AAII Journal - August 95

What to Do If You Are a Policyholder of a Failed Life Insurance Company

When all factors are considered, the wise move may ultimately be policy replacement, but the timing of the replacement is critical to salvage the maximum value.

You are in mid-sip when you realize that the $2.0 million estate planning policy you bought two years ago was with XYZ Life. How could this be--there was no warning, was there?

This is close to the situation policyholders of Confederation Life found themselves in on the morning of August 15, 1994. The day before, A.M. Best rated Confederation B++ ("Very good. Assigned to companies which, in our opinion, have achieved very good overall performance. . . "); while Standard & Poor’s rated it BBB+ ("Insurers with "BBB" offer adequate financial security, but their capacity to meet policyholder obligations is considered more vulnerable to adverse economic or underwriting conditions . . ."); and Duff & Phelps rated it AA- ("Very high claims paying ability"). Weiss Research, Inc., doesn’t rate Canadian companies. So in the Confederation case, policyholders should feel no guilt that they hadn’t been observant enough when the policy was purchased and later. Also, it is almost certain that death benefits will be paid.

Nonetheless, policyholders of failed insurance companies usually feel anger, soon accompanied by confusion over what they should do, which this column will address.

The Characteristics of Failure

Policies of life insurance companies that have been seized by regulators have certain characteristics that should be understood if rational decisions are to be made about retaining or replacing them.

During the period immediately following the seizure of a company by regulators, all surrender and loan values are frozen, except for hardship cases. This is to allow sufficient time to evaluate the situation without a run on the company’s assets by policyholders. Obviously, a policy with surrender values should not be canceled during this initial period. This initial rehabilitation period ends when the court with jurisdiction approves the rehabilitation plan offered by the person placed in charge of the rehabilitation process. (This first phase took about two and one-half years for Executive Life and Mutual Benefit, U.S. companies that failed in the early 1990s.)

The rehabilitation plan might feature a restructuring (which was the case with Mutual Benefit), or the sale of specific blocks of business to another company or syndicate (which was the case with Executive Life). During the early stages of the rehabilitation plan, there are usually substantial surrender charges if policyholders cancel their policies. For example, surrender charges during rehabilitation for Mutual Benefit’s adjustable life policies were: 55% during the so-called opt-in or opt-out period (in Mutual Benefit’s case this was about a two-month period after the company’s restructuring was approved by the court with jurisdiction and announced to policyholders); 33% the first year; 27% the second year; 21% the third year; 16% the fourth year; 10% the fifth year; 5% the sixth year; and none thereafter.

Policyholders who prematurely flee a failed company during the periods the policy values are frozen or later, when high surrender charges are imposed, leave behind all or a portion of the reserves or asset share that supports their policy. Theoretically, these profits from policies that are surrendered may be shared with policyholders who remain. Offsetting these potential profits are two pricing characteristics that are negative for policyholders of failed insurance companies.

A failed company’s future investment yields for assets supporting their life insurance policies are likely to be below market for an intermediate period as its asset portfolio is rehabilitated. In the case of Executive Life, junk bonds were sold. (However, the rush to sell these bonds has been severely criticized as harming policyholders; see an excellent article that appeared last year in Forbes.) In Mutual Benefit’s case, excessive real estate holdings, bought at a premium, were the culprits.

A failed company’s death claims (mortality experience) are expected to be higher than average due to healthier insureds leaving in much greater numbers than insureds who aren’t in good health. That is, people insured by a company that is seized who are in much poorer health than when the policy was originally purchased probably won’t be able to purchase a new policy with another company without paying very high substandard rates (or they may be uninsurable altogether). This is known as adverse selection.

When these factors (possible profits from surrender charges for policyholders remaining at least until the surrender charge period is over, versus probable lower medium-term investment yields and probable higher long-term mortality costs) are considered, the wise move may ultimately be policy replacement for insureds who are able to qualify for a standard rating with a replacement company. The timing of this possible replacement is critical to salvage the maximum value.

What to Do? Some Suggestions

The most pressing questions during the period immediately following the seizure of an insurance company and during the rehabilitation period, with surrender charges in place, are:

• Should the policy be replaced, and when?
• If the policy is to be retained (at least for the short-term) should the premiums be paid?

Here are some situations that policyowners of failed companies may find themselves in, along with some suggestions to consider. These suggestions, however, do not apply to Confederation policies since the rehabilitators have obtained a court order preventing anyone from encouraging Confederation policyholders to cancel, surrender or terminate their Confederation policies. The practical affect is that life insurance companies probably will not sell new policies to Confederation policyholders under any circumstances. It appears the Confederation rehabilitators prefer to crush the rights of individual policyholders to protect the aggregate of policyholders.

For those who are not Confederation policyholders, keep in mind that whatever the situation, when a replacement policy is purchased, low-load policies from companies with substantial financial strength ratings should be considered if cash value insurance is involved.

