders or general account earnings. Public companies are not always inclined to issue more stock to build capital since doing so dilutes the value of its already outstanding shares of stock. Since the senior executives typically own millions of dollars in company stock and options to buy company stock they will often instead elect to retain a portion of the general account earnings to build capital and not issue more shares of stock to do so.
The impact on credited dividends of these two topics (reserve and capital needs) are addressed later in this write up in more detail. Suffice it to say for now both of these can have a tremendous impact on the portion of general account earnings that find their way into inforce WL policies in the form of credited dividends.
DIVIDEND SCALE LOGIC
The earnings rate on general account assets is referred to in a number of ways.
The most accurate reference is calling it the “yield on invested assets”. The least accurate reference is when it’s called a company’s WL “dividend scale”.
The term “dividend scale” suggests a uniform average earnings rate that is spread evenly between all inforce WL policies. Nothing could be further from the truth when it comes to the earnings in the general account and how they are credited into the tens, if not hundreds of thousands of WL policies sold over decades that remain in force at any given time.
The actual reality is the general accounts of large insurance companies are segmented into “blocks of assets”. Blocks that pertain either to a particular series of WL policies sold in the past, or to blocks of policies sold over certain time periods where underlying economic factors (like interest rates) were stable and similar. Earnings are calculated within these blocks as discrete and applicable only to the policies whose premiums were invested in the assets making up the block of assets.
The timing of when premiums were received on any given policy series, and assets purchased to support those policy values, can yield far different earnings results for any given block of assets. Periods of high interest rates would find assets purchased to have far higher yields than those purchased during periods of low interest rates. The overall earnings rate of the entire general account is largely irrelevant to any given particular policy.
It is also true that based on design differences some policy series sold at the same time could have required the payment of very high premium levels per $1,000 of death benefit allowing for far more in income producing assets to be purchased while another WL policy series sold at that time was designed to have a far lower premiums per $1,000 of death benefit. The first series is designed to appeal to buyers interested in maximizing accumulations so they are happy to pay in higher premiums up to the level allowed by the IRS. The second type of targeted buyer is seeking to minimize the premium amount they must pay to obtain a particular amount of guaranteed death benefit.
Each segment, or block, of general account assets is impacted by the formulas that govern the design of the WL products sold in that block or time period. The dividends paid (or “credited”) into any given WL policy within any specified grouping of policies are a function of those original WL formulas, the premium levels charged and related actual results delivered by the assets purchased with those policies premiums. Subject to extraneous actions taken by the Board of Directors relative to reserve funding and capital needs (which are discussed later in this write-up).
So, it’s actually irrelevant to any given policy owner what the average yield on general account assets is for any given company at any given point in time. It has nothing to do with what will be credited into any given WL inforce policy. Calling the average earnings in the general account a “dividend scale” gives the totally misleading impression in that it infers a universal result applicable to all WL policies and their credited dividend amounts.
The actual dividend crediting level will be determined by how any given policy was designed, the benefit it focused on delivering, the time period during which it was sold and what has transpired since the policy was sold versus the illustrated assumptions. Again, subject to the discretion of the Board of Directors.
ACTUAL vs. ILLUSTRATED VALUES
Dividends, not guarantees, are the key to cash value growth in a WL policy. It is the crediting of dividends that can make a WL policy work as illustrated. Absent the crediting of dividends all there would be is a minimal guaranteed cash value amount and guaranteed death benefit. So two columns on an illustration would be sufficient. Anything beyond those two columns (aside from loan activity) is dividend related or dependent.
This is so because it is the crediting of dividends that adds to cash value build up and keeps the base WL product “in force” once the policy owner stops paying “out of pocket” base premiums.
A classic illustrated WL sales scenario involves surrendering cash values to pay premiums once the policy is well funded enough to allow for that. This occurs when the cash value of past and current year dividend additions “at a point in time” are sufficient to create funds “inside the policy” that can be used to pay all future year’s illustrated premiums.
