Uncommon Knowledge... Expanding the Conversation about Whole Life Insurance

Transcription

1 Uncommon Knowledge... Expanding the Conversation about Whole Life Insurance Executive Summary Life Insurance as an Asset Class: Managing a Valuable Asset

2 Life Insurance as an Asset Class: Managing a Valuable Asset By Richard M. Weber, MBA, CLU, AEP and Christopher Hause, FSA, MAAA Executive Summary Introduction Guardian first commissioned a research study in early 2008 called Life Insurance as an Asset Class: A Value-Added Component of Asset Allocation. That study received a Best Paper award in 2008 from the Academy of Financial Services, and it continues to receive acclaim and validation of its principles and concepts. In particular, it has positively recognized that whole life insurance is a valuable asset that contains living benefits that are uncorrelated to market volatility or other portfolio assets. Guardian took the step as the thought leader for this concept creating alternative thinking of life insurance as its own asset class. Many of the financial gurus on the television/radio circuit who focused on wealth-building through fund portfolios and who previously dismissed whole life insurance have shifted their viewpoints in recent years. While a few experts are still recommending conventional financial planning despite today s economy, a new wave of uncommon knowledge is gaining momentum. For example, The Wall Street Journal featured an article entitled Consumers Pile In to Life Insurance with Investment Aims, which recognized that, both whole and universal life delivered positive returns during the 2008 financial crisis even as many other investments sank. Another article entitled New Life for Life Insurance? by Barry James Dyke, author of The Pirates of Manhattan, appeared in the June 2009 edition of Medical Economics. The authors then recast life insurance in the vocabulary of investment management, as an asset class that should be managed and optimized through the use of Modern Portfolio Theory, in which each portfolio component has a role in achieving the client s goals and objectives in a balance of risk and desired growth. Relating easily to the financial planning process, the authors use a product risk matrix to help analyze Efficient Choices that will optimize returns. They also concluded that life insurance, as a core asset on the fixed side of the investment portfolio, can be paid for by leveraging other portfolio assets and not paid from a lifestyle budget. The final section considered some issues that a policyholder, especially a trustee of an Irrevocable Life Insurance Trust (ILIT), must address on an ongoing basis, so that the insurance portfolio continues to meet goals, in terms of expense, value, access to cash values, and naturally increasing death benefit. In their newest publication, the authors further amplify the objectives, processes, and results of actively and properly managing life insurance assets on an ongoing basis, to optimize the cash values and death benefit returns with the client s continued best interests in mind. This is the next logical step following the process of product selection, underwriting and fulfillment. In the first volume of Life Insurance as an Asset Class, authors Richard Weber and Christopher Hause described various types of life insurance coverage available for protecting a quantifiable Human Life Value factor. 1

3 Managing a Valuable Asset takes a deeper dive into various approaches of Efficient Choices combining multiple policy styles to achieve a desired balance which can often lead to the question of discontinuing or replacing an original policy. Weber and Hause take on the question of replacement when to hold or fold and provide several sample management tools that they encourage insurance professionals and financial advisors to use in order to be objective in their recommendations. The discussion includes the type or types of policies that will help optimize results and achieve the efficient result that is sought. In lieu of price, the authors highlight core values to fulfill Human Life Value the basic need of financial protection for those we care about as the primary reason to consider a life insurance portfolio with whole life at its core. Finally, following what is considered an epic financial crisis, the authors address possible changes in regulation and compliance for the insurance industry in the years ahead. As demonstrated throughout the study, life insurance ownership implies a continuum of management not a one-time purchasing event. This Executive Summary provides a brief overview of the complete study, Life Insurance as an Asset Class: Managing a Valuable Asset, which may be obtained from your Guardian representative or nearest Guardian agency. The sections in this Summary may consolidate related information from the original document. 2

