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.
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” write up before reading this one. The combination provides a sound foundation to understand the following discussion on WL guarantees.
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. This “guarantees” write up discusses the foundation upon which dividend based values are added. The combination of these two write-ups provides 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
These 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 such 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 guarantees. A separate write-up addresses dividends.
GUARANTEES
There are four primary guarantees provided in a WL product.
At least three of a WL policies guaranteed elements can be nailed down factually since they are typically stated somewhere in the issued policies contractual fine print.
GUARANTEED EARNINGS RATE: This is a guaranteed minimum earnings rate anticipated to be earned on the assets for any given WL policy series held in the company’s general account. It has historically been in the 2% to 4% range for most WL policies issued in the last few decades. This particular guarantee is misunderstood by virtually everyone who sells a WL product. We’ll get back to that later in this write up.
MORTALITY RATES: This is the mortality rate “per $1,000 of death benefit”; the amount to be charged for any given insured group (age/sex/tobacco use) to provide the death benefit feature of the product. This is tied to a published and regulator mandated mortality table that will generally appear in the policy fine print as well.
PREMIUM RATES: This is the premium level “per $1,000 of death benefit” to be charged for any given insured based on age/sex/tobacco use factors. A premium rate payable annually for the life of the WL policy until a stated maturity or endowment date. Since the illustrated premium for any given insured is the guaranteed required premium it is obviously a known amount. The fact it must be paid for the life of the policy is typically footnoted somewhere in the illustration but rarely mentioned to those buying WL products by those selling them.
OVERHEAD EXPENSES: The fourth and final guarantee relates to company overhead expenses. This amount is not disclosed in the policy fine print or on policy statements. This “guarantee” sets a cap on the amount that can be paid from the company’s general account for the stipulated expense categories for any given series of WL policies a company has sold.
This factor is part of the formulas that make up the policy illustration system. Each State’s regulators in theory verify this limit is adhered to as the years go by. Something anyone who has interacted with State regulators might find difficult to believe they are competent enough to actually accomplish.
These four factors are embedded in the WL formulas that dictate both the illustrated and future actual guaranteed values that appear on original sales illustrations and then on each year’s subsequent annual statement.
This statement is “less true” in early policy years where the “surrender charge factor” built into the overall master formula reduces the illustrated and actual guaranteed cash values. The percentage factor declines to zero over time (usually 15 to 30 years) which effectively releases more of the premiums paid to date and growth thereon into the available policy cash surrender values. The surrender factors could also be viewed as guaranteed in that they are typically not subject to change after a policy is issued. A good guess is no one can actually say for sure they have never been changed.
So the maximum overhead expense level to be imposed (paid from supporting general account assets) is left to the imagination while the other three guarantees are verifiable in the WL contract.
GUARANTEED EARNINGS RATE
The way the minimum earnings rate guaranteed in a WL contract works is something no one I’ve ever met, aside from a few actuaries, understands. It is applied in a manner no average person would ever even imagine.
Its one thing to say a 3% or 4% earnings rate is guaranteed in a WL policy. That would seem to be something everyone can easily understand. It’s far less meaningful, however, if no one actually understands what the minimum guaranteed rate will be multiplied against.
Or for that matter if it will be multiplied against anything at all.
So let’s start by taking a look at some common, logical and totally incorrect assumptions.
One logical assumption is this rate will be applied to the premiums paid. Similar to an earnings rate on a savings account, where each years deposit earns a stated rate. The assumption being the policy owner will receive that level of guaranteed return on the premiums paid, compounded over time on all the payments that have been made. Which is not the case with WL. So scratch that logical thought.
Another common and equally logical assumption is the guaranteed rate will be used to calculate the increase in cash surrender value from one policy year to the next. A cursory review of any WL illustration or annual statement will verify this is not the case. So scratch that logical assumption as well.
There are those who assume it is the rate of return guaranteed to be earned on the whole life assets making up the general account for any given year. The question then would be; “how much of a policyholders premiums paid to date will have been disbursed from the general account to pay for death benefits”. Clearly this would have a major impact on the amount left remaining and invested in the general account at any given illustrated and actual policy year end date. This would be important if that’s how the guaranteed rate was to be applied. Which it isn’t. So scratch that logical and widely held belief as well.