The illustrations reflecting this “point in time” literally show zero’s in the premium due column from that year forward. This is deceptive in that it obscures the fact premiums are still being paid via the surrendering of the cash value of dividend additions to fund those payments. There was a time when this was referred to as the year premiums “vanished”. A term that was subsequently banned as misleading.
NOTE: The illustrations people are given show an “imaginary” scenario where the surrendered dividends generate a cash value that is paid out to the policy holder who then uses those funds to pay the current year’s premium to the WL company. In real practice that’s all done inside the policy. However, its still accounted for as if it had made the round trip out of policy as a dividend distribution and then back into the policy as a premium payment.
The net impact on policy cash values of this imaginary round trip out of and back into the policy is basically zero (aside from possible surrender charge factors that might still be in play reducing the cash value of the premium payment temporarily which are discussed in another write up). The surrender is not a loan. The IRS views this as a non-taxable return of premium to the extent it does not exceed premiums paid into the policy.
Back in the 1970’s and 80’s the year this occurred was referred to on illustrations and by those who sold WL as the premium “vanish” point. Regulators, in the mid to late 1990’s, in perfect hindsight after interest rates had plummeted from historic highs and these “vanish” points actually disappeared, forbid the use of the term “vanish”.
The drop in market interest rates resulted in a drop in general account asset yields, which in turn resulted in a decline in credited dividends to levels far below the originally illustrated levels. The practical result found the illustrated vanish point being pushed into the future by years, or in some cases even decades.
Oddly enough, State regulators had for a decade or more blissfully allowed the use of the term “vanish” on illustrations and in sales materials (all of which the regulars had approved for use with the public). They did so without requiring any reference to the fact premiums were actually being paid from inside the policy by the surrender of dividend cash values. The very same regulators subsequently “after the fact and in perfect hindsight” (when they do their best work) announced the term was deceptive.
After all, it had to be since WL premiums by design must be paid from one source or another each and every year.
So with great fanfare the use of the word “vanish” was subsequently banished. Massive fines were levied on WL companies by the same regulators who previously allowed its use to punish them. Regulators who had never objected before to the use of this term. As one would then expect class action attorney’s leaped on this opportunity to mount industry wide litigation on behalf of disgruntled policyholders who were being forced to pay premiums for longer than had been illustrated.
The result was many hundreds of millions in legal settlements designed to punish WL companies for having mislead the buyers of WL policies. Of course, the regulators who sanctioned the illustrations and terminologies were never litigated against. They got to enjoy the benefit of the fines they collected. Go figure.
The nations regulars subsequently also required the use different language in illustrations to describe this “point in time” to eliminate any confusion as to what was occurring. Oddly enough, they still allowed this “vanish” year to be illustrated in the same deceptive manner it always had been.
A “vanish” point that now had to be referred to “as the year in which accumulated and future non-guaranteed dividend additions become sufficient to pay ongoing annual premiums”. Clearly a far more accurate description of what was being shown, but one that was utterly incomprehensible to the average buyer of WL.
NOTE: The three or four WL illustration pages with all the little numbers on them are pretty much the only pages most WL buyers ever bother to review. Those pages still showed “zeros” in the premium due “out of pocket” column at the illustrated vanish year. Regulators are seemingly oblivious to the fact buyers rarely read the other thirty or forty pages of complicated explanations of various policy features, including assorted disclosure footnote language. So it really didn’t matter if the word “vanish” had been used, or the long winded phrase the regulators now preferred was used.
So WL policy illustrations remain every bit as deceptive today as they ever were irrespective of the language added by regulators to enlighten WL policy buyers. Typical regulator ineffectiveness.
The very idea the average person is going to read thirty of forty pages of life insurance terminology and policy provision explanations is ludicrous. What the buyer sees are the numbers illustrated and those numbers still told the same deceptive story. What people see is far more powerful than what they hear. And when what they see is reinforced by the sales associate verbally as they review an illustration with the buyer adds to this visual impact.
The fact is the year this premium vanish “point in time” occurs is totally dividend dependent. Those who buy WL policies anxiously await the arrival of that illustrated year when they can stop paying WL premiums “out of pocket”.