4 Life Insurance Properly Acquired Owning life insurance implies a continuum of management not a one-time purchasing event. Know your client is the key message to determine the suitability of a concept, plan, or product. It includes being familiar with the client s lifestyle, goals, risk tolerance, time horizon, as well as the client s skill and experience with planning and investing. While questionnaires are helpful in uncovering information, there is an intuitive component that a skilled professional develops. Above all, life insurance should never be viewed as a commodity acquiring the right type and amount requires time, effort, study and discipline. Common Questions from Life Insurance Consumers In purchasing life insurance, five questions must initially be addressed and answered 1. Do I need life insurance, and if so, how much? 2. What kind of policy would be in my best interest? 3. If my investor style suggests a type of life insurance that doesn t have a fixed and guaranteed premium, what should I expect to pay for my life insurance (given that no one wants to pay more than they have to)? 4. With which life insurance company and 5. from what agent should I make such an important and long-term commitment? For those with dependents, death destroys the economic engine of an individual who dies prematurely. The authors ask how much life insurance must be deployed to take care of a family in the same way as if the breadwinner had lived to typical life expectancy. In the first volume of Life Insurance as an Asset Class, the various product types were defined and discussed, including various duration term insurance, whole life, universal life, variable universal life, adjustable life, and equity-indexed UL. Determining the appropriate policy is based on time horizon, investment style, and financial resources in that order. A key point to remember is that term life insurance purchased for a short period but ultimately held to life expectancy can cost as much as 70% of the insured s death benefit in cumulative premiums. Cost is typically a consideration in purchasing most goods and services. But cost is rarely the best way to evaluate value in life insurance products. As there is a broad spectrum of premium possibilities, it s smart to isolate a client s risk tolerance how certain do they need to be that the premium they are paying will on projection reliably sustain protection to the insured s death, no matter how long she lives? Even those clients with high risk tolerances will have the expectation of 80%-90% certainty, so funding premiums need to be higher than generally illustrated, and the higher values generated by paying more than you have to must also be considered. When choosing an insurance product, the client should also consider the carrier which companies will be there for the long term, and continue to deliver value year after year? Financial strength ratings are important criteria in choosing a life insurance company. COMDEX, a composite index created from various current financial strength rating agencies, gives a company s standing, from 1 to 100, in relation to other companies that have been rated. Four major mutual insurers, Guardian, MassMutual, New York Life, and Northwestern Mutual have recent COMDEX scores of 98 to 100, which are considered extremely safe. 1 1 As of November

5 The Importance of a Blueprint to Manage Expectations When you don t know where you re going, any road will take you there. The concept behind this statement is that clients should first pursue a strategic planning process so that their financial future has an objective, concrete foundation upon which to build. The authors point out that many people set out to enhance wealth with spontaneous investments, without considering those investments in the context of risk and reward versus the client s risk tolerance or financial situation. A questionnaire as well as a sample Insurance Policy Management Statement can be found in the full edition of Life Insurance as an Asset Class: Managing a Valuable Asset. The IPMS can be used in conjunction with other tools (such as those found in The Living Balance Sheet ). Life insurance products and planning require time, thought, and study. The true value of life insurance as an asset class versus a commodity is recognized when it is properly acquired though careful analysis. The Important Role of the Insurance Policy Management Statement When it comes to investments, professional financial advisors develop a blueprint an Investment Policy Statement to guide investment choices and manage expectations. The same methodology can be applied to the client s insurance assets, to assess various risks that may be associated with different types of insurance. An Insurance Policy Management Statement (IPMS) can be developed as a statement of work to anticipate, just to name a few, such issues as: Overall risk tolerance and influence on policy choices How risk tolerance is affected by the client s perception of life insurance Inflation risk The Living Balance Sheet and the Living Balance Sheet Logo are registered service marks of The Guardian Life Insurance Company of America (Guardian), New York, NY. The graphics and text used herein are the exclusive property of Guardian and protected under U.S. and International copyright laws. Copyright , The Guardian Life Insurance Company of America. Premiums as expense or asset creation Access to cash value The need (or desirability) for naturally increasing death benefits over the life of the insured 4

6 Myth Busters: Classic Life Insurance Myths and Truths Myths: 1. You only benefit from whole life when you die. 2. Whole life is a lousy place to put your money. 3. Once you retire, you should cash in your life insurance policy. 4. Whole life is too expensive. 5. All life insurance is created equal. 6. Once you buy life insurance, you don t have to think about it again. The Plain Truth About Today s Common Life Insurance Myths In this section, the authors especially target commonly heard myths, which are quickly debunked with rational explanation. Addressing myths and internalizing the truths will help clients assess their needs and make intelligent choices. Debunking Myth #1 - The living benefits of whole life from a mutual life insurance company are typically substantial, and may be enjoyed throughout the life of the policy generally income tax-free if the distribution is structured properly. 2 Debunking Myth #2 - Considering what the country has experienced during the past few years, people are seeking the security and stability that life insurance provides. Death benefits are guaranteed, and policy values overall are uncorrelated to the stock market. So, to the contrary, whole life insurance is a very good place for a portion of the assets of those financially fortunate enough to have the luxury of choice to include whole life in their insurance portfolio. Debunking Myth #3 - Retirement is another phase of life, and life insurance plays an important part in many ways: Cash values can help supplement retirement income, which boomer couples can rely on Provides an added level of financial security Puts in place a legacy for heirs Addresses future estate liquidity needs Provides liquidity for the joys of older age (e.g., grandson s graduation/granddaughter s wedding) as well as the unanticipated medical expenses not covered by Medicare. Debunking Myth #4 - Many people are distracted by the lower initial cost of term insurance, and renting versus buying is a good comparison. While protection to the full extent of Human Life Value comes first, it s important to note that over a lifetime, whole life is substantially less costly than a lifetime of premiums paid for term. Debunking Myth #5 - Values, culture, and safety and security of a company, are critical criteria in a client s choice of carriers. Life insurance is purchased for the long term, and the credibility (and capability) of the insurer to pay out a substantial death claim decades in the future is a major consideration. Debunking Myth #6 - Filing and forgetting is anything but an appropriate way to treat a valuable asset. The policy should be periodically reviewed and managed to match both personal and external financial and economic changes. 2 The typically substantial benefits come from dividends, which are not guaranteed. Term insurance kept beyond its initial duration can cost 70% of the death benefit to life expectancy and more than 400% to age

