May 3, 2003

Mr. Kenneth Client
P.O. Box 12345
Anytown, USA 12345

Dear Ken:

You retained my services to review the proposal made by Charles Agent of Merrill Lynch. Mr. Agent recommended that you replace 11 Northwestern Mutual Life (NML) participating whole life policies with two universal life policies with secondary guarantees offered by American General. I also analyzed and am commenting on another perspective about your life insurance. Based on this report you will decide whether to replace the NML policies with the American General policies. You could decide to replace all or some of the NML policies. If you decide to keep some or all of the NML policies you will also decide whether to continue paying no out-of-pocket premiums or to begin paying premiums on some or all of the policies that allow premiums. Finally, you need to decide whether to transfer your life insurance to an irrevocable trust.

NML Policies

Table 1 lists your 11 NML policies. The policy number is the last three digits only. All of the policies' dividends are paying premiums with excess dividends buying paid-up-additions. The purchase of paid-up-additions increases death benefits every year. Only policy #034 appears to have no excess dividends because of internal term insurance costs. This is discussed below.

Table 1 - NML Policies

@ Values as of next policy anniversary date

NML is one of the top life insurance companies in the world. They have superior financial strength and claims paying ratings. Also their current pricing is legitimately excellent. I know of no better pricing.

NLPG

Mr. Agent's recommendation features a relatively new life insurance policy concept that is known as no-lapse-premium-guarantee (NLPG). I have sent you a paper I wrote on NLPGs. NLPG's refers to policies that purport to have severely better guarantees than the NML policies' guarantees. Because of this difference in policy guarantees Mr. Agent's letters cast doubt on your continuing to pay no out-of-pocket premiums with the NML policies. He mentions they could resume at $41,000 a year. This is completely fanciful. We would have to experience unprecedented pricing conditions for NML's dividends to fall so much that premiums would have to resume (except for policy #034). If this did occur it is reasonable to speculate that it would also affect American General's financial structure. Mr. Agent praises American General's NLPG policies without a word of caution. This is unfortunate because while NLPGs are an interesting concept it is certainly not a foregone conclusion that replacing your NML policies with NLPG policies is in your best interests.

Since Mr. Agent is basing his recommendation exclusively on the American General policy guarantees lets take a closer look at this issue. All permanent insurance policies have built in guarantees. The basic guarantee is that the insurance company will pay the stated death benefit when the insured dies. For that guarantee to be honored the insurance company must remain financially solvent. Your NML policies have guaranteed premiums, cash values and death benefits that will cause the policy to become paid-up at age 100 without reference to dividends being distributed. The American General guarantees are much better. The very conservatively set guarantees for conventional permanent policies (i.e., NML) have never been breached in the United States (although there may have been some shuffling around at some companies during the 1930s). It is a near certainty that their failure would only occur on a systemic basis, affecting all life insurance companies similarly, due to some cataclysmic mortality and / or economic event(s). In fact, it is more correct to think of conventional guarantees not as a promise made by the insurer that policyholders will never be charged more or credited with less, but as an indication of the worst situation the insurer has prepared for through reserving.

NLPGs have a much smaller margin for error than conventionally set guarantees. NLPG insurers could experience non-systemic solvency strains that only affect some insurers selling NLPGs. If NLPGs are generally underpriced it could cause the pricing for that company's non-NLPG policies to be adversely affected. It is also possible that a company aggressively pricing and selling NLPGs could end up under-reserved and seized by regulators. While I think this is quite unlikely it is a possibility that cannot be ignored.

Static and Market Pricing

The American General policies are static-priced. This is in contrast to the NML policies that are market-priced. NML's non-guaranteed dividends are what make them market-priced. Future policy performance is affected by future dividends that are driven by NML's investment performance and mortality experience. Market-pricing is ideal for permanent life insurance and the only rational way of pricing for insurance companies with a commitment to fair treatment of all policies because the factors that control pricing (mortality and investment yields) are going to change. Adjusting pricing as mortality and investment results are booked allows policies purchased 35 or two years ago to receive essentially the same pricing during the times they are all in force together.