If dividends credited into WL policies exceed those illustrated the “vanish” year will arrive sooner than illustrated. If dividends credited into those policies lag the illustrated levels, the “vanish” point will move further into the future. The more extreme the variation, the more extreme the movement of the year in which illustrated premiums will “vanish”.
NOTE: It is also possible premiums that were able to be paid by surrendering past and current dividend additions will once again at some time in the future have to be paid “out of pocket”. This happens when future dividends credited continue to fall from the levels that were being credited at the time the “vanish” point calculation allowed it to be triggered. When this happens it comes as an absolute shock to the policy owner who assumed they were done paying WL premiums forever.
Beyond the payment of ongoing future premiums using accumulating dividends it is the further accumulation of dividends above the level needed to pay premiums that then funds the ever popular classic illustration of supplemental retirement income. Again, these future distribution levels are not guaranteed since they are also dividend dependent. They may, or may not, ever come to pass.
Illustrations that feature both the point in time “out of pocket” premium payments can be stopped and future supplemental retirement distributions are the norm when it comes to selling WL policies. Most people buy WL to obtain the future distributions. The fact they don’t have to pay premiums out of pocket for life, however, is a very important factor in the typical buyer’s decision making process.
Those who sell WL tend to fuel the fire of that hope by stressing the conservative nature of the WL product. They repeatedly stress WL has many guarantees and based on prior experience from decades long past they verbally make assurances the cash value levels illustrated are likely to be there when needed in the future. They may or may not mention the dividends that drive cash value growth are not guaranteed, something stipulated in the illustration footnotes.
Those who sell WL have been schooled to believe the performance illustrated is likely to occur. They believe it, and there faith that will occur often transfers to those they sell to.
Unfortunately, the total lack of information regarding the assumptions used in these sales illustrations, combined with zero feedback on how they compare to subsequent actual results, makes it pretty much impossible for the typical buyer of a WL product to evaluate how the product is performing even after they buy it.
Most simply assume what was illustrated is likely to occur.
Most also incorrectly assume they would be alerted by the company that issued the policy if that were not the case. Another perfectly logical assumption, which of course, is not likely to be the case. Most companies take little or no action to enlighten the WL product buyer that they may have to pay premiums for far more years than was illustrated. They do so because the fear the wide spread surrender of the WL products sold in the past and the devastating impact that would have on the company’s capital, not to mention its ability to continue paying its overhead expenses from general account funds.
Company executives seek to protect the company (and their jobs and income) first and the policy owners second. Time and again this has been proven to be the case. It’s human nature at work and human nature is not likely to change.
WHAT REMAINS INVESTED CAN MAKE ALL THE DIFFERENCE
The dividends credited into any given WL policy above guaranteed cash values are a function of several major and many other lesser factors. The major factors include:
- How much of the premiums paid and earnings thereon remain invested and producing earnings in the general account after death benefits and company overhead expenses have been paid in any given year.
- The average yield net of investment related expenses on the remaining invested assets in the general account (rate of return earned) in any given year.
- The portion of annual earnings diverted to fund required reserves and meet company capital needs and/or goals (at the company’s Board of Directors sole discretion).
The resulting accumulated total general account balance carried forward at the end of any given future year, which is the cumulative result over time of all of the above, may ultimately become the most significant driver of future results. The reason being only the amount actually left in the general account at any given time can earn a return.
Initially, it’s fair to say the payment of death benefits can have the biggest impact on what’s left invested and growing in the general account. However, over time earnings (or a lack thereof) on general account assets can become an increasingly important factor. If the variation from the assumed illustrated earnings rate is large, after a few decades the amount remaining invested in the general account will likely become the most important driver of future dividend results versus those originally illustrated.
The more extreme the variance from the original illustrated return assumption, the truer this statement is. At a point, if the variation is extreme enough and has gone on long enough, it creates an irreversible positive or negative dividend scenario going forward.
