No Lapse/Secondary Guarantee Life Insurance Policies: What Are They, And Are They Appropriate For Estate Planning?

Transcription

1 No Lapse/Secondary Guarantee Life Insurance Policies: What Are They, And Are They Appropriate For Estate Planning? John T. Bannen A. General Product Characteristics Of Life Insurance Policies Focusing On Guarantees 1. Life Insurance Guarantees In General a. In modern permanent life insurance policies, there may be fewer guarantees than the purchasing public suspects. b. It might be helpful to review the demise of insurance policy guarantees to place the phenomenon of no lapse guarantee policies in perspective. c. Interestingly, the earliest life insurance policies did provide significant guarantees; they charged a premium which at a conservative guaranteed rate endowed (i.e., the cash value at the guaranteed rate equaled the contractual death benefit) at age 100; these early policies did not share the company s earnings if experience was better than what was priced in the guarantees. John T. Bannen is a partner with Quarles & Brady LLP in Milwaukee. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA by calling CLE-NEWS and asking for customer service. (Have the order code SL023 handy). Or order online at 5

2 6 ALI-ABA Estate Planning Course Materials Journal June 2006 d. With the advent of mutual insurance companies, a participating whole life policy was born. i. It worked in the same manner as the whole life policy, which endowed at age 100, but the policies shared in the divisible surplus when the company s experience was more favorable than what was priced in the guarantees; that is to say the policy could receive dividends. ii. Premiums tended to be higher than nonparticipating whole life policies to reduce the company s risk, but if the dividends developed, the net cost might be less than with a nonparticipating policy. iii. A mutual company has no way to generate capital other than through or investments; in other words, a mutual company cannot sell stock or incur debt. iv. Until the late 1960s these two forms of insurance, i.e., participating whole life and nonparticipating whole life, both of which endowed at age 100, were the primary forms of insurance. v. Dividends allowed a participating policyholder to share in the company s actual earnings if they exceeded those assumed in pricing the product; dividends could be used to pay fewer or buy paid-up additions to increase the death benefit. e. In the late 1960s, Economatic life insurance was developed by mutual companies to compete with lower priced nonparticipating whole life policies. i. Companies issuing participating contracts with higher (dividends could not be guaranteed) sought a way to lower their to compete with nonparticipating policies whose were lower. ii. The participating whole life contract added a term component (thereby reducing the initial premium). iii. The mix between whole life and term was such that anticipated dividends could purchase paid-up additions that would eventually equal and replace the term amount. iv. Usually the policy provided a guarantee period and the term would be paid up under low dividend scale assumptions before age 100.

3 No Lapse/Secondary Guarantee Policies 7 v. The mix between whole life and term was set by the company. vi. If policy performance was unfavorable, i.e., dividends did not keep pace with the actual costs of the policy, more premium was needed, or the death benefit needed to be reduced. vii. No withdrawals could be made from the policies, but loans could be taken either to pay or simply because the owner wanted to access the cash value; such loans would have an impact on the performance of the policy, i.e., if the loans exceeded the cash value, the policy would lapse. f. When interest rates spiked during the Carter years, a new type of insurance policy was born, namely the universal life policy. i. Insurance companies were experiencing an outflow of money (principally through low-cost policy loans) as people withdrew funds from low-paying policies to invest in high-paying debt instruments, e.g., Treasury bills paying 18 percent and money markets paying 21 percent. ii. The newly created policies embraced a new money crediting rate that directly reflected the investment by the insurance company in the higher yielding debt instruments. iii. In addition, universal life offered flexible, i.e., were no longer set, rather the owner at a minimum needed to pay enough to keep the policy in force. iv. Universal life also ushered in an essentially transparent policy in which amounts earned or added (earnings and premium payments) and amounts debited (changes for the mortality or term costs and insurance company expense loads) could be directly seen; essentially the policy became a checkbook with the cash value being the account balance; so long as there was a positive balance, the policy stayed in effect; if there is no cash value, additional had to be paid or the policy would lapse. v. Traditional universal life policies may have a guaranteed crediting rate, but the policies will not endow, i.e., cash value will not equal death benefit at age 100 unless the premium is calculated to do so.

4 8 ALI-ABA Estate Planning Course Materials Journal June 2006 vi. Universal life insurance policies may permit the policyholder to invest in separate accounts that, like stock mutual funds, will earn or lose with the underlying investments; such policies, popularly known as variable life policies, lack any guarantee with respect to earnings, although there may be guarantees that mortality costs or expense loads will not exceed certain parameters. g. Summary Of Life Insurance Designs Before No Lapse Guarantee Policies Traditional Whole Life Blended Whole Life Term Policy Universeral Life Variable Universal Life Fixed rate (or guaranteed cash value increase) to endow at age 100 Nonparticipating products pay no dividends Participating product could pay dividend if experience is better than guarantees; dividends may buy additional benefits Fixed adjustable Combination of whole life and term rate (or guaranteed cash value increase) on whole life but not on term endow for face amount at minimum crediting rate (or guaranteed cash value increase) at age 100 Dividends pay up term If dividends insufficient, increase or coverage is reduced Flexible rate endow at age 100 at minimum guaranteed rate Flexible Separate account (mutual fund/ equity) investments No guaranteed crediting rate (unless a fund with a guaranteed rate is chosen) endow at age The Universal Life No Lapse Guarantee Policy Structure Traditional (Non-Shadow Account) Design a. What the no lapse guarantee policy adds to the traditional universal life design is a secondary guarantee (i.e., in addition to any guarantee with respect to crediting rates, mortality costs, or expense loads) that if a certain

5 No Lapse/Secondary Guarantee Policies 9 premium or are paid in the manner specified in the contract, the policy will not lapse. b. Note, the cash value of the policy is not important or even relevant to the death benefit guarantee (although it may be very important to the insured for other reasons). i. The no lapse guarantee policy will continue even though there is no cash value. ii. A lower crediting rate (i.e., lower than a policy without the no lapse guarantee) may be quoted, thus depressing the cash value growth. iii. The charges for mortality or expense loads may be higher, thus causing smaller cash values than would be the case with a universal life policy without a secondary guarantee. iv. In an indirect manner, these less-favorable crediting rates and highercosts are an additional cost of the guarantee. v. These additional costs are not evil or nefarious; they simply reflect the fact that the guarantee has value, and features with value cost money. c. The first generation of no lapse guarantee policies typically had a strict requirement that be paid on or before the due date. i. A late premium would void the guarantee and the policy would be left to sink or swim with its beleaguered cash values. ii. A policy loan, a withdrawal of cash, or the payment of a smaller premium would in this earliest policy design typically void the guarantee or result in the guarantee dropping to less than a lifetime guarantee, e.g., age 85. iii. Without the guarantee, the policyholder could be faced with higher nonguaranteed, which would be burdened with unsubsidized mortality expense costs and the possibly lower crediting rate than would be present in a policy without the no lapse guarantee. d. A no lapse guarantee policy may permit a make-up contribution, i.e., a payment of late plus interest, but the make-up periods are typically short, e.g., one to two years.