7 The Better Buy The cost of life insurance coverage is calculated so that it will be fully sufficient and profitable for the contract holder and the issuing company, no matter when the insured s life comes to an end. Any amount paid that is lower than the sufficient cost introduces risk to the policyholder and to the company. Life Insurance Illustrations: Fact Versus Fiction The authors offer the following truths for consideration, when reviewing life insurance illustrations: We Hold These Truths to be Self-Evident 1. We re drawn to the attractive impossibility rather than the less attractive probability. (paraphrasing Aristotle s Rhetoric) 2. Historic performance data is of little or no practical use in determining which policy will perform better? 3. If it s too good to be true, it probably is. 4. Comparing apples to apples the only way to rely on policy illustration premium sufficiency calculations is to use stochastic (probability) analysis. 5. There s no free lunch. We re drawn to the attractive impossibility rather than the less attractive probability. Historic performance data is of little or no practical use in determining which policy will perform better? Changing markets make predicting economic outcomes impossible. Illustrations calculating and projecting forever 14% crediting rates in 1982, have no bearing on today s realities. If it s too good to be true, it probably is. Most insurance companies and their representatives want to serve the best interests of their clients, but people can be lured into an attractive impossibility. This is why it is important that clients understand the details underlying the coverage; not to simply accept the face value of the illustration presented. Comparing apples to apples Weber and Hause refer to the first volume of Life Insurance as an Asset Class, where they demonstrated Monte Carlo Simulation, an economic modeling technique using stochastic analysis that imbues a sense of likelihood that assumptions made today will have some future validity. The appearance of a bargain is far more frequent than the experience of a bargain. There s no free lunch. Some items in our lives should be approached on the basis of best price, but not life insurance and especially current assumption/indeterminate premium types. Policy illustrations show conceptually how the policy design can work over time. The results that some illustrations show are not likely to occur, projecting decades into the future. 6

8 Real Real Returns Compared to Permanent Forms of Life Insurance In this section, the authors cite an article, The Study of Real Real Returns December 31, 1979 December 31, 2009, published by Thornburg Investment Management in August The study, published annually, provides a detailed assessment of returns both gross and net after taxes, expenses, and inflation on various categories of bonds and equities. The authors apply the concept of quantifying real real returns to comparing various styles of life insurance. Please note that throughout this section and the entire study, hypothetical policies not for sale are used as examples. What Determines Value in a Life Insurance Policy? In the first volume of Life Insurance as an Asset Class, we learned that price doesn t determine value. It is important to look at cash value and death benefit, and how each component adds value and may be valued. Here, the authors focus on anticipated performance, where performance is measured by policy design the basis on which: Interest or investment returns are credited; Expenses and charges for Net Amount at Risk are charged. In Managing a Valuable Asset, the following diagram provides a snapshot of Best Price and Best Value as measured by Internal Rate of Return (IRR) for the major forms of permanent life insurance on a $1 million face amount policy for a 38-year-old male, second-best class. 38-year-old male in a second-best rate class category BEST BEST 5.26% Par WL $4,716 Variable UL 4.74% 4.16% 3.84% VALUE Variable UL UL No-Lapse UL $5,715 $6,344 $7,630 PRICE UL No-Lapse UL Non-Par WL 3.26% Non-Par WL $13,840 Par WL IRR of Premium to Death Benefit at Life Expectancy Premiums Sufficient to Age 100 Based on Current Assumptions 7