So just how does the rate guaranteed in a WL policy work. To find out, read on!
WHEN IS 3% MORE THAN 4%
So here’s another mind blowing fact about WL. The answer to the above question is; when we are talking about guaranteed WL cash values. That’s when 3% equals more than 4%.
So here’s how the policy minimum interest rate actually works in a WL contract. As explained by someone who actually designed the formulas that made up the WL illustration system of one of the nation’s largest life insurance companies at the time.
So how can anyone seriously suggest a 3% guarantee will yield higher guaranteed cash values illustrated in any given policy year versus a 4% guarantee.
The reason is simple enough to understand when you look at the mechanics behind what that guarantee in WL actually means. All of which are based on an internal revenue code (IRC) definition in IRC Section 7702 that stipulates what constitutes WL from a statutory point of view.
The starting point in the guarantee calculation isn’t the current cash surrender value amount. Nor is it the current guaranteed cash value amount. Nor is it tied to premiums paid into the policy. Nor does it have anything to do with assets supporting WL values remaining in the general account.
Any and all of which many who sell WL seem to imply in their sales efforts.
Instead, the calculation actually starts with the guaranteed base death benefit amount at the contracts maturity date many decades in the future. Most of the policies sold in decades past used the 1980 CSO table which mandated a maturity date (also called an endowment date) at age 95.
So, getting back to IRC Section 7702, here’s what the tax code says; “the maximum guaranteed cash value at any point in time in a WL policy can be no greater than the single sum required under the its guaranteed terms to endow it (have the cash value equal the death benefit) at the policies maturity date”.
Another way to say the same thing is; the guaranteed cash value at any point in time is the single sum needed to grow to the base death benefit amount at the products maturity date under its guaranteed terms. I’ve always felt that way of saying it is a lot easier to digest.
When we do the math it turns out the higher the guaranteed rate used, the lower the lump sum needed at any given earlier point in time to deliver the same fixed total amount at the policies maturity age.
Obviously, the single sum needed at 4% to get to a given future total amount will be less than the single sum needed if 3% is used. It’s easy to see that at 3% the single sum needed would have to be higher to get to the same fixed amount later at a stated future point in time versus the sum needed if 4% were used.
NOTE: The actuary who explained this did so because a new WL policy with a 3% guarantee was being designed to replace a prior policy that had a 4% guarantee. The sales force was “up in arms” and wanted to know why the company would “water down” our guarantee versus competitors who still offered a 4% guarantee who would surely use that against us. The sales force assumed our companies illustrated cash value growth would fall far behind the competitions.
It turns out our company was actually trying to increase the illustrated guaranteed cash values the new product would deliver versus the prior WL design.
The question being, what would our customers would want? Higher illustrated cash values versus competitor illustrations or a little understood reference in the policy fine print to a higher guaranteed rate. A higher rate that didn’t translate on illustrations to higher cash values.
Customers would clearly want more guaranteed illustrated cash value. Competitors who claimed to offer a higher guaranteed rate but actually illustrated lower guaranteed cash values would not look good in the eyes of a customer. They would look like liars unless they could actually explain how cash value guarantees work. Which of course they were largely clueless about as evidenced by our own sales force.
Actuary’s love it when they can blow the minds of ordinary folks. Especially top sales people who often earn more than the company’s executives and actuaries. Which is a nice way of saying that when they talk to people who are ignorant on the topics they spend their life’s working on, the rest of us seem a bit dumb in comparison. Which amuses them no end.
So when it comes to whole life, a 3% guaranteed earnings rate produces higher guaranteed cash values illustrated in every policy year versus a 4% guarantee rate, right up to the year the contract matures (age 95 in this example). At that time and only then will the guaranteed values be equal. They must be because it is the guaranteed death benefit that both calculations are guaranteed to end up equaling.
