Vol 10 No 9		October 2008

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Life Insurance in a Distressed Economy

The economy's liquidity problem is probably short term. The long lasting problem is that we have spent more than can be supported by income and assets. There has been far too much credit in the system that will never be repaid. Issuing more credit, some that will also be unpaid, may cover things up for awhile, but the economy has to be restructured. Economic growth should have strong production and saving components. Unfortunately, socializing America and lobbyist obfuscation will probably cloud America's long-term future.

In hard economic times, investors look for ways to lighten their financial load and life insurance has its role to play. There are three possible ways that the management of life insurance can assist in such periods. First, instead of buying higher cost permanent policies that generate cash values, investors can stick with much lower cost term insurance. Second, to save cash flow permanent policies' premiums might be skipped. And third, if investors need funds they may be able to withdraw or borrow from cash values of permanent policies. Case studies follow to explain these options.

Term Insurance

Dave and Anne have their first child. Anne has lost her bank position and Dave has been let go from his auto company position. He is fortunate to sign on with a consumer products company, but at a lower salary. Dave and Anne realize their family income is down and want to maximize the amount of life insurance protection each of them has. Both are 35 and in very good health, Dave acquires a 20-year level term policy for $2,000,000 with an annual premium of $1,100 and Anne is insured for $500,000 with an annual premium of $260. Term lets them maximize protection within their budget.

Bob and Jean are both 55 and in good health, Bob is a real estate developer. He astutely stopped building slightly ahead of the housing collapse but his inventory of land is not liquid and his cash flow is relatively poor. He and Jean need $10,000,000 of survivorship life insurance for estate tax liquidity. A low-expense market-priced survivorship universal life (SUL) policy has target premiums of $70,000 for lifetime coverage. This is more than Bob wants to commit in these rough real estate times. But he can use the same low-expense SUL policy as surrogate joint-life term by only paying premiums to keep it in force for 20 years. The target premiums for this design are $9,000. By comparison a true 20-year term policy insuring Jean has premiums of around $22,000 a year. Using the low-expense SUL policy gives Bob and Jean flexibility of increasing the funding when they have the cash flow to make the policy last their lifetimes.

UL

Tom, 62, already purchased his permanent estate tax liquidity life insurance. Five years ago his trust purchased a $15,000,000 no lapse UL policy. No lapse UL policies have guaranteed premiums and death benefits. They are like term for life. No lapse UL policies are very different from other permanent policies that don't have these aggressive guarantees. I refer to the no lapse policies as static-priced because the pricing won't change regardless of interest rates and mortality trends. Conventional permanent insurance is market-priced because its value, and therefore premiums, do depend on interest rates and mortality. (See my July 2003 AAII Journal column , "The Potential Problems with No-Lapse Premium Guarantees," for details about no lapse policies and their differences). A drawback to static-priced UL is low to zero cash values relative to market-priced policies that have robust cash values.

Tom's estate soared during the housing boom due to his ownership of a mortgage company. Now he is having cash flow problems. His combined annual life insurance premiums are around $245,000. Because of low cash values Tom has little leeway in skipping premiums. He can skip the next two years and then the policy will lapse. Had Tom purchased a market-priced UL (low-expense version) with much higher cash values, it would continue for 10 years without premiums. Of course skipping static- and market-priced UL premiums means higher premiums will be needed when they are resumed.

In two years if Tom still doesn't have the resources to pay the $245,000 annual premiums his static-priced policy will terminate. Instead of just walking away from his static-priced UL with no surrender value he might try selling it in the life settlement market, but not before he reads my March 2008 Journal of Financial Planning column, "The Life Settlement Mosaic". This lack of liquidity is a serious drawback to static-priced UL. Had Tom purchased market-priced UL with slightly higher target premiums in the first place, the loan or surrender value would be about $1,000,000. He could continue the policy or surrender it for the cash.

Whole Life

Greg, a surgeon 59, purchased a large amount of term insurance and a much smaller amount of high premium whole life (low expense version) fifteen years ago in an integrated plan of family protection and tax-deferred savings. The annual contract premiums are $44,000 and the cash values are now about $1,800,000. A golfing buddy broker convinced Greg to invest in two residential homes with mortgage payments of some $120,000 a year. The idea was to flip them within two years. The house prices have tanked. Greg has decided to wait for a market turn around but he needs liquidity to finance this delay. Unlike a UL policy where premiums can be missed, whole life premiums need to be paid. But they don't need to be paid by the policyowner. Dividends can easily pay Greg's $44,000 premiums and he can withdraw or borrow cash values if necessary to fund the $120,000 annual mortgage payments. Cash value withdrawals are tax-free if they don't exceed Greg's cost basis (sum of his premiums). Greg's cost basis is $988,000. Whether withdrawing or borrowing cash values is best depends on whether they are likely to be repaid. If repayment is likely a loan should be taken because it can simply be repaid. Withdrawals can't be repaid. But if repayment is not expected it is better to take a withdrawal so there is no loan interest associated with it. Since Greg hopes to sell the properties and repay the funds taken from his whole life policy he will take them as loans.

Variable Universal Life (VUL)

George, 62 sold his business in 2000 for $2,500,000. He invested the down payment in a VUL and also expected to invest half the 10-year payments into the VUL. At 65 the VUL was illustrated to allow him to take out $100,000 a year for life with a large inheritance for his children from the death benefit. Eight years later the business has failed and the VUL cash value is 50% less than illustrated due to the volatility of the stock market (duh!). George's retirement is in great jeopardy. George's best move is to transfer his VUL cash values to an income annuity to take advantage of the much higher cost basis and receive a guaranteed income for life. With Social Security George can receive about $75,000 a year. With its high expenses and volatility of investments George seriously risked losing his entire nest egg with the VUL. VUL is a flawed life insurance concept and especially in the situation described above.

Some investors and all VUL sellers expect the illustrated 10% to 12% constant returns to come true. In real life, equity volatility and high VUL expenses almost always reach out to spoil the party. Please avoid VUL in good and bad times. See my VUL columns at www.peterkatt.com.

Summary

Financial assets and decisions come under stress in difficult economic times. Decisions about life insurance during such periods are important. Term insurance is much more relevant because of its simple low costs. Low-expense SUL should also be a player because of very flexible costs. Static-priced UL with low to zero cash values show its significant weakness when liquidity is needed, and might be rejected for that reason alone. Finally, VUL is a poor life insurance choice during all economic periods.