NOTE: If the balance being carried forward decades later is far higher than assumed in the original illustration it means the dollar amount of earnings available to be credited into any given WL policy series will be far greater than was originally illustrated. Even if the number of inforce policies is slightly higher than was assumed based on positive mortality improvements. Similarly, consistent below assumed earnings results over time will result in a far lower general account invested balance than originally illustrated. Meaning, a far lower total dollar amount of earnings will be available to allocate into in force policies as dividends. Then the likely marginal positive mortality experience would further reduce the dollar amount of earnings “per policy” available to be credited as dividends at that time. Since more policies would remain in force.
The more extreme the variance in earnings from the original assumptions and the longer that scenario persists, the greater the impact. At a point the variation in the anticipated assumed general account value built into the illustration system can be so great no amount of future earnings from that point forward would be sufficient to offset the impact. At that point, the cumulative past results create an irreversible future subsequent reality.
Which is the situation today, as described below.
THE WL GENERAL ACCOUNT REALITY TODAY
As implied above, the value of the block of general account assets supporting any given series of previously sold WL products can become increasingly important over time. This occurs when actual results, either positive or negative, vary further and further from originally illustrated values. The longer this persists, the truer this statement becomes.
The reality today is general account earnings levels have been far below the rates assumed in WL illustrations run decades ago. With no likelihood on the horizon that this will change any time soon. This situation has persisted for over two decades. Far longer than anyone would ever have imagined possible.
True, there has been a continued modest improvement in mortality experience versus that which was originally assumed and illustrated. However, the positive impact of this marginal improvement has not been sufficient to offset the dramatic shortfall in earnings caused by prolonged low interest rates. That shortfall is also a function of ill advised by well-intended regulatory impositions. These are discussed in great detail in a separate write-up.
NOTE: This can easily be proven. Even though this sort of information is never communicated directly to policy owners by WL companies it is shared with State Insurance department regulators annually. The entire makeup of the general account is detailed; including the breakdown of asset classes, the average maturity of the assets in each asset class, the average yields earned within each asset class and the amount (if any) of unrealized capital gains). Once shared with the regulators this data is considered “public knowledge” available for the asking. Certain organizations do exactly that and from time and they actually publish this data in industry journals. This occasionally may include comparisons between actual current policy values versus those that had been illustrated at the time of sale for specified ages at issue. The data shows the average yield on invested general account assets has plummeted from historical levels; a trend that has persisted for the last few decades. Most companies now are barely, if even, earning enough to meet their guarantees. The actual current values today for virtually all WL companies are woefully short of those originally illustrated.
Of course, assumptions made in illustrations run in the past were consistent with general account yields typical in the past. Which means originally illustrated future cash values and the levels of dividends they could generate exceed subsequent actual results. Often by a great deal. The shortfall in cash values for policies several decades old (or more) is extreme. And at this point its impact is irreversible.
Suffice it to say the balances in the nations WL company’s general accounts for these policy series is a fraction of what was originally anticipated and illustrated. As are the dividend levels those balances can generate at today’s abysmally low yields.
A situation that has perpetuated this scenario relates to the nations regulators. They continue to allow WL companies to illustrate earnings assumptions for new WL products at levels consistent with their current general account yields. When rates in the market place are falling the overall general account earnings rate will always be higher than the current market rates. The reason being the general account holds older higher yielding assets purchased in the past that have yet to mature.
The practical impact of this regulatory practice, which was implemented decades ago to stem unbridled optimism in earnings assumptions at a time when rates were consistently rising, finds illustrations run during times of declining market interest rates showing cash values that consistently exceed what subsequent actual earnings rates can allow for. This is so because the premiums collected in the subsequent years can only be invested in the lower yielding investments currently available. Yields far higher than currently available.
The only way this approach that regulators require could work out is if the company could go back and time and buy the higher yielding assets currently. Something apparently beyond the grasp of the typical State Insurance Department regulators.
What this means, from a practical standpoint, is even the more recently issued WL policies are facing significant future shortfalls in cash value growth and subsequent dividends credited versus those illustrated. While not as severe as is the case for older policies issued in decades past the negative impact of today’s abysmal low yield levels can still have a substantial negative impact on recently issued policies. For instance, the illustrated “vanish” point is unlikely to occur when scheduled and instead will be pushed into the future. Possibly very far into the future.
