Vol 10 No 1		January 2008

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VULs in Life Insurance Portfolios

I have written often about my client experiences with variable universal life (VUL) policies. When these policies fall apart due to equity sub-account losses, the current cash values and target premiums can be illustrated as incapable of properly supporting the policy. Expected large premiums are shown that seem like the equivalent of a margin call and this often triggers a solicitation of my services. But this doesn't mean that VUL can't be used for clients life insurance needs. With astute management VULs can be part of the life insurance portfolio.

The problem is that VUL has often been treated as just a better performing version of whole life (WL) and universal life (UL) without realizing its inherent investment volatility that makes VUL a very different kind of life insurance. The major reason for the failure to recognize this is VUL illustrations. Agents and buyers get their primary understanding about life insurance by viewing an illustration provided by the insurance company. Illustrations show how a policy is illustrated to perform based on the premiums, insurance costs and constant investment yields. WL and UL illustrations are less likely to be wildly inaccurate because companies use their current investment experience that is heavily weighted to fixed income instruments that change in predictable ways and don't suffer losses. But the investment volatility of equities funding VUL policies is a completely different situation as losses of 20% or 50% can occur in a very short period of time with no guarantee that subsequent gains will offset the losses any time soon, or that the investor policyowner won't get out of the equity funds thereby removing their participation in a recovery. This VUL fact simply cannot be seen by viewing their illustrations.

By far the largest problems with VULs involve policies with level death benefits. It is impossible to know premium amounts and the timing of premiums with such investment volatility. The extent of this target premium malfeasance can be seen by doing probability studies such as Monte Carlo testing. Measuring outcome probabilities has been around since the 1940s and is very useful in decision making. If it were routinely used when considering the purchase of level death benefit VULs, few would be purchased because it would become obvious that there is no way to manage premiums with such investment volatility. But this doesn't mean that VUL can't be used for clients life insurance needs. With astute management VULs can be part of the life insurance portfolio.

I have a client 53 with a VUL that represented the entire insurance program. After looking at alternatives the client decided not to pay any additional premiums and to retain only a portion of the VUL, diversifying into three other types of non-VUL policies by withdrawing three-fourths of the cash values and reducing the death benefits by at least the same amount. I did a Monte Carlo test on the remaining cash values and death benefits and determined a 35% to 50% failure probability, measured around life expectancy and beyond, without the payment of large premiums at some unknown time. In lieu of this I dropped the death benefits to one-third ($2,300,000 to $773,000) with a remaining cash value of some $400,000. The death benefits were changed to the specified amount plus the cash values, or $1,173,000. This amount of initial death benefits and cash values allow for the policy to become paid-up at age 100 at a constant 5%, making it a conservative ratio of cash values to death benefits and making it quite likely that the death benefits will experience a significant increase over time. I calculated the ratio of cash values to death benefits for every year to 100. The safe management of this VUL design calls for a downward adjustment of the death benefits anytime the cash value ratio falls behind and stays there for several years. As a demonstration of this I used a slice of historical total stock returns, less appropriate VUL expenses, but intentionally ended the period with two years of losses to provide a better demonstration of how this management system handles losses. The following table is not intended to be a prediction or estimate, but merely a demonstration of how this management system works.

$400,000 CV Funding for $1,170,000 Initial DBs VUL / DEMONSTRATION

As a healthy insured gets older, the CV to DB ratios get higher. In the demonstration the ratios have been good until age 85 when it drops below benchmark due to the large losses. The ratio at 85 should be around 80%, but is down to 75%. If the insured were in declining health I would probably reset the ratios downward and 75% would be fine. Even if the insured was in great health I would not drop the death benefits, waiting to see if the markets came back up and self corrected the problem, but I would closely monitor this situation and reduce death benefits or ask the policyowner to provide some additional funding.

With astute management of VUL policies clients can have equity participation in their life insurance portfolio without nearly the problem of volatile equity investments.