9 This analysis does not offer enough data to compare policy styles in a consistent manner, or tell which policy style is better. Moving to the next level of analysis to get past price mentality, it is necessary to estimate Internal Rates of Return (IRR) on both cash values and death benefits at life expectancy. Comparing Cash Values and Real Real Returns Some Eye-Opening Results Remember this myth? You only benefit from whole life insurance when you die. Whole life has strong guarantees and low volatility compared to the other asset classes. The information provided in this section further and effectively debunks that myth about life insurance. In fact, whole life insurance does very well among its peer asset classes in an approximate comparison to Thornburg s summary of different asset classes. Asset Type REAL Real Returns Nominal Return Domestic Large Cap 5.21% 11.24% Domestic Small Cap 4.81% 10.36% International Stock 4.55% 10.21% Municipal Bonds 3.33% 7.54% Long-Term Government Bonds 1.94% 9.68% Whole Life Cash Values 1.68% 5.19% Corporate Bonds 1.28% 9.20% Intermediate Government Bonds 1.06% 8.40% Real Estate/Single-Family Home 0.36% 4.49% Treasury Bills -1.00% 5.49% Commodities -3.50% 0.46% Note: Par whole life with annual premiums of $18,365 paid for 25 years produced a total cash value (including cash value of paid-up additions) of $946,676, representing a pre-tax IRR of 5.19%. The cash value accumulation in a par whole life insurance policy is net of expenses and taxes, leaving only inflation to be accounted for. As shown, life insurance provides a measurable return, both through death benefit and living benefits or cash value. The authors demonstrate in the following sections that by optimizing different styles of life products, a life insurance portfolio can produce competitive returns compared to fixed-return investments. 8

10 A Practical Guide to Core Values and Efficient Choices When it comes to life insurance, it is important to focus on the quality of the product and the company offering it. The foundation, or core values, of life insurance ownership is protection of Human Life Value. The authors have earmarked the amount of protection using a range of 50%-75% income replacement and using a dollar figure baseline of approximately $5 - $10 million. Depending on risk tolerance and the financial situation, a client may then seek to expand a life insurance portfolio, combining various policy types to create a mix to meet longer-term goals and objectives. In each example given, the authors cite the importance of type of insurance, amount, financial objectives and risk tolerance and the financial strength of the company. Core Values Protection goals may be initially filled with term insurance, so it is important to focus on the quality of the product and the company offering it. A financially strong company with a COMDEX of 95 or higher is recommended for term face amounts up to $10 million. If the protection need is greater, it may also be appropriate to consider further diversification by issuing insurance company. Life Insurance Portfolio Options: Refinement and Application of Efficient Choices Layer 1: Core Values Building upon a foundation of protection may be done in layers of diversification to optimize a portfolio. If a financial portfolio includes a certain level of risk among various asset classes, then moving from term insurance into participating whole life may be a good option to start, especially for clients with limited resources. The thought here is that at the core of every financial portfolio is guaranteed protection and whole life Layer 1 should be at the core. Asset Optimization A client who has estate liquidity needs may have concerns about the long-term depreciation of the death benefit of certain types of life insurance especially that of guaranteed death universal life due to inflation. In that case, along with access to cash value, the client would like to have the death benefit grow as much as possible during his lifetime. As a result, the authors explain that the client s assets might be allocated into various types of insurance products to meet his financial objectives. Portfolio of Policies Layer 3: Layer 2 PLUS a Portfolio of Choices Although rare, high net worth individuals look to the multiple advantages of life insurance the premium leverage, investment value, and tax efficiency in passing on their legacy to future generations. In this type of scenario, the authors point out that core values are not primary. Rather, the key consideration may be to offset loss of the death benefit s purchasing power while building cash values to take advantage of trust investment opportunities in the future. Core Values Efficient Choices A typical situation may be a client and her husband who have had a second child in three years. They have numerous expenses as well as protection needs and they need to obtain immediate protection at the most affordable price. Core Values Layer 1 Start the Conversation with Protection Layer 2 Efficient Choices Layer 2: Core Values PLUS Efficient Choices If we are truly treating life insurance as an asset class, the authors point out that the next layer in constructing an insurance portfolio, beyond the core protection of whole life, is to focus on optimizing around cost, access to cash value, and naturally increasing death benefit (to offset the depreciating value of future death benefit due to inflation). A typical solution would be highquality term life insurance, convertible to permanent life insurance within a 15-year period. The couple will base the timing of conversion of the rest of the insurance on anticipated bonuses. 9 Life Insurance as an Investment