Static-pricing refers to pricing that is certain because it is guaranteed - what-you-buy-is-what-you-get. Static-pricing can only have two aggregate outcomes. In retrospect either static-priced policies will be overpriced or underpriced. While overpricing is not good for policyholders, it is the static-pricing outcome of underpricing that is of great concern because too much of it could cause the financial integrity of the company to be placed in jeopardy.

Although it may not have occurred to Mr. Agent, NLPGs have one potential advantage, two potential disadvantages and one potential disaster. To wit:

1. Static-pricing provides premium certainty for the NLPG option. Future pricing factors (primarily fixed-income yields), in retrospect, may have caused market-priced policies' premiums to be consistently higher than NLPG guaranteed premiums. Advantage NLPG.

2. If fixed-income yields increase market-priced policies may turn out to be a much better value. Advantage market-priced policies.

3. Market-priced policies have much higher cash values that can be withdrawn, borrowed, or available upon surrender. Advantage market-priced policies.

4. NLPG policies can become such a good deal that the company becomes insolvent and is seized. - NLPG disaster.

Comparison of NML and American General

A precise direct comparison can't be made between the NML and American General because Mr. Agent erred in his proposals. He misrepresented the amount of cash values that can be transferred from NML. Full NML cash values aren't earned until the last day of the policy year but Mr. Agent used end of year cash values for the amount transferred to American General. Therefore, they were overstated. In fact, participating whole life policies should only be replaced just after the anniversary date, otherwise you lose values. To do it right you would go through the replacement process five times because there are five different monthly anniversary dates with your NML policies. However, the information available is good enough for you to make decisions.

Because NML policies are market-priced some better perspective is useful. It isn't necessary for the static-priced American General policies because they have no moving parts. While the vast majority of NML's general investment portfolio is fixed income instruments, their DIR is also affected by its equity investments. NML's equity investments are more substantial than most other life insurance companies. This is primarily due to their investment portfolio only supporting participating whole life (consistent premium flow compared with very uneven premium flow for universal life) and NML penalizing policies with loans (dividends are reduced). This gives NML a more dependable cash flow and allows NML to invest longer-term than some other companies. As I understand it NML folds realized capital gains and losses into the dividend-interest-rate (DIR) calculation using a smoothing technique so they don't have too much of an affect on year-to-year DIRs. NML's current 8.2% DIR is higher than any other companies' DIR or crediting rate. This is probably due to this smoothing strategy. That is, NML's DIR was lower or higher in some past years than it could have been. The current 8.2% is very likely higher than this year's investment yields could support sans their smoothing strategy. I do expect NML's DIR to come down in the near-term. Table 2 is NML's DIR since 1981.

Table 2 - History of NML Dividend-Interest-Rate

NML's dividends are also affected by a mortality component. I believe NML has reduced the mortality component of their dividend six times since 1990. For example, even though the DIR was reduced from 8.8% to 8.6% in 2002 dividend values for most policies were actually slightly better because NML's reduction in mortality had a greater impact than the decrease in DIR.

Tables 3, 4 and 5 compare continuing the NML policies with American General replacement policies. Table 3 is based on NML's current DIR of 8.2% for the policies you own. Table 4 is based on a reduced NML DIR of 7.0% for the policies you own. Table 5 is based on NML's current 8.2% DIR for the policies Barb owns. I can't compare the policies Barb owns at a 7.0% DIR because policy #034 requires additional premiums starting in 13 years, so it can't be compared with the American General illustration. (More on this below). I have not assumed reduced current interest crediting for American General because it only affects the cash values and you aren't interested in the cash values if you buy the American General policies. For this reason I am not showing a cash value comparison at 7.0% NML DIR.

Table 3 - NML @ 8.2% vs. American General - Ken-Owned Policies

& Illustrated year NML DBs exceed Am Gen's - 88% probability you will be alive
# Life expectancy - NML illustrated to have 94% more DBs

Table 4 - NML @ 7.0% vs. American General - Ken-Owned Policies

& Illustrated year NML DBs exceed Am Gen's - 78% probability you will be alive
# Life expectancy - NML illustrated to have 39% more DBs

Table 5 - NML @ 8.2% vs. American General - Barb-Owned Policies

& Illustrated year NML DBs exceed Am Gen's - 90% probability you will be alive
# Life expectancy - NML illustrated to have 47% more DBs

Based on the current DIR the NML policies produce more death benefits by ages 79 and 78 when there are 88% and 90% probabilities you will be alive for yours and Barb's owned policies respectively. NML has 94% and 47% more death benefits at your life expectancy (age 91) for your and Barb's owned policies respectively. (The reason for this 94% and 47% difference is due to policy #034 that Barb owns. This is explained below).

