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Guaranteed Universal Life: The Wolf in Sheep’s Clothing?

One of the largest benefactors of the “flight to safety” after the crash of 2008 was the guaranteed universal life insurance policy.

Although it was introduced in the 1990s as an alternative to expensive whole life and risky variable life, the product didn’t truly catch on until the 2000s, when interest rates began falling and people sought the certainty of the inherent underlying guarantee. The financial crisis added fuel to the fire, and, according to a LIMRA study, guaranteed death benefit universal life (GDBUL) made up more than 53 percent of all universal life sales in the United States. 

Many insurance companies experienced a boom of single premiums and 1035 exchanges as clients and advisors exchanged old, underperforming cash value policies and leveraged the money into a guaranteed UL policy that provided multiples of the original death benefit as well as a guaranteed interest rate.

Even if there was no money to fund a guaranteed policy upfront, many people came to view guaranteed UL as akin to “lifetime term” that could be purchased at a fraction of the cost of a traditional whole life or universal life policy.

At the beginning of the GDBUL sales surge, although the guaranteed interest rates were lower than assumed crediting rate on insurance companies’ general portfolios, they were still in the range of 4-5 percent and the assumed illustrated rates were running at 6-7 percent. This meant that early adopters of GDBUL policies benefited from a relatively high guaranteed interest rate.  However, as the Federal Reserve continued to reduce interest rates after 2005, the crediting rate on GDBUL dropped as well.

Finally, the Fed essentially reduced its interest rate to zero at the end of 2008. As is typically the case, insurance company crediting rates lagged the decrease in the Fed rate. However, the fact that rates have remained at zero since 2009 has led many carriers to decrease rates all the way to the current 2 percent level.

The low interest rate environment has affected not only guaranteed crediting rates. Many carriers are matching their current crediting rate to the guaranteed rate on their policies, the only difference being the maximum insurance charges. A couple of carriers have even gone so far as to completely eliminate a current crediting rate from their illustrations, and they now show only guarantees.

Conceptually, it would seem that the guaranteed policy would leave the client in a safe position. As long as clients pay the premium on time, they can rest assured that their policy will remain in force and that their beneficiaries will receive the death benefit. This added security is enhanced by the fact that many clients who purchased variable policies and non-guaranteed UL or whole life policies with a term blend had to increase their premiums (sometimes significantly) to keep their policies in force. The “set it and forget it” nature of GDBUL has mass appeal to both clients and advisors in such an uncertain environment.

Unfortunately, the perception of safety that the GDBUL provides, in all but a very select number of cases, is actually putting the client in a very precarious position.

The main culprit of the unforeseen risk is exactly why GDBUL originally attracted such mass appeal, and that is interest rate volatility. Clients need to be fully informed of these risks so they can make a sound decision regarding which type of product to select.

There are four main scenarios where GDBUL could end up negatively affecting clients.

1) Late Premium Payments

Although GDBUL policies are still considered to be “flexible premium” policies, the timing of premium payments can have a significant impact on the guarantees in the policy. Technically speaking, clients can vary their premium payments, and as long as there is enough cash value in the policy, it will remain in force. However, because the guarantee in the policy is typically a “secondary” guarantee, the insurance carrier can lapse the guarantee if the minimum premium is not paid on time, regardless of the cash value.

Because of this lack of flexibility, after a typical grace period of 30 days, if the minimum guarantee premium is not paid, the guarantee can lapse and the client must pay a “catch-up” premium to restore the guarantee. This can be especially important for older clients who may have trouble remembering to pay the premium on time – and this could jeopardize their guarantee at the time when it’s needed most.

Another area where this could have a significant impact is in trust-held policies where gifts to the trust may not be made in time to pay the premium. For trustees with a fiduciary responsibility, the lapse of the guarantee could expose them to liability in the future.

2) Tiered Premium Designs

One popular design for GDBUL policies was to tier the premiums. Many advisors used this design so they could save their clients money on premium payments. Rather than paying a level premium for a lifetime guarantee, the idea was to pay a premium to guarantee the policy for a certain number of years (e.g., to life expectancy) and then, if the client was still alive at that point, they would pay a catch-up premium for the premiums they had not paid over the years.

Unfortunately, it’s largely unknown that the catch-up premiums sometimes were based on non-guaranteed assumptions. Therefore, the premium needed to guarantee the policy may be significantly higher once the end of the guaranteed period was reached.

Additionally, even if the catch-up premium was guaranteed, at the time the catch-up premium is due (typically 20 or more years from the date of issue), there is no notification given from the insurance company in a majority of cases. This can result in a lapse of the guarantee, and the whole policy will often lapse.

3) Lagging Crediting Rates

Similar to the way that crediting rates from the insurance companies lagged the decrease in market interest rates, the recovery in crediting rates also will lag the market rates. This means that it will take years of rising interest rates before those higher rates are passed on to the clients who purchased GDBUL policies. This is especially important for polices that were sold with a large spread between the guaranteed rate and the assumed crediting rate. The closer a policy gets to the guaranteed rate in a GDBUL policy, the less likely it is that there will be cash value in the account. Again, it’s very important to recognize this point because obviously  the less cash value there is in a policy, the more likely it is that a client will lose coverage if premiums are not paid on time.

4) Internal Charges

One of the largest factors affecting the performance of an insurance policy over the long term is the internal charges within the policy. As the policy ages and the clients get older, the insurance charges within the policy typically increase.

Although GDBUL policies do have guaranteed maximum charges that the company can levy, those are typically much higher than the charges being shown at the time the policy is sold. If maintaining the policy becomes prohibitively expensive assuming current insurance charges, then the company can increase those charges.

There are two ways in which policies can become too expensive for the insurance company to maintain. The first way is if the company experiences higher-than-expected mortality. The second way is if the company experiences lower than expected returns on its general account. With insurance companies experiencing very poor performance due to the low-interest-rate environment, it becomes more likely that they may begin to raise the in-policy charges. This is another situation in which the cash value account performance can be dragged down, making the policy more likely to lapse due to missed premiums.

As the saying goes, perception is often not the reality. In the case of no-lapse guarantee universal life, this is true in many instances. Because so many advisors and clients experienced decreasing crediting rates on their permanent life insurance policies throughout the last couple of decades, GDBUL came to be perceived as a “safe” alternative.

However, given the fact that interest rates are at historically low levels, it is likely that we will see increasing rates in the long term. Since permanent life insurance is typically intended to be a product purchased with a time horizon many years into the future, it makes sense to make decisions based on long-term projections. Essentially with GDBUL, clients are locking in these historically low interest rates and paying a comparatively high premium to do so.

Although there are some situations in which GDBUL may be the best alternative for a client, other options should be explored so that a client is fully informed. Purchasing a product that is priced using current interest rates projected over the next 20 to 30 years is certainly a risky proposition and one that many are ignoring in return for the comfort of a guarantee. The lack of flexibility and the low interest rates in GDBUL policies could put clients and advisors back in the tenuous situation that drove them toward the policy in the first place.

 

Josh O'Gara, CLU, ChFC, CFP, is a brokerage manager at First American Insurance Underwriters, Needham, Mass. Josh may be contacted at [email protected] [email protected].


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