The prolonged market slump is creating a situation where, if policyholders do not contribute more money, their universal life insurance policies could lapse. Because of their low fund values, minimum funded contracts would be the first to go.
The investment portion of most non-guaranteed universal life (UL) policies must be maintained above a certain amount to stay in-force. (Some companies guarantee their policies will not lapse, despite low fund values, for the first five years.) This situation for policy lapse occurs when weak markets deteriorate the investment portion of the policy below the minimum amount required by the insurance companies.
Minimum funded contracts that employ a yearly renewable term (YRT) cost of insurance (COI) and have investment portions that are linked directly to the volatile markets have the highest risk of lapsing.
A minimum funded UL is when the client pays the lowest premium amount. This amount, calculated by the insurer, is based on the estimated amount that will be necessary to cover the COI and maintain a sufficient fund value throughout the life of the contract.
“You should never put your money into an index if you’re minimum funded,” exclaimed Ted Sliz, Product Manager at Peak Investment Services, a national full-service managing general agency (MGA).
“Assume for a moment that you are already in retirement. For the last 24 months, almost 36, the market has been level or negative. If you had a YRT – and the whole assumption of the YRT is that your investments will have performed sufficiently to be able to absorb the increased mortality charges – the investments are going south while the mortality charges are going north!”
The problem at retirement, Mr. Sliz pointed out, is that these clients are not working and will lose their coverage if they are not able to produce the necessary funds to keep the policy onside.
Policies with a level COI, on a term-to-100 for example, are also at risk but much less so. The big danger here is if the premium is paid annually in addition to being minimum funded. “Anyone that is minimum funding at T-100 absolutely has to pay monthly,” stated Jim Britton, Managing Director, Insurance and Estate Planning at IPC Insurance Strategies, another national full-serve MGA.
Each month the mortality charges are taken out of the fund portion, he explained. If the markets are going down then the fund could be depleted before the end of the year and the policy could lapse unless more money is put in. “If they pay it annually, it had better be in 100% guaranteed investments. Absolutely nothing market related… and yet you see brokers selling it all the time!”
Mr. Sliz said it is because of that risk that his company deposits the annual premiums into a term deposit on behalf of the client and then pays the contract monthly.
If the risk of policy lapse is so high, why minimum fund the policy in the first place? Joe Kordovi, Assistant Vice-President at Transamerica, explained that minimum funded YRT can be inexpensive and a great way to guarantee insurability. “You are young and healthy but you cannot afford much insurance now, so by buying a YRT policy, you lock in the fact that you are insurable.”
“Someone may buy a minimum funded policy intending to start funding it in two to five years,” furthered Klause Zabel, President of Marketing Concepts Group and of the Canadian Association of Independent Life Brokerage Agencies. “It happens all the time,” he said, but added that brokers selling minimum funded UL intending to keep it as such occurs much less frequently now than in the past.
Intent is one thing, but reality is another, contends Gerry Anthony, Senior Consultant, Life Insurance products, Education and Sales Department at Standard Life. He said that very often the intended additional funding is just a pipe dream because the money the clients planned to have never materialized.
Mr. Britton also pointed out that if the money is not in the policy by the seventh year, then because of tax regulations it is not possible to deposit large amounts.
“This is defined in Regulation 306 of the Income Tax Act,” explained Mr. Britton. The regulation roughly states that the cash surrender value in year ten after you have made your deposit cannot exceed 250% of the cash surrender value of year seven. “You can never do dump-ins. Therefore, if you have got a minimum funded contract with virtually no money in it in year seven, you’ve got a minimum funded T-100 policy. And if it is YRT, you’re screwed!”
Insurers not concerned
Insurers are well aware of the risks of lapsing policies, but do not see this as a cause for concern.
Mr. Kordovi explained that, “For some clients it will be a concern because they may have been more aggressive with their investments than others, so their fund value may have dropped more. And some contracts will lapse faster than others depending on how the contract is worded (if it is based on fund value or cash surrender value).”
According to insurers, though, there are several solutions to avoid policy lapses. “Our contracts allow clients to switch from YRT to level COI and a lot of our competitors do the same,” explained Mr. Kordovi. “That is where a client can lock in a level COI rate and not get burned by future YRT rates. They can also turn on the Optimizer (reducing death benefit option) if they don’t need it to shelter the funds that they have in there.”
“I cannot imagine as a rule that anybody is going to get surprised by this, including the policyholders,” added Mr. Zabel. “People are now more aware. In the past, the surprises came from illustrations that were at 18% and when that did not happen, they were surprised that they had to put in more premiums. If the product is sold properly, it should not lapse at all.”
Brian Taylor, Vice-President, Retail Pricing and Design at Maritime Life, affirmed that his company is a latecomer into the YRT market and so have fewer concerns regarding this issue. He did not have minimum funded figures on hand.
Mr. Anthony of Standard Life stated that in the fall his company is going to educate its brokers how they can provide more guarantees in the UL contract. Brokers need “to make sure the client has a proper mix of investments … so that the people who are minimum funding their contract will not have a fear of the contract lapsing because of poor performance.”
The company will also be launching new illustration tools to allow brokers to demonstrate what happens in a variable rate environment when the market fluctuates. “I think more than anything else it is an education process,” added Mr. Anthony.