Vol 3 No 2		July 2001

Katt & Company is a fee-only life insurance advising firm. We work with clients throughout the U.S. - primarily by phone, mail, email and telecopy. Typically, we assist clients buying life insurance, those who need existing policies reviewed and managed, and in support of litigation. For references please contact us.

Alert

A large number of life insurance companies are offering what are known as secondary-guarantees for policy death benefits. Death benefits are guaranteed for a specified period of time (typically to age 85, 90 or 100) when a designated minimum annual premium is paid even though the policy's cash values are not guaranteed. Secondary-guarantees are two to three times better than conventional-guarantees. However, the National Association of Insurance Commissioners are concerned that these secondary-guarantees are not being adequately reserved for and have promulgated new regulations (known as Triple X) to force insurance companies to increase their reserves to protect the public from potential insolvencies. Unfortunately, clever insurance company actuaries have been able to use alternative interpretations of these regulations to continue very aggressive pricing. Such aggressive guarantees have three principal risks. First, they draw attention to these exaggerated-guarantees and away from observing how a company has treated policies over a very long period of time; the only true measurement of how worthy a company is to receive your clients' premium dollars. Second, exaggerated guarantees can cause company insolvencies. Third, they can encourage underfunding a policy such that at very old ages your client has nothing more than term insurance left with huge premiums needed to continue the coverage. Three examples of companies' exaggerated-guarantees causing their financial collapse come to mind. Baldwin United guaranteed too high an interest rate for their annuities in the 1980s, Mid-Continent Life guaranteed premiums that were too low on their universal life policies in the 1990s and Equitable (of Great Britain) also guaranteed interest rates that were too high during the 1980s. The fact is insurance companies can't absolutely guarantee anything (conventional or exaggerated) since they can't print money and have no armed forces. The more aggressive their guarantees are, the greater the danger they could collapse because of them.

Prudent insurance companies' conventional-guarantees are one of life's quaint euphemisms that provide many with a false sense of security without doing any harm. Exaggerated-guarantees are not benign if they are the reason a particular insurance policy is purchased while ignoring far more important criteria. Further, your clients have to be alert to outliving the guarantees with their policies' premiums becoming so large they can't be maintained. Finally, exaggerated-guarantees do raise the risks of insurance company insolvencies.

Tip

Several times a year I see participating whole life policies with dividends being accumulated at interest. The annual interest earned of these accumulated dividend values is taxable income to the policy owner. Using dividends to buy paid-up-additions (PUAs) produces about the same policy values and flexibilities as accumulating dividends without the annual tax drag. I have yet to have a client that has been using accumulating dividends be able to explain why. Whenever we encounter a client with dividends being accumulated we change to PUAs to rid them of yearly tax payments on their life insurance policy.

Information

Individual disability income insurance (DI) premiums can be tax-deductible when paid as a business expense. Insurance agents frequently promote this DI tax-deduction, but there are two very significant drawbacks. The first problem is certain, the second problem only occurs when a lawsuit is necessary to force a company to pay benefits. Whenever DI premiums are taken as a tax-deduction the benefits are taxable. Conversely, if DI premiums are not taken as a tax-deduction the benefits are tax-free. As a simple matter of personal financial logic, clients are financially much better able to withstand paying non-deductible premiums than having their DI benefits taxed after a disability. That is, while working and paying premiums clients are financially strong, but if disabled they are financially vulnerable making the right to receive tax-free DI checks very significant. The second problem deals with having the DI transaction subject to ERISA jurisdiction because the premium has been expensed as an employee benefit, even if it is a one-person professional corporation. If ERISA jurisdiction is accepted by a court (as recently happened in a Cincinnati case) no punitive damages are generally allowed, which will cause plaintiffs to have to pay for legal representation because without punitive damages lawyers aren't likely to take a case on a contingency basis. In practical terms this will very likely preclude legal action to force the payment of claims. This knowledge may embolden insurance companies who are interested in contesting claims. I do not recommend taking tax-deductions for DI premiums.

Also, see various DI articles on my website, including my August 2001 column in the Journal of Financial Planning.