11 Prototype Portfolios The Risk Index Matrix, which is detailed in the complete study, may be used to create a design starting point for prototype life insurance portfolios that are based on both price and value objectives. These prototypes can then be used as the beginning of the discussion to identify core values + Efficient Choices. Here are examples of VALUE versus PRICE prototypes: Balance Risk Index (6.18) When VALUE is paramount VALUE (% PAR WL) PRICE (% NLG) (% VUL) RISK INDEX Balance Risk Index (6.18) When PRICE is paramount 5 VALUE (% PAR WL) 3 PRICE (% NLG) (% VUL) RISK INDEX Instructions for use: 1 From the Life Insurance Policy Management Statement, determine the appropriate Risk Index to match risk tolerance (ranging from 0.0 for very conservative to 15.0 for very aggressive); 2 take into account risk index rows 3 above and 3 below the chosen Risk Index; 3 determine whether the portfolio focus is primarily on PRICE or VALUE; 4 among the 7 rows, choose the highest value in the chosen column (i.e., PRICE); 5 the row in which the highest value appears is the recommended proportions. Note the dramatic shift in proportions of policy styles, based on a focus of Value versus Price. Again, this process is not intended to lock the client into a particular apportionment of policy styles, but rather to begin with an objective process and then supplement it with any subjective considerations. Long-term VALUE is typically a key consideration. As you ll see in later sections within this summary, looking to buy the cheaper alternative when the current policy runs out of gas, is fulfilling something that may look good today, but most likely can t be properly fulfilled tomorrow. The key to determining and selecting the proper policy mix is completion and annual review of the Insurance Policy Management Statement. 10

12 New versus Old Policies and Illustrations and Replacement versus Remediation You gotta know when to hold em, and know when to fold em This section discusses a number of issues that have been raised by product enhancements, actuarial improvements and changes in the marketplace, explores whether or not it makes sense to replace life insurance coverage. Participating Whole Life For par whole life policies, it would rarely be in the client s best interest to trade in an old model for a new; the current dividend, if declared by the company, would most likely return the advantage of better mortality experience to its longstanding clients. In other words, keeping an older par whole life policy would provide better value. A replacement may not be in the client s best interests if all of these factors are not thoroughly evaluated. Current Assumption Universal Life With current assumption UL policies, the longer reserve and maturity periods allow for lower premiums and lower accumulating cash values. With guaranteed credited reserve rates as low as 2½% on many new products, there may be less difference between policies with 4% guarantees to age 95 or 100, and today s longer durations but lower rate guarantees. Other UL Products It is possible that mortality improvements can result in lower Cost of Insurance (COI) charges in UL/VUL/EIUL products. However, these reductions may be offset when considering that a new policy replacing the old would incur new acquisition costs, surrender charges periods imposed on the policy owner, plus a new two-year contestability period. Conclusion For various types of Universal Life, replacement should be carefully considered. On one hand, a new policy is less likely to provide better value if the original policy was purchased with specific goals, and through a thoughtfully applied process. On the other hand, if it was purchased because the company s illustration showed it was the cheapest at the time, then a new policy may be worth exploring, especially if the first policy wasn t properly acquired in the first place. This is because no UL/VUL/ EIUL policy could possibly deliver death benefit to life expectancy and beyond with a minimum premium and an expectation of lifetime crediting rates of 10% or better which is what may have been illustrated for the client at the time of purchase. Need, objective, cost, duration, current health of the insured, and funding sources a few of the issues in any discussion of potential replacement. Other Pricing Factors Investment Returns, Expenses, and Lapses Mortality is one factor that affects product pricing. And if mortality improvements are not as great as projected, the mortality profit component will be lower than expected. Expenses are another factor that depend on the difference between the actual and expected. If actual expenses turn out to be more than anticipated, insurers may need to increase the expense component of their policies. The most sensitive profitability component over the last decade has been investment experience, especially from Companies that have sold large amounts of nolapse guarantee universal life have been especially affected, as these companies are not achieving the anticipated shadow account net returns of 6% 7.5%, necessary to profit from the low premium, guaranteed products. Since neither crediting rates nor expenses can be altered for the life of the policy on these fixed-premium products, lower investment earnings will weigh down any other gains for the foreseeable future. Policy lapses are a fourth factor that affect pricing whether the policy is surrendered for cash, or the policy owner simply stops paying premiums. In the 1990 s, policies were priced anticipating that many would lapse and that the gains from these would benefit the policy owners who remained a self-defeating notion that detracted from the purpose of life insurance. Companies have responded to unprofitable treatment of life insurance policies, such as life settlements and strangerowned life insurance (STOLI), by adjusting pricing methodologies to diminish the attractiveness of this type of investment orientation. Ideally, then, the uses for life insurance can begin to revert to the original purpose as a tax-advantaged financial benefit protecting families and businesses. 11