NOTE: When it comes to mathematical calculation terms this is referred to as a “regression analysis”. The starting point is an ending value at a specified future time (in the case of WL the maturity date and policy face amount) and a regressive calculation (working backwards) is needed to determine at any given earlier year the amount needed to reach that ending value at that ending date.
So that’s how it works. That’s what the guaranteed rate in a WL means. Only in the crazy world of whole life’s inverse logic can 3% equal more than 4%.
Most of those who sell WL boldly assert the policy owner will earn the guaranteed return. They do not boldly elaborate as to what it will be earned on. It’s just a matter of pride with those who sell WL to boast about the products guarantees. Even the guarantees they can’t explain.
Every WL policy owner I’ve ever met assumed they were earning the guaranteed rate on what they paid into the policy and that it compounded as the rate earned on prior earnings as well.
They logically apply bank and brokerage account logic to what they are hearing and make that assumption. What is amazing about this is how easy it is to prove that isn’t the case by making a few simply multiplications and additions.
But oddly enough, no one ever seems to do that.
NOTE: Of course, as noted earlier, the impact of surrender factors in the formulas governing cash value accumulations also has a major impact on the guaranteed cash values shown in the early policy years.
What is also common is a sales associate taking the annual increase amount in the guaranteed cash value (or total cash value for that matter) on an illustration or policy statement and telling the policy owner (or potential buyer) it’s all the result of returns being earned in the policy. They blissfully ignore the fact more money (another premium) has been paid into the policy that year as well. Of course, any added amount paid by the policy owner would first need to be deducted before an increase from earnings alone could be determined.
NOTE: Imagine if a bank or investment firm tried to tell a person the amount they deposited as additional savings into their account that year represented earnings. Would anyone be foolish enough to buy that nonsense with a savings account? But with WL, which most people don’t understand to being with, it’s much easier to tell a confused policy owner something like that and not have them notice the illogical nature of the comment. Especially when looking at illustrations that have hundreds, if not thousands of numbers accumulating over many decades.
To be fair, these are rarely intentional deceptions. Instead, they are the result of poorly thought out statements made by those lacking a true understand of how the WL policies they sell, or have sold, actually work.
MORTALITY TABLES GUARANTEED “RATE PER $1,000” DEATH BENEFIT FACTORS
Every few decades the life insurance industry completes a formal study and adopts a new updated mortality table for use in its policy designs and the assumptions embodied therein.
These mortality tables, referred to as Commissioners Standard and Ordinary Mortality (CSO) tables, are typically named after the year the analysis was completed. There was one adopted in the 1950’s, another in the 1980’s and yet another in the early 2000’s.
Each successive CSO table has reflected fewer deaths for any given age group than were anticipated based on the previous CSO study (table). Meaning people are consistently living longer from decade to decade. That’s been the case for many, many decades.
NOTE: Its recently been suggested the over use and illegal use of pain pills of various nature will cause this trend to abate or reverse when the next mortality study is completed.
What past experience suggests is subsequent actual mortality experience has been more favorable than the tables included in the illustrations when any given past WL policy was sold, which in turn assures a more favorable actual mortality result than was illustrated.
When insureds pass away at a slower pace than anticipated the payment of death benefits from the general account occur at a slower pace than anticipated in the original sales illustration. Which in turn means more of the premiums paid to date remain invested and producing earnings in the general account than was assumed in the illustration.
The table used in determining any given life policies illustrated assumptions, both “guarantee” and “current” is identified in the policy. The fine print will show the “rates per $1,000 of death benefit” to be used for any given insured (age/sex/tobacco use) taken from the referenced CSO table.
Therefore the “guaranteed” rates “per $1,000” of death benefits are known. There is no mystery relating to this assumption used in the WL formulas that govern illustrated values when a WL policy is sold. However, the actual level of death benefit payments occurring over time impacting any given WL policy series is a mystery.
What can’t be easily determined is exactly how mortality assumptions illustrated impact illustrated future cash values. Meaning determining the values they would leave invested in the general accounts after death benefits are paid out for any given group of insureds (age/sex/tobacco use).
