Welcome back to my ongoing series about Universal Life. We’re exploring how Universal Life policies work, and why yours might be failing, especially if you bought it between the late 70s and late 90s. Previously, we talked about how UL works in broad terms, and discussed that it was designed for flexibility, and to take advantage of the high interest rates at the end of the last millennium. Following that, we discussed how the ongoing trend of declining interest rates has impacted the performance of these types of policies, resulting in many of them failing. Today, we’ll look at the other major moving part of Universal Life, cost of insurance.
In my vlog post – What is Insurance – I covered the insurance term “Premium.” The premium is simply the dollar amount you pay the insurance company in exchange for your coverage. Whether you’re buying auto insurance, a warranty on your phone, or insuring Beyonce’s legs, the premium is calculated by the carrier using some assumptions. The folks doing these calculations are called actuaries, and their job is to analyze (among other things) the likelihood of having to pay a claim on a policy, and how much interest they can earn on your premiums until they have to pay. From these assumptions, they calculate a premium. All else being equal, the lower the likelihood of a claim, or the longer it will be until a claim is likely to be paid, the lower the premium. In addition, the higher the interest rate they can expect to earn, the lower the premium.
With life insurance, besides the interest rate, the biggest factor determining your premium is your life expectancy. Most life insurance companies have been in business for over a century, and during that time they’ve been gathering and analyzing data on who lives and who dies. If you’re expected to live a long time before they have to pay your death claim, they can collect a low premium on you, because they have lots of time to earn interest on those premiums before they ultimately have to pay your claim. This life expectancy component of life insurance pricing is known as the cost of insurance.
With the other two main forms of life insurance, namely whole life and term life, the cost of insurance is simply baked into the premium. You never see “how the sausage is made.” You simply pay your premium and you’re covered. With Universal Life, however, they make this component of your premium visible to you from day one. Each Universal Life policy (like, the actual paper contract that binds the carrier to pay) includes a cost of insurance schedule. If you look at it you’ll see a table of figures that show how much you can expect to pay for your cost of insurance at each age. As you get older, the likelihood of you dying in any given year increase, and therefore, so does your cost of insurance.
The intent of a Universal Life policy is to take advantage of interest rates by paying in more than the cost of insurance when you are young, and then using that cash value build up to cover your higher cost of insurance when you are older. This is why you can find a situation on older policies where the premium being paid is much lower than the actual cost of insurance. The interest you earn on your cash value is intended to make up the difference.
As we saw last week, though, if interest rates fall, that cash value might not be there to help you pay. In a prolonged period of declining interest rates, such as what we’ve experienced since about 1981, a Universal Life policy can find itself in a situation where the premiums paid, plus the interest earned, is still lower than the cost of insurance. In that situation, the difference is simply deducted from the cash value.
Once you’ve reached this “tipping over” point, it can be a pretty dramatic downward spiral from there, since your policy is going to be hit by a “triple whammy” of compounding problems. Since you have less cash value the following year after your policy tips over, you will earn even less interest, meaning the policy will have to consume even more cash value to stay in force. On top of that, in most policies, you only pay cost of insurance charges for what’s known as the “Net Amount at Risk”. For example, in a policy that has a $100k death benefit, and a $20k cash value, you’re only paying cost of insurance charges on $80k of risk. Next year, if your cash value has gone down to $19k, you’re not only earning less interest, but you’re also paying for $81k of risk. On top of that, you’re paying the cost of insurance associated with being one year older. So you’re paying more money per dollar of coverage, for more coverage, and you have less interest to help you pay it – a triple whammy.
Typically, once we see a policy tip over, there’s at most a decade of coverage left in the policy before it lapses entirely, leaving you with no cash value, no death benefit, and no policy. If the policy has served its purpose, maybe that’s not a problem, and you can just surrender it or let it go. Most people I meet, however, want to try to fix it somehow. Next week we’ll talk about some options that have worked for our clients.