So the actual impact of the rules governing how illustrations are run has for several decades resulted in a consistent gross overstatement of future cash values, dividend accumulations along with overly optimistic illustrated vanish points and future retirement distribution levels. The blame for this can be placed squarely on the State regulators in that they remain blind to any evolving problem until a virtual avalanche of lapses, disappointments and resulting bad press combined with endless litigation makes them aware a problem exists.
At which time the nations regulators can be counted on to always grossly overreact. They fine all the companies involved, implement rules that backfire later when economic factors once again reverse, while wallowing in the windfall the fines that fund their bloated budgets create. The State Insurance Departments are ineptly run at best. One reason being most of them are run by political appointees with no experience or background in the matters their departments regulate. Individuals whose sole focus is the next political office this position will assist them in running for.
Adding insult to injury (so to speak) most of them are also involved in the outright blackmail of the very same insurance companies they are paid to regulate. Blackmail in the form of campaign contributions; the very reason most sought the State Insurance Department appointments in the first place.
Anyway, the publically available data the companies share with the regulators clearly tells the tale of what is unfolding. And it’s a sad tale it tells indeed. Sadder yet because the very regulators the data is disclosed to have no idea what it means. Nor are they able to discern what actions that data should prompt them to take before policyholders suffer irreversible damages. A sorry situation indeed.
NOTE: Today’s situation is the exact opposite of what occurred with WL policies sold prior to the mid 1970’s. Those policies benefited tremendously as interest rates spiked steadily upwards after those policies were illustrated and sold. This produced far better dividend results and cash value growth than had been originally illustrated in decades past. Often double what had been illustrated. That scenario came to an abrupt end several decades ago when interest rate trends reversed after which they have steadily declined to today’s far lower levels. Abysmally low levels they have stayed at for far longer than anyone ever imagined possible. The policies issued since that decline started are at this point hopelessly behind in cash value accumulation. Which also means dividends are a fraction of what they were anticipated to be.
The reality at this point in time for most, if not all WL policies in force today, is accumulated actual values are so far behind originally illustrated levels they can never recover. The situation is absolutely irreversible. These policies can never recover. They are at definitive risk of lapse because premiums assumed to have “vanished” long ago are once again being required to be paid out of pocket. Or, for more recently issued policies, vanish points that should be on the horizon are now nowhere in sight and unlikely in many cases to ever occur.
Unfortunately, these WL policies also won’t be able to generate much if any future dividend levels sufficient to fund illustrated distributions to meet supplement retirement income needs. Most will likely be cancelled or allowed to lapse by their aging owners, many of whom are long retired and living on fixed incomes so they can’t afford to resume premium payments.
This lapse scenario will occur long before the insured party is likely to pass away. Meaning the policy owner will not only be forfeiting all of the prior premiums they had paid but there will also no longer be any death benefit coverage to protect their spouse.
The “myth” is that older people don’t need life insurance. The reason being the need an existing life policy was purchased to cover no longer exists. While that may well be true, the reality for senior citizens is that when one spouse dies (usually the male who was often the primary income earner with older couples) the social security income most are living on will be cut in half. This, of course, leaves the surviving spouse (usually the wife who will outlive the husband by an average of five years based on mortality statistics) with a steep drop in income and only a minimal offsetting drop in living expenses.
The reality is no age group needs life insurance more than our nation’s senior citizens. They are also the most likely group to own older WL policies and the most likely group to lose that coverage when their policies end up lapsing.
ASSET RESERVES AND CAPITAL CONSIDERATIONS
As noted earlier, asset reserves required by regulators, combined with the need to maintain capital levels for both regulatory and borrowing purposes, can also have a very substantial impact on how much of the general account earnings find their way into policy holder cash values in the form of dividends.
This is well worth mentioning since either of these two factors can wipe out most, if not all, of any given years general account earnings that would otherwise be available to credit as dividends into WL policies (for any given life insurance company at any given point in time). There are extreme situations that can arise that can cause this to happen. These situations often relate to a subsidiary the life insurance company owns that operates a totally separate and unrelated businesses.