13 When to Replace Guardian s Replacement Questionnaire (RQ) developed by the Society of Financial Service Professionals (FSP) and for which permission has been obtained for thoughtful use by agents and advisors should be deployed when considering a replacement; note that additional requirements and rules vary by state. Ideally, the RQ will be used in conjunction with an Insurance Policy Management Statement, or something similar. This is a good way to test policy assumptions against the needs, considerations, objectives and expectations of the client, and may ultimately uncover the right choice when the question comes up to consider replacing a policy. Important Points to Remember About Replacement Life expectancy projections based on current health at older ages should be considered (which can also include determining your personal life expectancy ). For participating whole life policies, look at how dividends may be able to offset or reduce future premiums while increasing the death benefit through paid-up additions. Look into repaying a policy loan, which may be diminishing dividends. Remember that the illustration is not the policy when considering replacement. Guardian s Replacement Questionnaire, when used in conjunction with the Insurance Policy Management Statement, is an excellent tool for helping clients consider whether or not a replacement is a wise move. Active Management Life insurance properly acquired and actively managed produces an asset that is possibly the most valuable, self-fulfilling long-term asset used for the creation and transfer of wealth that an individual can own. Ongoing management is required for all policy types (or components such as dividends), with pricing elements that will change over the insured s lifetime. Active management follows good acquisition strategy, flowing from the Insurance Policy Management Statement (IPMS) and resulting in a policy or insurance portfolio (Efficient Choices) that fulfills the client s situation, profile, and objectives. With indeterminate premium policies (those without guaranteed level payments), the inherent premium flexibility makes it all too easy to abuse the privilege, i.e. pay what you want/when you want. This type of policy shifts risk to the policy owner, and should be carefully managed so as not to lose benefits. If this disciplined approach doesn t fit the client s profile, then the client may need a guarantee-structured policy such as whole life or no-lapse guarantee universal life. Universal Life and Variable Universal Life policies shift risk to the policy owner. Consequently, these types of policies should be carefully managed so as not to lose benefits. 12

14 Issues to Consider in the Life Insurance Management Process Some issues encountered in managing life insurance as a long-term asset include: Transparency when UL was first introduced, expenses, cost of insurance charges, and interest rates were isolated in company illustrations, but soon market competition manipulated these numbers to create a more competitive product. Deviation with the loss of transparency, credible product pricing of indeterminate products can be inferred only by comparing to an actuarially determined standard. Interest Crediting Rates compare today s interest crediting rates (2.5% 5.0%) on indeterminate premium products to the 1980 s, when the rates were 12% 14%. The focus on these products should be on the current and future costs. Also note that some insurers with large blocks of UL business more than 10 years old today will not likely increase their current crediting rates above the floor of (generally) 4%, even when interest rates in the economy inevitably begin to rise. Life Expectancy decisions are made on how to manage resources depending on how long we anticipate living. Average life expectancies tend to rise, especially among those in the upper 50% of income and education. And as we age, the longer you live, the longer you live! The tables used when a product was purchased may no longer apply today, so the financial need may change, and be extended for decades. Additionally, the tables used are too general they do not contain information on wealth, access to medical care, smoker status, family history, or the state of the individual s health. Life Insurance Optimization Even if a life insurance policy was not properly acquired, (where properly acquired implies completion of an IPMS, or at least purchased with long-term objectives in mind), the advisor and client may take steps to optimize the policy s use. These steps include: 1. Create or update the IPMS (or any tool that sufficiently documents the objectives set forth). 2. Assess the life insurance policy based on its guarantees, independent of the insurer s nonguaranteed inforce illustration results. 3. Use personalized information for analysis of the client s life expectancy. The Internal Rate of Return calculation for death benefits can be optimized by establishing a baseline expectation, and managing to that expectation over time. 4. Examine available options, such as: Increasing the premium where possible or practical Decreasing the death benefit in order to bring the policy s future expenses and likely returns into balance Consider replacement of an inappropriate policy type through a 1035 exchange Consider if the policy is still needed Establish an ongoing management schedule 13

