What’s Behind the Increase in Cost of Insurance Charges?

Some life insurance carriers have begun to announce increases in the cost of insurance (COI) on certain closed blocks of outstanding universal life (UL) products. “COI” refers to payments of claims and is the largest single cost incurred by life carriers. COI charges can account for 75 percent to 85 percent of the total premium. An increase in COI charges will have an immediate economic impact on non-guaranteed policies, forcing policyholders to make some hard economic decisions.  

As an advisor, what steps should you take to proactively represent an irrevocable life insurance trust (ILIT) trustee, who must look out for the best interests of the trust beneficiaries? Do you have clients or ILIT trustees who don’t know the COI charges on policies they’re responsible for? Would you know if the cost of a client’s or trustee’s policies have been increased?

Guaranteed vs. Non-Guaranteed

Guaranteed policy elements within a life insurance policy are those that the carrier can’t unilaterally change. For UL-type products, guaranteed policy elements include: the maximum loading and COI charges; the minimum guaranteed interest crediting rate (sometimes collectively referred to as the “guaranteed assumptions”); and the policy face amount. For traditional whole life (WL) and term policies, guaranteed pricing elements include: the policy face amount; cash values (on WL); and premiums. 

Non-guaranteed policy elements within a life insurance policy are those that the insurer can change unilaterally. For UL-type policies, non-guaranteed policy elements include: the excess of the actual interest credited to the policy over its guaranteed minimum crediting rate (MCR); and the difference between the actual loading and COI charges assessed to the policy cash value and the guaranteed maximum COI charges. Current assumptions are the actual loads, COI charges and credits being applied to the policy, but they’re subject to change based on evolving carrier experience. For WL-type policies and term policies, non-guaranteed policy elements include dividends. A carrier can’t unilaterally increase premiums or lower guaranteed cash values for inforce WL policies, although it can lower or even eliminate the dividend payments on participating (par) policies (that is, the policyholder has a contractual right to share in the favorable or unfavorable operating experience of the carrier). 

Insufficient Interest Rate Spread

In a UL policy, the premiums contributed become part of the cash value, and the cash value grows tax-deferred based on the carrier’s investment return. In a current assumption UL policy, the cash value is invested primarily in fixed income investments (general account of the insurer). The crediting rate movements of carrier UL portfolios have historically tracked closely to movements in the 5-year rolling average of the Moody’s AAA Corporate Bond Yield (Moody’s). The current Moody’s benchmark is about 4 percent. Crediting rates on UL policies have dropped over the years and have now been at or near historical lows for an extended period, leaving carriers without sufficient interest rate spread on certain blocks of older business. In a UL policy, each month the carrier deducts various charges from the policy cash value. The largest component of these monthly charges is typically the COI, which increases each year as the insured ages. All insurance policies are assessed mortality charges to pay for the pure insurance or death benefit coverage for that year. The recently announced increases in COI rates by some carriers are on top of the natural annual COI increases that occur steadily as the insured ages. 

Once a policy is issued, the life insurance companies have two ways to make money: COI charges and interest rate spread (the difference between what the life insurance companies earn and what they credit to the policy). As noted, a current assumption UL policy has a current crediting rate and a guaranteed MCR, below which the current crediting rate can’t fall. For those current assumption UL policies issued between 1980 and 2005, it’s estimated that roughly 60 percent have dropped to the guaranteed MCR. For those policies issued between 1980 and 1995, roughly 78 percent have dropped to the guaranteed MCR. For UL policies issued between 1980 and 1995, the average guaranteed crediting rate is roughly 4.3 percent, so there’s virtually no spread available on these blocks of business, as the carrier can’t lower the crediting rate below the guaranteed MCR. In prior periods of higher interest rates, a 150 basis points spread between the portfolio income generated by the carrier and the actual crediting rate on a policy could be realized. On older blocks of business, which have a guaranteed MCR of 4 percent or higher, a carrier can’t generate profit because there’s insufficient interest rate spread. If the carriers can’t make money on the interest rate spread, their only alternative is to increase the COI on these profit-starved policies.

Notices to Policyholders

To date, a handful of carriers have sent notices to policyholders indicating their plans to increase the COI on closed blocks of outstanding UL policies. Years ago, it would have been unheard of for a carrier to increase the COI on a policy, as it was viewed as a sign of serious financial vulnerability. To see increased COIs on a variety of products across multiple carriers in such a short time frame is remarkable. Today, even highly rated financially healthy carriers view targeted COI increases as a short-term business decision to generate new revenue from older, currently unprofitable closed blocks of business. 

Considerations When Resetting Rates

Carriers have relied on different language in their policies for determining which factors they may or must consider when reviewing and resetting COI rates. In a single consideration policy, any change in COI must be based on the carrier’s “expectation as to future mortality experience.” In a multiple consideration policy, the carrier’s review and redetermination may be based on a number of considerations, which typically include “expectation as to future mortality, lapse (persistency) expense and/or investment income expense.” The multiple consideration policy often lists these considerations as being non-exclusive, which increases the scope of the carrier’s discretion. In a silent consideration policy, the factors that the carrier may or must consider aren’t listed, reciting that the carrier generally has discretion to reset the COI without identifying the factors or considerations.