Most people would have difficulty understanding how an unrelated business owned by a life company could cause the dividends otherwise payable to its WL policy owners to be directed to another use. The fact is, insurance companies can and do take earnings from the general account and use them to build up required asset reserves and or to maintain required (or desired) company capital levels.
Relative to capital levels the goal may be maintaining or improving ratings, but in the extreme this action might also be necessary for the parent life insurance company to remain solvent and in business. Consider this extreme real world example from the not so distant past, a glaring example of this type of scenario.
EXAMPLE: A company, one of the nation’s largest at the time, owned a stock brokerage firm in the 80’s and 90’s. That stock brokerage subsidiary sold a large number of limited partnerships which were all the rage at that time. Sadly, the limited partnerships subsequently collapsed in value after the 1987 tax reform act gutted the tax benefits they were created and sold to deliver. The unintended but devastating consequence of this revamping of the tax code was the financial collapse of tens of thousands of otherwise financially healthy limited partnership entities.
This was not the subsidiary brokerage firms fault. Nor was it the fault of the many other brokerage firms that had sold clients limited partnership interest for their then valid and highly desirable tax benefits. It was strictly the fault of Uncle Sam and the above noted change in tax laws. None the less, those who invested in these tax shelters lost tremendous amounts of money; billions upon billions. This, of course, resulted in an avalanche of litigation and regulatory finger pointing.
The subject parent insurance company, subsequent to this debacle, was advertising in industry journals (targeting life agents who might sell their WL products) touting the fact they had earned the highest yield on invested assets in their general account in the entire industry in a then current year. Of course, they referred to this as the parent life company having the “highest dividend scale” in the industry. The obvious goal of this advertising was to induce other life insurance sales professionals to sell this companies WL products.
Oddly enough, for the very same year, the dividends credited into the WL policies they had sold over the prior decades were almost or actually zero. Aside from guaranteed cash value increases these policies realized little or no added cash value growth from credited dividends for a number of years immediately following this tax law change.
One would think the opposite would have been true if the company had the highest yield on invested assets in its general account during one of those years. Anyone would think this meant they also paid their WL policyholders a very high dividend rate tied to these general account earnings. A fiction their advertising actively sought to foster among those who sold WL policies.
But that was not the case. Not even close. So here’s what actually had happened.
As noted earlier in this write up every year the Board of a life company votes on how much of the general account earnings will be credited into their inforce WL policies as dividends. There is no “law” or “regulation” requiring all or any part of those earnings to be allocated into those policies. It’s at the sole discretion of the Board.
The Board of this company had actually voted to retain the bulk of that years general account earnings to increase the capital value of the company. Meaning, the funds were not credited as dividends into their WL policies. Actually, they were indirectly used instead to offset the payment of fines, penalties and legal settlements relating to the subsidiaries limited partnership problems.
Indirectly in the sense the accounting for the brokerage subsidiary losses dramatically reduced the parent’s capital as these fines, penalties and settlements were paid. This loss of capital was effectively “offset” by the Board simply by their not voting to credit all, most or even some of the general account earnings for the years involved into their outstanding “in force” WL policies.
Instead, since the earnings were not credited into the WL policies they were actually retained in the general account. Since they were not allocated to the WL policies supported by the general account assets, those earnings were accounted for as effectively increasing the parent company’s capital. That increase offset the decrease from the subsidiary brokerage firm’s losses that had flowed up to the parent.
The term “credited dividends” refers to the portion of general account earnings actually allocated into WL policies. The misleading term “dividend scale” has no actual direct relationship to the amount “credited”. It simply is a reference to the average level of earnings (yield) on the assets making up the general account.
A Director that subsequently left the company (in disgust) related that the Board deemed it to be “in the best interest” of the policyholders (that were at that time the owners of that mutual company) that this be done. Their “best interest” having been defined by the Board as having the company maintain its AAA financial strength rating (not to mention its need to remain solvent).
The thought behind this being allowing the company to become insolvent, or even suffer a dramatic ratings decline, would not be in the best interest of its policy holders. Or, its senior management for that matter. And that reality was on the horizon. Hence the action taken by the Board (or lack of action, as the case may be).