All that can be said for sure is “generally speaking” actual experience historically has been better than what was anticipated and illustrated when any given WL policy series was sold irrespective of the CSO table that was used.
So when it comes to actual experience only the insurance company’s actuaries and its senior executives are privy to the actual experience for any given group of insureds in any given WL policy series it has sold in the past as the years go by. The fact is these actual numbers can and do vary for any given company, or policy series sold by any given company, and for any given group of its insureds even if they are consistent for the population overall.
The point being this actual mortality info is never shared with those who sell or buy WL policies. It’s proprietary. That said, reinsurance agreements are used by most life insurance companies to “smooth out” the death benefit risk differences any given company might actually experience versus its competitors.
Reinsurance companies literally buy the death benefit risk by accepting a percentage of the premiums collected by any given WL company. Many large life insurance companies “cede” as much as 90% of the premiums they collect to reinsurance companies, meaning they sell off as much as 90% of their mortality risk.
What is also not commonly understood is the actuarial tables used when a policy is designed have more than one rate that can be used for any given age/sex/tobacco use group of insured. A higher published rate per $1,000 of death benefit is used in the “guarantee” assumption formulas versus a lower “current” rate assumption for cash value growth above guaranteed levels.
The higher assumed “guaranteed rate per $1,000 of death benefit” assumes the high end of possible deaths within any given group of insureds “allowed by law” (or regulations). It is a more conservative number the State insurance regulators want life companies to use to protect the company selling the WL product from the risk more insureds might pass away than were reasonably anticipated. The reason being an unanticipated large number of deaths in the general population above the level of recent actual experience could wipe out the capital of most, if not all, life insurance companies.
NOTE: Imagine the impact of a new strain of flue or other type of virus causing a large spike in deaths above what mortality tables anticipated impacting all life insurance companies at the same time. By allowing a much higher than actually anticipated mortality rate to be charged under a WL policies guaranteed assumptions the regulators are effectively providing the nations life insurance companies with a cushion against this risk. The goal is to make sure death benefit payments can be made from the general account (existing reserves) so they don’t bankrupt all of the nation’s insurance companies which in turn would overload the demands on State guarantee funds.
A far lower assumed rate per $1,000 is used in the “current” assumptions that determine the cash values illustrated above guaranteed levels for any given group of insureds (age/sex/tobacco use). The lower rate per $1,000 used in the “current” formula assumes the more likely mortality result “all else being equal” based on the current CSO table. It may actually also include some level of anticipated improved experience.
The impact of this approach is more insured people in any given group of insureds are assumed to die under the guaranteed actuarial assumption than under the current assumptions. That in turn means more death benefits are paid out of the general account under the guaranteed assumptions. Which in turn means less is assumed to remain invested and earning in the general account under the guaranteed assumptions.
The decade’s long improvement in life expectancies versus the CSO levels anticipated in WL policy assumptions (the CSO table used when an illustration was created) is one of the major reasons actual cash values in WL statements in decades past tended to exceed originally illustrated values. That was the case prior to the 1990’s when actual interest rates also tended to be higher than anticipated earnings rates built in WL formulas.
The higher CSO rates used in the guaranteed assumptions, versus lower CSO rates in the “current” assumptions, tends to make it look like the executives of any given insurance company are doing a bang up job running the business. The reason being, at least as pertains solely to mortality assumptions, the accumulating values in the general account will be higher under illustrated “current” more optimistic assumptions than under “guaranteed” more conservative assumptions.
A built in positive that actually has nothing to do with how the company is operating or the quality of its management. Instead, the reality of this excess in “current” illustrated earnings above “guaranteed” levels is “baked in” ahead of time. The executives could be deaf, dumb and blind (as many seem to be) and the illustrations the WL software produces would still reflect the above noted favorable mortality results above guaranteed levels. It sets the stage, all else being equal (which “all else” never is), for better actual versus illustrated results.
GUARANTEED PREMIUM RATES
One of the strongest selling points of the WL product vs. the UL product is the fact WL premium rates for the death benefit amount purchased can never be increased. The premium is determined at the time the policy is issued based on the then current age of the insured.