Reasons for Increased COI Costs

There are a variety of reasons why the life insurance carriers have begun to increase COIs on UL and WL policies:

• The persistent low interest rates the carriers currently earn on their general account investments provide them with a strong motivation to decrease crediting rates on inforce UL policies and dividend rates on WL policies. New money bond yields have been decreasing since the early 1980s. Consequently, portfolio earnings have faced downward pressure for some time, resulting in decreased crediting/dividend

interest rates passed through to policyholders. Because it takes time for investments to mature, there’s a time lag between the change in new money rates and the resulting change to portfolio earnings. If new money rates increase, then eventually portfolio earnings will rise, which will lead to higher crediting/dividend interest rates. For policies now operating at their guaranteed MCR, the interest rate spread has never performed as originally priced and illustrated. Five-to-20-year-old UL policies have higher guaranteed MCRs than the depressed guaranteed MCRs now offered on new policies. To date, these older UL policies with high guaranteed MCRs, especially higher face amounts (over $1 million) on older insureds (over age 70), have been the focus for the carriers that have raised COI rates.

• Substandard mortality experience on specific blocks of closed business may also account for why some carriers are increasing COIs. The primary driver of worse than expected mortality experience was overly aggressive underwriting assumptions on issuance of these UL policies. Competition five to 10 years ago was intense, and carriers aggressively competed for UL business. Many of the closed blocks of UL business rely heavily on reinsurance to backstop their guarantees. When performance is poor and more claims are paid out earlier than expected, reinsurers increase their rates charged to life insurance companies. Moreover, in the past, carriers have managed mortality charges on new policies to keep them competitive. Experience has shown that most carriers haven’t passed on better mortality experience to inforce policies, instead retaining the excess mortality margins for themselves. Other carriers, typically mutual companies, have a track record and a stated intent to pass on favorable gains to policyholders of inforce policies. Because it’s difficult for a policyholder or advisor to predict which carriers will pass on favorable mortality experience in the future, many policyholders or advisors select guaranteed policies that insulate the policyholder from making such carrier selection.

• UL policies have traditionally been sold as flexible premium policies permitting the policyholder to initially pay term-like costs and deferring significant premiums until and after life expectancy. These policies were sold by optimizing the internal rate of return (IRR) on premium outlay to death benefit, locking in permanent coverage at reduced initial cost and providing the policyholder with an option to pay higher premiums for continued coverage later in life. If structured as no-lapse guarantee (NLG), the policyholder—but not the carrier—holds an option to change premiums in the future to retain coverage. Minimal early year funding, combined with compressed interest rate spread, puts pressure on the carriers to properly price and assess mortality risk at issuance of these policies. Slight underperformance could result in too many claims and an unprofitable block of business.

• Some industry commentators privately speculate that excessive policy persistency, or too few policy lapses, has contributed to the COI increase. Clearly, policy persistency or unexpected lower than anticipated policy lapses, due perhaps to the emerging life settlement market in which policies of unhealthy insureds are purchased by third parties and held to maturity, may contribute in some small way to the COI increases.

• A few carriers acquired certain blocks of closed business from other carriers. Discrepancies between the acquiring carrier’s current assumptions and the issuing carrier’s original assumptions may suggest a COI increase. 

• Some speculate that current and future changes to European accounting standards for insurance have prompted their U.S. subsidiaries to increase COIs.

NLG UL Policies

Many of the UL policies affected by the COI increase were sold as NLG policies. So long as the policyholder continues to pay the premiums on time to maintain the carrier guarantees (payment of death benefit, no change in premiums for life or an extended duration), the policy will remain in force. Guaranteed premiums can’t be higher, nor death benefit lower, than originally illustrated at issuance if the guaranteed premiums are paid on time. Cash value performance can be worse than illustrated. Most importantly, individuals purchase NLG policies for the death benefit protection and relatively low but flexible premiums, not for cash value

accumulation. The COI will be charged against the cash value with the result that increased COI charges will accelerate the decline in the cash value of NLG policies. Remember, however, that the cash value in an NLG policy can be reduced to zero, but the policy and its guaranteed death benefit amount will remain in force so long as premiums are paid on time. 

Carriers that issued NLG policies have few available options on outstanding blocks of closed business. While they can reduce the crediting rate to the contractual minimum or raise COI charges perhaps up to the contractual maximum on an NLG policy, the policyholder has no immediate out-of-pocket risk, and the death benefit remains unchanged. Of course, the policyholder—especially a trustee of an ILIT—must continue to monitor the long-term claims-paying capacity of the carrier to ensure the future financial viability of the carrier. The carrier may be able to justify raising COI charges on other non-guaranteed blocks of policies, but this comes at an out-of-pocket cost increase or reduction in coverage for such policyholders. Healthy insureds are likely to look to alternative, less expensive carriers. Diversification among a number of highly rated carriers is essential to mitigate long-term risk exposure to the insured and beneficiaries of the death benefit promises of the NLG carriers. Some suggest that the carriers can more easily raise COIs on NLG products because there’s no out-of-pocket or economic impact to the policyholder, just acceleration of the cash value reduction.

