Journal of Financial Planning - November 2004

No-lapse premium guarantee universal life policies can be an excellent match for some clients. But planners need to caution clients about the potential insolvency risks.

The Risk/Benefit Trade-Off of No-Lapse Premium Guarantee Policies

by Peter Katt, CFP, LIC

My July 2003 Journal of Financial Planning column discussed universal life policies with no-lapse secondary guarantees. I referred to them as no-lapse premium guarantee (NLPG) policies. These NLPGs have very exaggerated guarantees and probably rely on policy lapses to provide a margin of safety for the companies selling them. If they don't get the number of lapses anticipated and interest rates don't soar, these policies won't be profitable for these companies. This is especially the case for the most aggressively priced NLPGs.

Last year, the only coverage I saw about NLPGs appeared to be press releases from the companies themselves touting their wonders. I spent time lobbying other influential life insurance voices to join me in a critical analysis of NLPGs because it appeared that they were (and are) dominating new and replacement policy sales. It continues to be my opinion that understanding the solvency implications connected to NLPGs is by far the most important issue in the life insurance world.

Finally, help has arrived in the form of penetrating and critical pieces from, most importantly, Moody's Investment Services, Fitch Ratings, and Joseph Belth's The Insurance Forum. Before you sell an NLPG policy or advise on a purchase, do your clients and yourself a favor and obtain copies of these pieces (www.theinsuranceforum.com, www.moodys.com, www.fitchratings.com). If you fail to disclose that companies selling NLPGs have greater solvency risks, and a company whose NLPGs you have recommended fails-causing considerable damage to the guaranteed pricing - be prepared for litigation.

The dangers the most aggressively priced NLPGs pose aren't hysterical speculation. They are real, and notice of the dangers is increasingly widespread. Ignorance should not be a defense. That said, I don't know how to quantify the chances of insolvencies associated with NLPGs and I note that Moody's and Fitch haven't downgraded their ratings for the top NLPG sellers.

Increased risks don't mean that all clients should avoid NLPGs; it means that all clients should be advised of the possible risks so they can make informed decisions about whether the potential advantages are more important than the increased risk. The presentation of NLPGs as an option has become a staple in my practice. A client's view of an NLPG policy should be based on the risk/benefit assessment. Several brief case studies may provide some clarity about this.

Two Sets of Concepts

Before presenting these brief case studies, two sets of concepts need to be understood. One set has to do with death benefit designs. One design is level death benefits from the time of purchase until the policy matures. NLPGs can only have level death benefits. The other death benefit design has initially lower death benefits that increase. NLPGs cannot have increasing death benefits. These two death benefit designs are evaluated using the same premium payments.

The second set of concepts is what I refer to as market-priced and static-priced. As noted in my July 2003 column, NLPGs are static-priced. The premiums and death benefits are guaranteed - what you buy is what you get. We can think of this as term insurance for life. Static pricing is in stark contrast to market-pricing, which has been the only pricing used for permanent insurance from 1980 to 2002. In conjunction with a level death benefit design, a market-priced policy's premiums will fluctuate with investment and mortality experience.

Compared with market-priced policies, static-priced policies will have one of two aggregate outcomes. They will either be overpriced or underpriced compared with a market-priced policy, as measured from the time of purchase until insureds' deaths. Unlike a static-priced NLPG, market-priced policies can have either level or increasing death benefits. Only a very few companies have true market-priced policies whose pricing is fairly adjusted for both new and old policies. Almost all other companies give more favorable pricing treatment to newer designed policies and the older policies' pricing falls below market. Giving poorer pricing to older policies negates the concept of market-pricing. Also, you should not consider market-priced policies from companies selling aggressively priced NLPGs-not only because they are likely not giving true market-pricing to older policies but because if the NLPGs become unprofitable, the market-priced policies without the exaggerated guarantees may be tagged to make up for NLPGs' losses with very poor pricing.