Of course, as mentioned previously, it must be paid for life for policy guarantees to apply. While it can be paid from dividends while they are sufficient to fund said payments, once they are not the premiums must be paid out of pocket or the policy will lapse. While using loans from the guaranteed cash values is also an option, its one that can quickly turn into a nightmare scenario unless interest billed is paid out of pocket annually. When added borrowings are made to pay the interest, the loan compounds and creates a potential tax trap for the policy holder.
This guaranteed premium level is a very powerful and perhaps the most important guarantee offered by a WL product.
With the UL design the actual cost of term insurance is charged against cash values to create the death benefit. At older ages the cost of term is very high. The UL policy must have a rapidly growing cash value and a level face amount to avoid a major problem. The reason being the term rates are only applied to the “amount at risk” which is the difference between the total cash value and the death benefit amount.
The fact term rates are always at the insureds current age is a very real and detrimental aspect of the UL design since “insurance” charges inside the policy are based on the rate per thousand for the insured current age as each year passes. It’s constantly increasing.
This becomes a bigger problem when cash value growth lags and the “amount at risk” actually grows annually instead of declines. At a point the ever increasing annual term rates will then have an extreme negative impact on the policy. If the situation persists the term cost deductions will eventually eat up all of the policies cash value. Then the actual current cost of term insurance for the full policy face amount at the insureds current age must be paid “out of pocket” or the policy will lapse. It’s generally not possible for people to pay that very large cost when this occurs. Assuring a policy lapse.
The guaranteed premium rates in a WL contract avoid this problem. The premium that must be paid to keep the policy in force never changes. It is disclosed in the tables included in the fine print of the typical WL policy and clearly shown in the illustration itself. It will also always appear on each annual billing.
There is an offsetting negative pertaining to this premium guarantee. A negative that is rarely if ever mentioned by those who sell WL. The negative is the WL illustrated premium must be paid each and every year for the life of the policy for the other guarantees in the WL product to remain in force.
If the mandatory annual premium is not paid the policy will lapse. That statement is always made in the illustrations fine print, but most who buy WL policies never read all the fine print in the illustrations they are shown.
The WL policy base premium can be paid in any of three different ways. It can be paid out of pocket and must be until such time as one or both of the remaining two alternatives become possible. It can be paid by the surrender of dividends and/or additions to the extent available. It can be paid by borrowing from guaranteed policy cash values to the extent the policy loan provisions allow.
This risk of lapse if WL premiums are not paid each and every year is a definite negative. This is particularly true for older insureds whose policies may have for a time become self-funding based on accumulated and currently earned dividends, only to find those running out in later years meaning “out of pocket” premiums must again be paid. But the risk is nowhere near as extreme as exists with UL policies since the WL premium does not increase as the insured ages.
Sadly, with the steep decline in general account earnings rates over the last two decades, the lapsing of WL policies is becoming a very common fact of life for older policies that typically are insuring older individuals. The reason for this is twofold.
First, seniors are usually retired and living on a fixed income. So even if the premium is the same fixed amount originally due when the policy was issued, it may still be more than they can afford at the time.
Second, there is generally little or no advance warning the next premium will need to be paid out of pocket. The first most policy owners become aware of this is when a pending lapse notice arrives in their mailbox. When they call the 1-800 number on the notice the customer service representative is left with the task of educating the policy owner why this is happening.
This usually happens when premiums that have been paid for one, two or even three decades by the surrender of dividends and accumulated additions which are no longer sufficient to pay the premiums due. This confuses the average WL policy owner who recalls the original sales illustration had shown that once they no longer had to pay premiums out of pocket that situation would persist for the remaining life of the policy.
It may well be no one ever explained to them this might not actually happen. Or, it may have been explained but over the years long ago forgotten. While annual statements might contain footnotes about this, it’s also possible they will not mention the situation. So when a bill arrives they must pay out of pocket they tend to be very surprised and upset.
