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A Premium Management System Broadly speaking, there are only two basic permanent life insurance policy designs. One has level-to-maturity death benefits (LTM/DB) that we may think of as a Defined-Benefit design because the death benefits are known, but as we will see the premium costs are unknown. The other has robust premium payments relative to very low initial death benefits that are almost certain to increase significantly without any changes to the premium payments. This design we can think of as defined-contribution since the premium payments are known but policy values are uncertain. At the time of purchase defined-benefit premium payments are usually structured so that the policy’s cash values are projected to equal the death benefits (known as endowment) at policy maturity. The presentation of such a design via policy illustrations creates the illusion that the premium costs can be known in advance – they cannot because the investment, mortality and expense components of the policy’s pricing structure, above the policy’s guarantees, will change. Therefore it is certain that defined-benefit style policies will alternate between being overfunded and underfunded. These problems are exaggerated when so-called vanishing-premium designs are used. Universal and whole life policies’ (UL and WL) investment component is primarily bonds held for yield. Changing yields will occur gradually with considerable short-term predictability. Nevertheless, premium management for UL and WL defined-benefit type policies will result in significant premium fluctuations, primarily as interest rates fluctuate. Much more difficult to manage are variable life (VL) policies whose cash values are invested in equity funds because stock prices are volatile and unpredictable. Conventional premium management for defined-benefit VL policies is impossible. The case study to follow explains the problems associated with managing a defined-benefit type of policy design and shows a premium management solution that we refer to as the Modified Defined-Benefit (MDB) premium management system. Please refer to Peter Katt’s November 2001 AAII Journal column for a more complete explanation of the VL Defined-Benefit problem. This column can be found at www.peterkatt.com under the articles section or you can contact us at (269) 372-3497 and we will mail or fax this column to you. Case Study Bill Davis, 61, purchased a $1,000,000 level death benefit UL policy in 1991. At that time UL interest crediting rates were 8.5%. The UL illustration calculated the target premium for Bill’s policy to become paid-up at 100 as $9,382 using the 8.5% crediting rate. (Exhibit 1 is a simulation of this point-of-sale [POS] illustration). Although Bill and his agent didn’t think of it in these terms this is a defined-benefit or LTM/DB policy design. Every year Bill has received a premium notice for the original target premium of $9,832, which he has paid, and an annual statement that he has filed with the policy but hasn’t understood. While Bill has realized that interest rates have been declining, he has not thought much about the policy since it was purchased in 1991. The agent, who has tried to sell some new insurance, hasn’t said anything about the $1,000,000 policy since 1991. Exhibit 2 simulates actual policy premium payments, interest crediting rates, and cash values. Note that the estimated cash value in the 11th policy year from the 1991 POS illustration (Exhibit 1) is $104,491 but the simulated actual cash value in year 11 is $89,733. Bill’s policy is underfunded. The Problem This year Bill’s agent shows up with a simulated in-force illustration for the 1991 UL policy (Exhibit 3). To his dismay Bill discovers that the policy has become significantly underfunded because of a declining interest rate that is now 5.75%. The policy is projected to lapse at age 84 if he does not significantly increase the annual premiums. In that Bill is still in excellent health there is a 54% probability that he will still be alive, making the prospect of the policy terminating at age 84 unacceptable.
The reason Bill’s agent has shown renewed interest in this UL policy is because he is recommending that the underfunded UL policy be rescued by replacing it with a VL policy. The proposed VL policy’s cash values can be invested in equity funds that Bill’s agent assures him can produce a higher average investment yield than the UL’s crediting rate. He shows Bill a VL illustration (including a tax-free exchange of the existing policy’s current cash value of $89,733) that assumes a net investment yield of 10.5% (Exhibit 4).
Bill hires our firm to review the agent’s attempt to replace his UL policy with a VL policy upon the recommendation of his attorney who is suspicious of this supposed rescue. The first thing we do is ask Bill to read three articles that deal with VL designs and permanent life insurance premium management. These AAII Journal articles, found in the Articles Section of our Web site – www.peterkatt.com, are:
These articles make three important points regarding VL policies:
Before showing Bill a premium management system that can work with a defined-benefit VL policy we show him a simulation of why the traditional premium management systems can’t possibly work. There are two possible traditional premium management alternatives. The first alternative pretends the problem doesn’t exist and calls on divine guidance to protect your policy’s solvency without too much overfunding through undulating market returns. This head-in-the-sand approach is dangerous because 1000 simulations in which the actual average yield matches the assumed yield with a 15 percent variation in year-to-year yields shows that half of the time such a VL policy will terminate because the cash values have run to zero. The other traditional premium management system resets premiums every three years based on actual performance and some specified prediction of future investment performance. Exhibit 5 simulates resetting premiums every three years looking back 39 years (when Bill is 100) to the present. The premium range is zero to $52,200 to keep this defined-benefit policy from experiencing too much overfunding and underfunding. Obviously, a premium range of zero to $52,200 isn’t acceptable. Modified Defined-Benefit Premium Management for VL Policies The best way to describe how the MDB premium management system works is to review and explain Exhibits 6 - 9. Exhibit 6 – A target premium of $17,980 is calculated using a conservative average yield of 5.5 percent. This simulated illustration is for a $1,000,000 level death benefit, usually referred to as Option A. Exhibit 7 – The actual policy is purchased using Option B, where the death benefit is the specified amount of $1,000,000 plus the cash value. Each year our firm reduces the policy’s death benefit by the increase in the conservatively set benchmark cash value. Generally, this will cause the policy’s death benefit to increase by the difference between the actual and benchmark cash values. This simulation, again looking back from 39 years (when Bill is 100) to the present shows a fluctuating death benefit that (except for the early years) exceeds the original $1,000,000 and grows very large in very late years because of large randomly selected yields. Referring to Exhibit 7, note that the death benefits drop to $940,075 in the 3rd year because of the randomly selected negative investment yields in years 1 and 2. When this occurs the client can be given the options of:
One thing should be obvious about this MDB premium management system: it necessarily changes the policy design from defined-benefit to a version of the defined-contribution design. (This defined-contribution version has much larger initial death benefits and more modest increases in benefits than is typical). This can’t be avoided and tells us that the defined-benefit design is such a flawed concept that it simply cannot be used in its pure form. Modified Defined-Benefit Premium Management for UL Policies As previously noted the difficulties in managing defined-benefit policy designs are not limited to VL policies invested in equity funds. Large differences in target premiums can also be experienced with UL policies. Exhibits 10 – 12 simulate Bill Davis’1991 purchased UL policy, beginning in 2002.
Again, as noted for the VL MDB, it is obvious this MDB premium management system changes the policy design from defined-benefit to a version of the defined-contribution design. This can’t be avoided and tells us that the defined-benefit design is a flawed concept that simply cannot be used in its pure form. Notes:
Prepared by Katt & Company
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