Case 1

Howard is 74 with a history of heart disease. As part of overall life insurance planning, I reviewed an existing $3 million market-priced policy with an annual target premium of $67,000 and a cash value of $1 million (ABC Life). The underwriting for new insurance on Howard ranged from standard to sub-standard Table 8. Only one insurer, XYZ Life, offered the standard rating, and it is also has very aggressive static pricing. XYZ Life's static-priced policy has two premium modes: one with guaranteed premiums of $47,000 to age 100, and another with a $17,000 premium for 15 years followed by premiums of $206,000 from age 90 to 100. Measured at Howard's life expectancy, XYZ Life's present-value premium advantage compared with his existing ABC Life policy using the $47,000 premium mode is $175,000, and $435,000 if two-tiered premiums of $17,000 for 15 years followed by $206,000 for 10 years. (Because of Howard's life expectancy, the probabilities are strongly in favor of using the two-tiered premium mode).

I fully disclosed the risks associated with static-priced NLPGs. The reduction in guaranteed costs are so great that even if XYZ Life is seized due to solvency concerns, the probable resulting premium adjustment may very well be no higher than if he retained his ABC Life policy. Finally, ABC Life also sells static-priced NLPGs, so this may not be much of a safe haven anyway. Howard did replace his ABC policy with the XYZ Life NLPG. The standard offer with very aggressive static pricing does increase XYZ Life's financial risk, but the advantage is so great that even if XYZ Life fails, its resulting pricing may not be any higher than ABC Life's.

Case 2

Paul is 71 and Irene is 70. Paul is a sub-standard risk and Irene is preferred. They own a family business, with two children working in the business, and two who don't. They want to distribute the business only to the children in the business and be sure to equalize the inheritance to the others. Paul and Irene want a level $10 million life insurance policy.

I provided Paul with a report describing and comparing static- and market-priced policies. Because the market-priced premium for a level death benefit policy will fluctuate, the critical issue is the potential premium difference with a static-priced policy. XYZ Life's guaranteed annual static-priced premium is $195,000. Table 1 shows the market-priced premium based on different average dividend interest rates for Premiere Mutual Life (PML). PML's average dividend interest rate since 1992 has been 8.6 percent, which may represent an era of higher interest rates than we will have in the future.

PML's average dividend interest rate must be eight percent to match the guaranteed XYZ Life's static-priced premium of $195,000. PML's current dividend interest rate is a bit below eight percent. It is very likely that it will decline for a few years at least. Without taking into consideration the potential solvency risks associated with static pricing, Paul may very well have gone with XYZ Life. But the risks were fully disclosed and because he got burned by Executive Life's failure, Paul has no interest in taking any additional risks with his life insurance program. PML is his choice.

Case 3

Bruce is 78 and in excellent health. His estate assets are almost entirely marketable securities since he sold his business some years ago. Bruce is insured with a $1.6 million universal life policy with $605,000 of cash values from Acme Life. This Acme Life policy is poorly priced and will need significant premiums to continue the $1.6 million death benefit. An insurance agent recommended that he replace this policy with an XYZ Life static-priced policy with level guaranteed death benefits of $1,273,041 and no further premiums.

Bruce wanted a second opinion. The agent hadn't mentioned the possible risks associated with static-priced policies and didn't mention the option of having an increasing death benefit policy also funded with only the $605,000 cash values. Table 2 shows a comparison of having an XYZ Life static-priced policy with level death benefits of $1,273,041 or a PML paid-up policy. Both approaches are guaranteed to have no future premiums. A PML paid-up policy is market-priced and the actual increase in death benefits will depend on future dividends. Table 2 uses a dividend interest rate of seven percent, which is considerably below PML's current rate. Table 2 also shows the probabilities that Bruce will be alive.

Bruce's immediate and certain response was to replace his Acme Life policy with a paid-up PML policy because there is a fair chance it will produce better value and eliminates any risk.

Assessing whether the additional risks associated with static-priced NLPGs are worth the possible benefits should be made in every case so the client can make informed decisions. The failure to disclose static-priced NLPG risks may cause litigation problems for sellers and recommending advisors.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 17, Issue 11, November 2004.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).