That’s the situation that exists for many today, after many years of below anticipated earnings results caused by historically low interest rates. The accumulated dividends in most policies have declined to near zero levels and current dividends are far below those originally illustrated. The ongoing payment of premiums by surrendering past dividend additions accumulated in the policy exhausted those amounts.
It is a fact these seniors can instead elect to borrow against guaranteed cash values to make these premium payments. A suggestion it is likely the customer service rep may make to the distressed WL policy owner.
Most who do borrow to avoid making “out of pocket” premium payments also borrow to pay the interest due on the loan. This results in the loan balance compounding, growing dramatically over a short period of time. Soon, the interest due on the loan becomes equal to and then more than the premium they were borrowing to avoid paying.
The really bad news occurs once the maximum loan level in the WL policy has been reached. As noted earlier at that point both the interest and the annual premium must be paid “out of pocket”. Since they couldn’t afford to pay just the premium amount in the first place, it is a virtual certainty they won’t be able to afford to pay the far larger combined total of premium and loan interest amounts due.
So at that time, unless the policy owner can make these payments “out of pocket” their WL policy will lapse. Making matters worse, that lapse will create a taxable event to the extent of the outstanding loan balance. More on that later.
While all of this seems a negative, it is still a fact the WL premium the policy owner would need to pay to avoid a lapse is a fraction of the amount a UL policy holder would have to pay. It is actually affordable to some policy owners while the UL amount is unlikely to be affordable to anyone.
GUARANTEED OVERHEAD EXPENSE FACTORS
Certain levels of operating and overhead expenses are assumed in the formulas that determine the WL guarantee calculations. These set the limit on what can be paid out from the general account for those expenses, much like the guaranteed maximum death benefits that can be paid from the general account by the life company.
The amount of these expenses, or a breakdown of what they include, is not disclosed in the policy fine print, in the illustration or in any product brochures. In fact, it’s never even mentioned. And it never will be disclosed to those who sell or those who buy WL policies.
So this is a bit of information no one who sells WL or buys it has access to, or ever will.
That said, the theory is these amounts are disclosed to the regulators that approve product illustration systems and the individual life products these companies design and sell. It is the job of the regulars to then insure as the years go by that higher levels of expense are not charged against the general account than those assumed in the products design assumptions. Something that borders on hard to believe based on the seeming lack of ability that defines most regulators actions.
It is also possible the regulators can decide to allow higher costs to paid from the general account if they feel it will protect the financial health of a given life insurance company. This may, or may not, be so.
So this is an area of “trust”.
RECAP OF GURANTEED REALITIES
It is not clear to the casual observer that illustrated whole life values are the result of a myriad of assumptions, with ongoing compounding of assumed subsequent accumulations and multiple other interrelated calculations.
There is nothing stated in the illustration, or its footnotes to explain what’s involved. Even if the various calculations were referenced there would still be no specifics provided relative to all of the assumptions built into the calculations. Because WL is by design a “trust me” bundled product with hundreds of hidden moving parts.
That’s really what it is. Albeit a trust that is easily and perhaps often violated by companies as the need arises. All made possible by the lack of transparency the WL product affords since most or all of what determines WL values is hopelessly bundled and hidden from view.
It is fair to say that at some level and to some degree it is possible to take apart a few of the WL policies guaranteed elements. But while possible to some degree even this can be difficult, confusing and at a point it also becomes impossible.
WL is an absolutely ingenious, pre computer creation. A product developed at a time the detail computing power needed to track endless discreet details did not exist, and where it was necessary to devise an approach that would allow a bundled product to deliver some individualized benefits. If the economic environment would remain stable, if human nature were more trust worthy and if regulatory aberrations were not allowed to interfere it might even be the best product ever devised.
Sadly, those are not the realities impacting the WL policy design.
WRAP UP COMMENTS
The manner in which WL policies function and how dividends, which accumulate in the form of paid up additions (PUA’s) in a WL policy, are used is discussed in more detail in another write up specifically addressing dividends.
I’d suggest reading that one next for anyone inclined to continue the quest to better understand how WL works. 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. When combined with what was learned in the “WL box” story a very good start indeed. But just a start!