Based on a 7.0% NML DIR for the policies you own NML has more illustrated benefits by age 83 when there is a 78% probability you will be alive. And NML has 39% more death benefits at life expectancy. Although I can't show a comparison at 7.0% for the policies Barb owns, except #034, the same relationship would exist as shown for the policies you own.

It is possible that the American General level death benefits will be greater upon your death, even if you live to age 100. Conversely, it is possible that NML's death benefits will be higher. Finally, risks to NML's solvency are systemic and would affect everything in our lives, including American General policies. In contrast, American General could get into financial difficulties because of their NLPG pricing. This of course would be ironic. NLPG policies sold on the rhetoric of rock solid guarantees fail because of these guarantees. NLPGs have a problem because there is only a window of advantage. Life insurance pricing must deteriorate enough to make them a better value than market-priced policies but not enough to cause serious financial strains for NLPG sellers. This would seem to be a threading-the-needle strategy.

A final comment about Mr. Agent's recommendation, in reference to American General policies he states that "It is possible, however, that the insurance benefit can increase depending on interest rates and longevity," this is extremely doubtful.

Life Insurance as Wealth-Transfer Investment

Your estate is on the cusp of needing liquidity and having a wealth-transfer opportunity. Wealth-transfer refers to moderating the maximum increase in your estate value by making annual exclusion gifts and using your estate and gift tax credits. I realize that financial markets have been making something of a mockery out of worrying about the future maximum increase in your estate value. But, unless we have reached the end of human financial history, I suspect that asset values will increase in the years ahead. The first priority is for you and Barb to have the income and asset security you want. With an estate of some $20,000,000 you may have the opportunity to reorder your strategy a bit so that you don't build asset values more than is needed for your own needs and security because every dollar of additional value will be cut in half by the estate tax.

With this in mind Mr. Agent has recommended, as do I, that you transfer your life insurance to an irrevocable trust. You mentioned to me that Mr. Agent told you that the American General policies would have a much lower transfer value than the NML policies. His letters don't mention this and the American General illustrations do not support this thesis. It appears that the American General accumulation values in the first year are less than NML, but only by around $50,000. If either American General or NML policies are transferred to an irrevocable trust the gift value is around a $1,100,000. Your credits and annual exclusion gifts should cover this amount and you would not have a gift tax to pay. In addition to using your estate tax credit to transfer your life insurance outside your estate that will be effective after three years I recommend that you also consider starting to make annual exclusion gifts to this trust. You have two children and two grandchildren. Between you and Barb you can make annual exclusion gifts of $88,000. Remember, that for every dollar of annual exclusion gifts you make and whatever they can earn saves you heirs 50 cents on the dollar.

Gifts other than cash can be made, but non-cash gifts have two potential problems. First, tangible assets, such as real estate, lose their step-up in basis if you gift them. If you keep tangible assets they do receive a step-up in basis upon death. Also, tangible assets can go down in value which defeats the purpose of making the gifts. Therefore, cash is the preferred asset to gift. But cash needs to be invested. And here is where your NML policies may be seen in a different light. Nine of your 11 NML policies can accept current premiums totaling $29,016 and are illustrated to increase in value at a much higher rate than if no out-of-pocket premiums are paid. Policy #838 is paid-up and cannot receive any more premiums. The $1,000,000 policy (#034) is blended with term insurance so the death benefits with $15,467 premiums are illustrated to go up in 10 years, not immediately. The question is whether investing some or all of possible annual exclusion gifts in life insurance policies is a good idea.

Investing can be placed into two broad categories. The first investment category taxes earnings as ordinary income as they are earned each year (or whose earnings are much lower because they are issued by certain government entities and are income tax-free). The other investment category has returns that are mostly not taxed until they are sold. The first category is generally associated with bonds, mortgages and preferred stocks. The second category is generally associated with stocks and real estate. The taxes on the increased value of stocks and real estate are generally capital gains that are taxed at lower rates than ordinary income.