15 Major Issues of Policy Management All of these issues should be addressed in the IPMS during review: 1. Carrier financial integrity what are the current ratings of the companies issuing the policies? 2. Actuarial integrity of pricing the big picture on what life insurance really costs. Look at competitors pricing. 3. Ongoing policy management must be actuarially based to assess performance expectation not reliant on current policy illustrations. 4. Test assumptions what would happen if? The advisor should request a number of variations on fluctuating components, such as interest crediting rates, investment returns, expenses and cost of insurance charges. 5. Examine the illustrations for variance between projections and the law of large numbers expectation. Establishing Reasonable Expectations for Dividends 3 Life insurance is purchased for the long term, so how can we reasonably determine policy components now with respect to actual results decades into the future? A Look at Possibilities for the Future: Exploring Hypothetical Policy Performance In this section, the authors highlight the various results obtained using different underlying investment return assumptions for dividends not considering variations in expenses and mortality results. They take an analytic method to examining hypothetical policy performance based on three different premium payment/dividend approaches: Full Pay Paying level premiums through age 99; dividends used to purchase paid-up additions in all years; death benefit calculated at age 100 and cash surrender value calculated at age 100; average portfolio return rates assumed from issue to age 100. Natural Premium Offset Paying level premiums until paid-up additions cash values can pay the premium until age 100; calculating how many years the insured must pay out-of-pocket premiums; average portfolio return rates assumed from issue to age Obtain a personalized assessment of longevity. 7. Trustees have additional considerations of management as their fiduciary duties may be defined by state law. It is unlikely that one advisor can provide all the services necessary for an entire management process. An advisor specializing in life insurance portfolio management will deploy an appropriate range of experts. 14

16 Natural Premium Offset at Age 85 (NPO 85) Paying level premiums through age 84; dividends and policy loans used to pay premiums and provide annual income payments through age 100; average portfolio return rates and amount of cash flow payments to the insured assumed from issue to age 100. Using a random interest rate generator, the authors produced 1,000 sets of random portfolio return rates for all three policy options from issue to age 100 under various assumptions to determine the dividend scale for any given year. Here is a snapshot of the research results: 5 Full Pay Scenario Policy issue data: Male, age 38, Preferred Plus No Tobacco, $1 million face amount, level annual premium $13,840, dividends used to purchase paid-up additions. Mean Value at Age 100 Lowest Value at Age 100 Highest Value at Age 100 Standard Deviation Cash Value (CV) $4,850,000 $1,700,000 $12,485,000 $2,339,000 Death Benefit (DB) $5,021,000 $1,784,000 $13,452,000 $2,530,000 Interest Rate 6.6% 4.7% 8.7% CV IRR 4.62% 1.92% 6.63% DB IRR 4.71% 2.05% 6.79% Natural Premium Offset Scenario Policy issue data: Male, age 38, Preferred Plus No Tobacco, $1 million face amount, level annual premium $13,840, dividends used to purchase paid-up additions. Number of annual premiums needed to sustain policy Underlying interest rate Mean Lowest Value Highest Value Standard Deviation % 8.8% 4.8% 3 Dividends are not guaranteed. They are declared annually by Guardian s Board of Directors. 4 The premium offset year is not guaranteed. The offset is based on the amount of paid-up additions and payment of non-guaranteed dividends. 5 The insurance-related values are hypothetical and are not representative of an actual life insurance policy. Natural Premium Offset at Age 85 Scenario This scenario outlines the option for Baby Boomers who may be concerned about outliving their resources. Policy issue data: Male, age 38, Preferred Plus No Tobacco, $1 million face amount, level annual premium $13,840, dividends used to purchase paid up additions. Annual cash flow benefit Average Low Value High Value Standard Deviation $166,700 $90,000 $336,000 $59,000 Interest Rate 6.6% 4.7% 8.9% The exercise is to provide a reasonable basis from which to manage expectations, the key to which is policy management. Please refer to the full research paper for a more details on each of these scenarios. The wide variance of results in this carefully conducted analysis is a reminder that a life insurance portfolio must be both properly acquired, and actively managed on an ongoing basis. 15