All term policies:

• If the insured is able to qualify for a standard rating, purchase a new term policy, either immediately or at the next policy anniversary.

Cash value policies (included are participating and interest-sensitive whole life and universal life):

• If the policy was purchased less than a year ago, and the insured will qualify for a standard rating, buy a new low-load policy now if the first-year selling expenses for the existing policy have absorbed all of the first year’s premium, which is almost always the case. This can be checked by determining whether the existing policy had any surrender value prior to its seizure by regulators. If there was no surrender value, little is lost by simply walking away from the policy. However, if the insured is in poorer health than when the policy in rehab was purchased, you need to know what sort of substandard rating the insured will receive for a new low-load policy. Generally, if the replacement policy rating is Table C (also referred to as Table 3--typical substandard ratings within the life insurance industry) or better , it will probably be a better value and should be purchased immediately, letting the rehab policy lapse. However, if the rating for the replacement policy is Table D or worse, retaining the rehab policy is probably the wise move and premiums need to be paid.
• If the policy was purchased several years ago, but nearly all of the policy’s cash values have been borrowed prior to the company’s seizure, the same observations made above will apply.
• If the policy was purchased several years ago, there are substantial cash values in the policy, and the policy is participating or interest-sensitive whole life (in these policies, full premiums are required), allow the cash value to pay the premiums, and allow the loan interest to be absorbed by cash values as well. This will provide more time to evaluate the situation without committing more money to the policy. The premiums and cumulative interest not paid should be available in an ad hoc escrow account for repayment later if retaining the policy proves to be the best move.
• If the policy was purchased several years ago, there are substantial cash values in the policy, and the policy is universal life, no premiums are needed since the annual costs of the policy will be deducted from the policy values anyway, without a policy loan being created (one of the advantages of universal life). Retaining the policy without paying further premiums should continue until most or all of the surrender charges have dissipated. Then the replacement of the policy should be seriously evaluated; an example of this evaluation is presented in the examples discussed below.

An interesting issue for these last two situations is whether a replacement policy, with minimum funding, should be purchased now to guarantee that the insured(s) will have a policy with a standard rating when a possible replacement purchase is made. That is, if the policy in rehab has a standard rating, but possible replacement probably won’t occur for five years, there is no guarantee that the insured(s) at that time will still be a standard risk. (Of course, there could be a problem qualifying for additional coverage because the insured’s income or net worth may not support it, but given the circumstances, it is possible the replacing company will waive certain income and net worth ratios in these cases). This issue is discussed below.

The Evaluation Process

Two examples help illustrate some of the considerations that go into determining what to do if you hold a policy of a life insurance company that has been seized by regulators. One example involves a single-life policy that was purchased in 1990, the other is a survivorship policy purchased in 1993; both are based on a composite insurance company in rehabilitation. I am assuming that the seizure by regulators has occurred within the past year, and therefore the policies’ values are frozen. I also expect that, within two years, the company will enter the second rehabilitation phase, with five years of surrender charges imposed by the rehabilitation plan. Therefore, there will probably be a seven-year period before these policies come out of the rehabilitation process.

The single-life policy example:

The first question is whether this policy should be retained or replaced now. Because of the large amount of current cash value, there is no option but to continue this policy, at least until most or all of the surrender charges are gone. To do otherwise would cause the loss of the $133,000 cash value.

The next question is whether the $24,000 premium should be paid in cash, or via a policy loan from the policy’s cash value. The current policy cash value appears sufficient to carry this policy for about four years. This will allow the policyowner to keep the cash he would pay in premiums otherwise invested. During the next four years, he will be obtaining information about the future of this policy, allowing him to make a more informed decision about keeping it long-term.

The final decision that needs to be made now is whether the policyowner wishes to purchase a cheap term or minimum funded low-load universal life policy to protect his standard rating in the event he wants to replace the rehabing policy after the rehabilitation period (during which there are substantial surrender charges). I calculate that he can purchase a cheap $1.5 million term policy for a seven-year period for a net present value cost of $13,500. However, because of his young age and excellent health, he decides to forgo this insurance-on-insurance and take his chances.

In summary, due to the large amount of surrender value that would be lost if this policy is abandoned now, there is no question that it will be retained. To avoid future premium payments in cash, the policyowner is allowing the policy’s cash value to carry it for as long as possible, at which time another evaluation will be done to decide whether premiums in cash will be made, or the policy will be replaced. A third evaluation will be done after the rehabilitation process is over to again determine whether the policy should be replaced. Remember that due to adverse selection (the expectation that more healthy insureds will cancel their policies than unhealthy insureds), it is probable that a policy with a company that has been put through a rehabilitation process will have higher mortality costs compared with a low-load replacement policy if the insured qualifies for a standard rating with the replacing company.