Life insurance has significant income and capital gain tax advantages because the cash value build-up is tax-deferred and the pay out of the death benefits is entirely income and capital gain tax-free.

Fixed-income investments will always do much better within participating whole life (NML policies) than outside in conventional fixed-income vehicles such as bond mutual funds or certificate-of-deposits because there are no income taxes associated with life insurance proceeds whereas bond and CD yields are taxed as they are earned.

It is more complicated when comparing life insurance with conventional investing when equities are used because investing and taxation issues are more complex. Whether VL is a better alternative to conventional investing depends on three things. First, the actual amount of investment results. Higher actual investment returns favor VL although the amount of actual results can't be known in advance. Second, the stock investment strategy used. A buy-and-hold strategy reduces VL's advantage. On the other hand, active trading and / or market timing substantially favors VL. Third, the younger the insured the less advantage for VL. Prior analysis for unrelated cases suggests that VL works better when insureds are in their 50s, 60s and 70s. But when insureds are in their teens a buy-and-hold stock strategy using conventional investing appears to be better.

Therefore, if you do wish to begin making annual exclusion gifts of up to $88,000 a year, and these gifts are cash, you should consider investing whatever portion you want in fixed-income instruments as premiums to NML. If you want to invest in equities you can use conventional stock investing or use variable life. If you use variable life it should probably be in second-to-die.

I obtained several NML illustrations from Kevin NML Agent that assume premium payments resume. Table 6 shows the investment yields for the NML death benefits with and without premiums at 8.2% and 7.0% DIRs. These investment yields are completely free from income taxes and should be compared with municipal bond yields.

Table 6 - NML Death Benefit Yields @ 8.2% and 7.0% DIRs

The reason you may wish to resume premiums is because the after-tax yields for death benefits is stronger than other equally safe investments you can make. In a 40% marginal tax bracket at your life expectancy the equivalent pre-tax yields with premiums being paid are 11.5% and 9.5% at 8.2% and 7.0% DIRs respectively. Certainly, using life insurance for wealth-transfer is worthy of your consideration.

Using premiums as investments can also be done with the American General NLPG policies, which would increase the level death benefits. The same relationship to NML shown in Tables 3, 4 and 5 would continue but with larger benefits. That is, NML would have the advantage with probabilities of 78% to 90% based on DIRs of 8.2% and 7.0%.

As noted if you want to make equity investments and believe the criteria that give variable life advantages over conventional equity investing I can help you with this. (Accompanying this report is my July 2000 AAII Journal column).

NML Policy #034

This policy is a blend of term and base whole life. This is an excellent structure as it reduces the selling expenses. But blending can also skinny-down the premiums as well. I believe you have paid an annual premium of $15,467, but are letting the dividends pay this premium. Because the dividend is mostly paying the internal term costs the $1,000,000 death benefits, without the payment of annual premiums, aren't illustrated to start increasing for 24 years. This policy is also vulnerable to declining DIRs. At 7.0% DIR out-of-pocket premium payments must commence in 13 years and at the premiums shown the death benefits decline from $1,000,000 to $573,280 at age 100. (#034 illustration at a 7.0% DIR accompanies this report). This isn't a criticism directed at NML, but an observation that because you stopped paying premiums this policy is in danger of being underfunded. You have three options regarding this policy:

1. Replace it with an American General policy. Since the anniversary date is April, replacing it now is good timing. I calculate that amount that could be transferred is around $266,000, which I calculate would produce a $893,520 guaranteed level death benefit with American General. This is less than the current $1,000,000 NML death benefit.

2. Continue the NML policy with no out-of-pocket premiums with the understanding that it is possible out-of-pocket premiums would have to resume if NML's DIR declines enough to require premiums. And depending on the amount of premiums paid the death benefits could decline as the accompanying illustration shows.

3. Continue policy #034 but, not only resume the $15,467 premiums, increase the premiums so that the death benefits begin rising immediately. I believe NML refers to this as buying "outside APs." This would be the preferable strategy if you believe wealth-transfer is a good idea.

Please review and call to arrange for a conference call to discuss.

Very truly yours,

Peter Katt, CFP, LIC

Enclosures