17 Most Life Insurance Policies Should Be Remediated and Not Replaced We believe the era of replacing everything in sight with No-Lapse Guarantee UL is about to come to an end. It s going to be an interesting next few years! Weber and Hause Most non-guaranteed policies that were performanceillustrated, and many guaranteed policies, have been largely underfunded for the last 30 years the expectations of results and the lengthening of life expectancies will create situations where the insurance policy may no longer be in force when needed. Looking to buy the cheaper alternative when the current policy runs out of gas is seeking the attractive impossibility. There is a tendency to view in-force policy illustrations as accurate depictions of a growing problem, now or in the future, and then to be convinced, via the illustration of a new policy (with a feature or benefit that appears better), that the old policy needs to be replaced. This is especially so when applying the rubric that anything that is not guaranteed should be replaced with something that is. The missing step is the optimization of the current policy. The new rubric is: Fully utilize the total property rights and features of the current policy before considering comparisons to other policy types and moving toward replacement. The problem is that many agents have not been provided with the tools or training to do this level of analysis, so the easiest solution is to replace a problem policy with a new policy (with a new commission for the agent), and especially with a no-lapse guarantee UL policy. In Managing a Valuable Asset, the authors highlight situations where remediation not replacement was the answer: Case in Point: How Remediation, Not Replacement, Was the Answer for One Client Agent recommends adding $90,000 to the current $141,000 annual planned premium in order to sustain the policy to age 100. But, the agent had no knowledge that the insured woman was in a nursing home and in poor health. Solution The trustee could manage the premiums at half the level of the current $141,000 premium to a new statistical probability possibly reserving and not paying the unused portion of current premium plus the additional $90,000 recommended by the agent for funding, even when the trustee opted to fund to the 85th percentile of life expectancy. The client died 16 months after the assessment. Upshot Advisors, agents, and trustees must be careful with calculations and undergo frequent reviews, to ensure that the trustee reserves premiums against the statistical unlikelihood of the insured living longer than estimated. Other case considerations Some situations may suggest morbidity issues rather than immediate mortality. Agents and advisors must remember that life expectancy statistics are based on group results not individual and that group statistics must be managed to optimize an individual result. People don t necessarily die earlier than expected. In fact, they also live longer likely much longer in the future. This is a significant example of how and why life insurance is a valuable asset that must be carefully managed to optimize return. This section has brought to light several considerations in effectively managing a life insurance portfolio. It is better to rely on objective information regarding life and health expectations, rather than an individual s or a family s perceptions. A Life Expectancy and Health Expectancy report overlying in-force illustrations can serve to more completely assessing and managing an in-force policy for an insured who is age 70 or older. Situation $2 million Universal Life policy Possible underfunding because of lower interest rates 16

18 Precepts of Fiduciary Standards of Care Some Clarification about Fiduciary Standards Regulation of the insurance and financial services industry is understandably complicated, and is likely to become more so in the near future. There is already a network of state and federal agencies, including the National Association of Insurance Commissioners (NAIC), state insurance departments, and FINRA (Financial Industry Regulatory Authority); Congressional mandates such as the Securities and Exchange Acts of 1934 and 1940; and even industry-related associations with codes of conduct. There are more to come specifically, the Dodd-Frank Wall Street Reform and Consumer Protection Act Section 913 which will be implemented by January A Look Into the Future The most likely outcome for Registered Representatives, and possibly insurance agents and brokers in the near future, is that they operate under standards of care as a fiduciary, which includes the following: the client s interest is placed above the interests of the advisor/broker/agent; the client is provided with appropriate disclosure of all relevant facts to make a decision that is in their best interest; any conflict of interest must be disclosed to the client. For Many, Fiduciary Standards Will Not Pose a Problem Yet while this is a significant elevation of the standard of care, fiduciary should not be a significant problem for financial professionals who recommend product placement as part of the planning process. Here s why: Receiving commissions and disclosing to a client how a Registered Representative or agent is paid is already incorporated into the sales process for most representatives. Financial planners who hold the CFP designation have been under a fiduciary-like practice standard since July The financial professional should always make clear the value of the product and service he or she is recommending, and that managing a portfolio is an ongoing service typically provided without commission. As more changes occur, financial representatives should embrace the new fiduciary standard, as this really embodies the essence of the services they deliver to clients over the years A fiduciary is not expected to recommend only the best product. The objective is to recommend suitable products for the client s needs, risk tolerance, funding sources, and reasonable expectations. 2. A fiduciary is not expected to recommend noload products. Often, no-load products do not out-perform their commissionable cousins. 3. A fiduciary is not expected to have access to every product in the marketplace. However, if an agent is restricted in access to certain products, this should be disclosed to the client. 4. A fiduciary considers suitability and individual facts and circumstances to meet the client s needs not the seller s needs. 5. A fiduciary creates an objective process that is consistently followed. Several industry organizations have created Codes of Ethics, Rules of Conduct, and Disciplinary Rules and Procedures that may be used by any advisor holding a license to sell financial products. Clients may not fully understand the role of their Registered Representative, or insurance agent, stock broker, or financial planner in the planning process, and this confusion may make the case to elevate standards of care more broadly across the financial services industry. Accepting a universal standard of care may ultimately be in the best interests of all. When they re running you out of town, get at the head of the line and make it look like a parade!

19 As a reminder, this Executive Summary provides a brief overview of the complete study, Life Insurance as an Asset Class: Managing a Valuable Asset, which may be obtained from your Guardian representative or nearest Guardian agency. 18

20 Pub 4661 (01/11) The Guardian Life Insurance Company of America New York, New York