The reason for this decision and the problem it solved had nothing to do with the business of the life insurance company itself. Instead, it had everything to do with its brokerage subsidiary, the entity that had sold countless limited partnership interests to its clients. The problem was however solved at the expense of its WL policyholders who effectively were denied the dividends generated by the premiums they had paid to offset the above noted fines, penalties and legal settlements relating to the limited partnerships sold by its brokerage subsidiary.
The Board needed to take dramatic steps to rebuild its capital base. It had for several years pushed down billions of dollars in cash into its subsidiary, funds needed to pay the fines, penalties and settlements relating to the sale of those limited partnerships. The impact of these losses on its capital base had to be offset or insolvency, ratings reductions and other such negatives would occur.
Worth noting is the fact a dramatic a drop in ratings would also very likely have violated the terms of existing bond indentures and bank credit facilities; something that would have then further worsened the company’s financial problems. It was indeed a crisis. However, not one of the WL policyholders making. Not really their problem to solve. Unless the Board decided to make it their problem. Which they did.
What gave the Directors unfettered control of the situation was the fact this company was still a mutual company at the time. Meaning it was owned by its policy holders. These theoretical owners actually had zero input into how the company operated and who it employed as its officers and directors. “Owners” who received no information on its operations other than their overly simplistic WL policy annual statements.
There are no stockholders in a mutual company to report to. There are not SEC or stock market disclosures pertaining to its financial operations as are required with publicly held companies owned by stockholders. Aside from reporting to State Insurance regulators, who would be mortified if a company that large failed under their watch, the Board was free to do as it pleased.
So when the Board voted to use the general account earnings for capital purposes, not dividend purposes, it did not need to make disclosures about that decision to the policy owners impacted by that decision or explain to them that such a decision had been made. And that’s how they voted. And that’s why their WL policy owners received little or no credited dividends for a number of years subsequent to the tax law change, irrespective of the high levels of earnings achieved and advertised in its general account.
Examining a WL policy owned by a doctor at that time showed the extent of the impact on its individual WL policy holders. A Doctor had an illustration showing he would only need to pay premiums for six years before dividends would be sufficient to pay the premiums for the rest of the policies life. He was surprised and dismayed when he got a bill indicating he would need to pay a premium in the 7th year.
The good doctor found someone to help him obtain an “in force” illustration since the agent that sold him the policy had failed out of the business the year after this sale was made. The doctor was surprised at what this updated illustration showed. It took the actual first six years results as a starting point and then illustrated the future years thereafter. It showed the doctor would now need to pay 35 years of premiums out of pocket before his WL policy would reach its “self-funding” vanish point.
The reason for this was virtually none of the anticipated dividends had been paid into this policy over the six years it had been in force. This was true because the starting date had been a year after the tax reform act was passed and the Board of this company began its campaign to protect its capital base by not crediting dividends into its WL policies.
This was a very large policy with very high premiums. Needless to say, the doctor was rather upset by this unexpected turn of events. He had no idea something like this could happen without a word having been said to him. By a mutual company that in theory he was part owner of.
This was, of course, in total contrast to the implications of the ads run by that same company during this time frame wherein it touted itself as having the highest general account earnings and “dividend scale” in the industry; right around a 10% return at that time. Perhaps the actions of the Board protecting its ratings and capital base can be excused as necessary or reasonable based on the extreme nature of the situation the company faced. But another valid question would be does that also excuse the running of this type of ad promoting its theoretical WL products performance.
It was a sad reality indeed that this company was advertising the highest dividend scale in the industry to attract more people to sell their WL products, when in fact virtually none of their existing policies were benefiting from the earnings in their general account at that time. Necessary or not, this sort of right hand left hand deception speaks poorly for this companies ethics. At least in the eyes of the Director that had resigned in disgust.
The fact this happened while it was a mutual company, owned by the policyholders whom the executives were pledged to serve, makes it all the more unsettling. What is worse today is this company, and most other large life insurance companies, have gone public. The officers of public companies are pledged to protect the best interest of their shareholders even if that means doing so at the expense of their customers. So, if anything, the situation today for those who buy WL policies is worse than it was a few decades ago.