The survivorship policy example:

I calculate that a minimum funded low-load, survivorship universal life would cost about $8,750 to hold a $2.5 million policy at standard rates for seven years, when it is expected this policy is out of rehabilitation. Unlike the first example, the policyowners aren’t as confident that they will be able to qualify for standard rates in seven years, so they decide to purchase this possible substitute coverage; its cost is considered in my evaluation below.

Table 1. Comparison of Estimated Pricing Assumptions for Survivorship Policies Percentage Surrender Percentage Investment of Standard Charges as % of of Policies Yield (%) Mortality Cash Value Surrendered Year Rehab Normal Rehab Normal Rehab Normal Rehab Normal 95/96 5.55 7.40 100 100 100 0 10 2 96/97 5.55 7.40 125 100 100 0 3 2 97/98 5.55 7.40 125 100 55 0 10 2 98/99 5.90 7.40 150 100 45 0 8 2 99/00 6.10 7.40 150 100 35 0 6 2 00/01 7.03 7.40 175 100 15 0 6 2 01/02 7.29 7.40 175 100 5 0 10 2 Thereafter 7.40 7.40 175 100 0 0 1 1

The first example had enough surrender value to carry the policy for a number of years, giving the policy-owners more time to collect information to evaluate the situation. However, this second example demands an immediate decision about whether to retain or replace this policy. With a $19,450 premium due very soon, the policyowners need to make an immediate decision. Using the pricing characteristics for policies with companies that have been seized (potential profits from policies that are prematurely surrendered; lower intermediate-term investment yields; and higher long-term mortality costs), I created a pricing model to compare their retention with a possible replacement policy. Admittedly, these pricing assumptions are guesses, but in the absence of better information it is the only alternative to waiting until the company provides its pricing (which no company has done) or the individual’s policy has emerged from rehabilitation to try to figure it out. My pricing estimates are shown in Table 1.

This policyowner’s decision to replace this policy now or to retain it with the likelihood it will be replaced after the rehabilitation process is over can be made by analyzing three different scenarios:

1. Rehabing policy is retained: In this scenario, the future value of the $8,750 used to secure a possible substitute policy within seven years has been added to the cash value of the retained policy to make for an equal comparison with Scenario 3.
2. Rehabing policy is replaced with a low-load, survivorship policy now: In this scenario, the future value of $8,750 used to secure a possible substitute policy within seven years has been added to the cash value of the policy under Scenario 3 to make an equal comparison.
3. A $2.5 million low-load second-to-die policy is purchased now and minimally funded with $8,750, which, based on current pricing assumptions, appears enough to keep this policy in force for seven years. The rehab policy’s premiums of $19,450 are paid for seven years, then canceled and the values transferred to the previously purchased low-load survivorship policy.

The projected policy values for these three scenarios are presented in Table 2, using the pricing estimates shown in Table 1 and standard pricing for the low-load survivorship replacement policy.

Table 2. Comparison of Estimated Cash Values Based on Pricing Assumptions from Table 1 for Rehab Policy Ages Scenario 1 Scenario 2 Scenario 3 (male/female) Year ($) ($) ($) 73/62 2002/03 241,000 199,000 230,000 78/67 2007/08 374,000 360,000 403,000 83/72 2012/13 371,000 509,000 572,000 88/77 2017/18 34,000 432,000 534,000

Based on the estimated pricing for the rehabing policy, it appears that the probable effects of adverse selection (more healthy insureds cancel their policies than unhealthy insureds, causing the mortality costs to be higher) will cause the long-term values to be weaker than a low-load alternative. However, it is a close call as to whether the rehabing policy should be canceled with a low-load replacement now, or retained while minimally funding a low-load policy to guarantee later access to standard rates if the rehabing policy is ultimately replaced. (It is not as if the $8,750 projected funding for a low-load policy is lost; after all, the insureds have double coverage for the period both are in force).

Retaining the rehabing policy, while purchasing a possible substitute gives the policyowner more time to collect information to better evaluate the situation, and that is the decision these policyowners ultimately have made.

Conclusion

The important thing to remember when you own a cash value policy with a life insurance company that has been seized by regulators is not to panic and immediately replace the policy while there are substantial policy values subject to surrender charges. Your patience will be rewarded.

Prudent decisions should be made based on the health and age of the insured(s), the accumulated cash value of the policy, and the type of policy involved. Unfortunately, these decisions will have to be made with less than perfect information about how the rehabilitation process will affect the policy’s future performance.

The decision process could be enhanced if the companies would provide information regarding percentage of policies surrendered, investment yields, mortality experience, and whether or not they are using "profits" obtained from surrender charges to enhance the policy values of those who remain. For that reason, I close this column with an open request, asking companies in rehabilitation, the rehabilitators, and the regulators to provide this information to policyholders.

Peter Katt, CFP, LIC, is sole proprietor of katt & Co., a fee-only life insurance adviser located in Kalamazoo, Michigan; (810) 360-4468. His book, " The Life Insurance Fiasco: How To Avoid It" is available through the author.