Future Increases Likely

Will we see more life insurance companies increase their COIs on UL policies in the coming months? In all likelihood, the answer is yes. All of the carriers that have raised COI rates to date have been public companies, some of them owned by foreign holding companies. These public companies measure profitability by the quarter, and foreign holding companies may have to mark-to-market their life insurance assets. Mutual companies and privately held insurance companies may be able to withstand the need to increase COI revenue to generate near-term profits. 

In a private survey conducted by Harris Poll in May 2014 among policyholders who purchased life insurance policies, the level of policy ignorance was remarkable:

• 29 percent said they haven’t reviewed their policy since purchased;

• 60 percent think the policy terms are “set in stone”;

• 60 percent believe their policy benefits are guaranteed forever; and

• 47 percent say their insurance agent had never encouraged them to review the performance of their policy.¹ 

While a significant amount of life insurance is owned by trusts, the level of inattention by trustees is even more stunning. As of 2014, roughly 90 percent of trust-owned life insurance policies are managed by private trustees (family and friends), of which 70 percent had not been reviewed since 2008. Of the 10 percent of trust-owned life insurance managed by professional trustees, 83 percent of these professionals admit to not meeting the Uniform Prudent Investor Act guidelines.² To reassure clients and ILIT trustees that they made the appropriate choice in life insurance products and share with them when there are opportunities for improvement in coverage, it’s vital to understand what a client or ILIT expects and doesn’t expect from a life insurance portfolio.

Available Options

What are the options available to a policyholder?

1. Purchase a more competitive policy, if possible. If the policy is a non-guaranteed UL policy and the insured is in good health, consider purchasing a new NLG policy. Test different premium payment and guarantee options. To what extent will the existing cash value subsidize a new policy purchased in an Internal Revenue Code Section 1035 tax-free exchange? If no new premiums are paid into the new policy for an extended period of years, can the coverage be guaranteed? Perhaps there can be an initial premium holiday (no premiums due), after which premiums resume. It may also be possible to structure optimized step premium increases that defer significant premium payments until after life expectancy. Purchasing a diversified portfolio of NLG policies issued by top-rated carriers protects against future COI increases, while providing the best strategy for ensuring that all policy death benefits will be paid as promised. 

2. Pay the higher suggested premiums and keep the same death benefit amount, or lower the death benefit to an amount that will allow the policy to run to maturity with no further premiums. Paying higher annual premiums on a non-guaranteed policy or on an unhealthy insured may be the least desirable option available to keep coverage in force. Lowering the death benefit by perhaps 25 percent may sustain the reduced policy death benefit through age 100 without further premiums. However, if the policy matures during the insured’s lifetime, there will be minimal value paid out. Either way, there’s potential risk that the carrier may come back in the future and again raise COI charges.

3. Surrender the policy for existing cash value. If the existing policy is cash accumulation-oriented UL or WL, there will be tax due on any gain equal to the difference between the accumulation (cash) value and the premiums paid. This amount is taxed as ordinary income, which could exceed 40 percent for federal income tax purposes, excluding state income taxes. The balance will be available for the policyholder to reinvest. If the existing policy is NLG with little, if any, net cash value available, the owner can’t claim a tax loss deduction for premiums paid in excess of the cash value.

4. Sell the policy in the secondary life settlement market. If the insured is unhealthy with a substandard life expectancy, it may be appropriate to explore a sale of the policy in the secondary life settlement market. An insured with a normal life expectancy may be unable to sell a policy in this market.

5. Keep the death benefit the same, pay no premiums for a period of years and resume significantly higher premiums after life expectancy. This option is a bet that the insured won’t live to life expectancy. If the insured lives beyond life expectancy, the annual cost of coverage will quickly become very expensive, which requires timely planning.

6. Convert the policy to a paid-up reduced death benefit policy with no further premiums. If the existing policy is a non-guaranteed UL policy, lowering the death benefit by 30 percent or more may allow the policy to be placed on a reduced death benefit, paid-up status. The advantage of converting the policy to a paid-up policy is that if the policy matures, full value will be paid.     

Endnotes

1. See Gary DeVicci, “Life Insurance Policy Audits: Dispute Defensible Best Practices,” Section on Inattention by Policy Owners, adapted from the Life Insurance Policy Audit series that originally appeared in QuickRead (www.QuickReadBuzz.com). Gary DeVicci heads the planning team at CPI Companies with responsibility for the suitability elements of their PolicyAudits.com services. 

2. Elder and Special Needs Law Journal, Winter 2014, Vol. 24, No. 1.