It is interesting to note that abusing life insurance customers to protect the company is no longer a moral dilemma faced by its executives. It’s now the law. They are literally required to do so. A fact well worth pondering when it comes to an “opaque” product the design of which is largely a mystery. A product where there is no communication with the buyer about how actual results compare to original illustrated assumptions. A product the illustrations for which are inherently deceptive in their design absent a highly technical sales associate who can explain the pros and cons relating to how the product actually works.
When it comes to WL, and the ease of manipulating this “trust me” product, this reality is as disturbing a thought as anyone in the life insurance business can imagine when merged with the rules governing publicly owned companies. Especially when one keeps in mind the number of stock options the executives in these companies own. There is no doubt where their loyalties lie. To believe anything else is to defy all of human history.
One could debate why it is a small handful of companies are still focused on selling WL. The economy and dismally low interest rates do not favor its sale. Nor does the impact of State regulations on the makeup of the general account assets supporting WL policies. Yet some companies cling to selling WL as their main primary product. One view is it’s the only way those companies can fund their bloated overhead structures and keep their senior executives living in the style to which they have become accustomed. A cynical view perhaps, but perhaps one that is not entirely inaccurate.
It is likely most, if not all, of those companies can’t compete in the margin thin world of UL products where all product level costs are glaringly visible in black and white. If they need to bury their bloated overhead costs into a product where no one can see the impact of their doing so, WL is definitely the way to go. It would certainly be interesting to hear an explanation why they favor the sale of WL products in the context of today’s economic and regulatory realities. Interesting indeed.
RECAP COMMENTS
Certainly it can be argued the economic and regulatory realities of today don’t justify the sale of a WL product. Between asset reserve related regulatory realities and decades of abysmally low interest rates (that persist as of this writing) there is zero likelihood WL can deliver much of a benefit above illustrated guaranteed cash value levels. At best we are talking about a likely 1% or so cash value growth rate over the life of the policy for younger insureds, and less for older insureds.
Whether the life company is organized under the mutual format, or if it’s publically held, the executives can still have other matters in mind when it comes to the crediting of dividends into their WL policies. The opaque nature of the WL product design literally offers a temptation it would seem few executives can resist when it comes to protecting their jobs, their own net worth or the perceived best interest of “the company” and its stockholders (which often includes them).
It is not clear to the casual observer that illustrated whole life values are the result of a myriad of assumptions that compound annually to dictate future results. There is nothing stated in the sales illustrations, or its footnotes to explain how a WL product actually operates. The myriad of assumptions are not disclosed and subsequent actual results are not compared to them.
Meaning WL is a “trust me” product. Albeit a trust that is easily and perhaps often violated as the need arises and competing needs or perspectives are considered. All made possible by the lack of transparency the WL product design affords since most of what determines WL values is hopelessly bundled and hidden from view.
None the less, WL is an absolutely ingenious, pre computer design creation. A product developed at a time when the computing power needed to track endless discreet details did not exist, and when it was necessary to devise an approach that would allow a bundled product to deliver some individualized policy level benefits.
WL would have a definite place in the life insurance world if the economic environment always remained stable, if human nature were historically proven to be more trust worthy and if regulatory aberrations and over reactions were not allowed to interfere. It might even be the best life product ever devised if those factors held true. Or perhaps better said, at one point in time it was the best life product ever designed.
Sadly, those are not the realities impacting the WL policy design as we know it today.
WRAP UP COMMENTS
I’d suggest reading the remaining assorted write-ups for anyone inclined to continue the quest to better understand how WL works. This assumes the following have already been read; “WL Box Story”, “WL Design Basics”, and “WL Guarantees” and this “How WL Dividends Work” discussion.
Knowing about how the policy guarantees actually work and how dividends find their way into a WL policy is a good foundation to build on once one understands the concept behind WL’s creation and the components built into a WL products design.
Reading all of the above represents a good start.
But it’s just a start!
