Be a savvy insurance shopper.
But Mark has just discovered he has a problem, a problem you may share even if your personal net worth is $500,000, not $50 million. He has just learned that his universal-life policies are designed to run out of cash by his 86th birthday. So, if he lives that long and wants to keep his policies in force, he will have to pay astronomical premiums. If he won't--or can't--pay those premiums, the policies will lapse, his children's inheritance will diminish, and his $400,00 premiums will have produced no lasting benefit. But if he cancels and replaces the insurance policies now, he'll face stiff surrender charges and, as insurance companies scramble to make up in premiums what they once got in investment earnings, even higher premiums.
How could this happen? Mark thought he was following a well-designed, conservative strategy. He had no idea that he was betting he would die before the policies self-destructed. His advisors did not advise him well.
Unfortunately, Mark is like many successful executives and entrepreneurs: concerned enough about financial planning to buy a major insurance program, but not knowledgeable enough to make certain that what they are buying meets their needs and risk tolerance.
Mark's story illustrates some of the pitfalls of financial planning with life insurance. Used correctly, life insurance can provide a sturdy and stable financial structure; but when it is not used correctly, it can do considerable damage.
We'd like to offer some tips on how to shop for insurance so you don't find yourself in a position in which, like Mark, what you bought is not what you think you bought.
KNOW YOUR GOALS
Obviously, the principal purpose of life insurance is to replace the economic contribution of an individual who dies prematurely. But, thanks to its highly favorable tax treatment, it also has important uses for financial and estate planning. Unless you have been guilty of extremely poor planning, your beneficiaries can receive a death benefit free of income tax. And the cash value of an insurance policy grows tax-deferred and usually can be tapped through policy loans without any tax consequence--unless the policy is classified as a modified endowment contract. More on that later.
THE COMPANY IS KEY
When you buy insurance, you're buying a set of promises. But even some pretty sophisticated buyers overlook the fact that those promises are only as good as the company making them.
Obviously an insurer's ability to pay claims when they are due is an essential part of the story, one that we've been learning a great deal about lately. But what we haven't heard so much about, and may tend to overlook, is the company's efficiency--its ability to deliver coverage at low cost through good underwriting, investments, and expense controls. Some very secure companies are not as efficient as others because they have more liberal underwriting standards, less profitable investment experience, or higher expenses.
There is no crystal ball to tell you how secure or how efficient a company will be in the future. But there are many sources to help you discover how secure they are now as well as how efficient they have been.
For security, as a rule of thumb, you might seek out companies that are in the top two categories from at least two of the major rating agencies and that are not lower than the third-highest category from any of them. For efficiency, check Best's Review, which publishes an annual study of the economic efficiency of various insurance companies over 10-and 20-year periods.
TERM VS. WHOLE LIFE VS. UNIVERSAL POLICIES
Even though term insurance carries premiums that are much lower initially than premiums for insurance products that accumulate cash values, is term really cheaper than whole-life insurance? In one sense, yes, because term produces smaller sales commissions and, since few people actually die while it is in force, term involves lower mortality costs. But, while whole-life products have higher initial premiums, they generate tax-favored cash values--and they are designed to be held until death.
The choice of which type of insurance to buy depends primarily on for how long a period you need coverage. If you need coverage for 10 years or less, you're probably better off with term insurance, because the cost of a whole-life policy outweighs the benefits of its tax-advantaged cash value over such a brief period. On the other hand, if you need protection for more than about 14 years, some type of whole-life insurance is usually the better choice.
Your best choice for coverage between 10 and 14 years really is determined by your need rather than by issues of up-front cost. Do you have a growing family, for example, or parents who are becoming increasingly dependent? If so, you'd be well advised to spring for a whole-life policy. But, if your needs won't increase, term insurance coverage between 10 and 14 years should do just fine.
And then there's universal life --Mark's choice--which borrows characteristics from both term and whole-life products. Universal life is essentially a term policy that allows the owner to pay extra premiums into a side fund invested typically in a short-to-intermediate term fixed-income portfolio. Universal's appeal is its flexibility: Within limits, it allows the insured to pay more or less in annual premiums, and, in fact, to skip premiums entirely when there is enough cash in the side fund.
If the insured dies before a universal policy's side fund runs out or if the owner is willing and able to pay big term premiums after the side fund runs out, the universal policy will pay a death benefit. If not, as Mark belatedly discovered, it will slip quietly into oblivion. How quickly the side fund runs out depends, of course, on the size of the premiums paid in the early years of the policy, the rate of return on the side fund, and the insurer's actual mortality, expense, and commission charges. Mark unknowingly faced two kinds of risks when he bought his universal policies: An actuarial risk that he would outlive the side fund even if interest rates met the policies' projections, and the investment risk that the side fund would expire even earlier if interest rates did not meet projections.
Mark's choices today are to accept the risk that his policies may self-destruct, to start right away to pay higher annual premiums and thus reduce the actuarial risk, or to try to exchange his universal contracts for some type of whole-life insurance. Exchanging his policies would be, in a word, troublesome. He would probably have to pay a stiff penalty (because his policies are new, around 10 percent of cash value) and either pay higher premiums or accept lower death benefits for the first several years of the new policy.
Most whole-life policy proposals these days contain an estimate of future dividends. It is always a good idea to ask the agent to re-run the policy illustrations with significantly reduced dividend levels so you can evaluate how negative developments would affect the policy. And you should make sure that all illustrations are run through the insured's 100th birthday.
Term and universal policies do not pay dividends, but illustrations of these policies are also based on assumptions about mortality experience, expenses, and investment returns and so should be re-run with more conservative assumptions. This is especially important with universal policies. Regrettably, Mark's insurance advisors did not show him any such illustrations when they helped him select his universal policies a couple of years ago, at a time when interest rates were much higher than they are now. Had they done so, both the actuarial and the investment risk would have been obvious to Mark. He probably would have made major changes to reduce those risks, since his main purpose in buying the insurance was to provide a large bequest to his children.
A popular insurance product is the whole- or universal-life policy structured to require premium payments for a limited number of years, after which the policy is supposed to have sufficient funding to remain in force indefinitely. The problem is that, if the assumptions about expenses and investment performance used in determining the amount of the premium turn out to be inaccurate, the premium may not vanish as quickly as it is supposed to--and in fact may not vanish at all. Also, some policy illustrations show a vanishing premium because they assume payments will be funded by loans against the policy or surrenders of some coverage. These contracts typically are even more sensitive to adverse performance, since the funds taken from the policy to make premium payments must ultimately be replaced. Many owners of policies bought in the high-interest heyday of the 1980s will be surprised to discover during the next few years that premiums that were supposed to vanish will linger like unwanted guests.
As the name implies, blended policies combine whole-life contracts with term insurance. They are usually offered to buyers of insurance resistant to the
high premiums of a standard whole-life contract. The theory behind a blended policy is that the dividends on the whole-life portion of the contract will buy paid up additions, or additional whole life, which will gradually displace the term.
The strategy works as long as the dividends are sufficient to displace the term insurance. But if dividends are lower than illustrated, the steadily increasing term premiums spiral out of control, resulting in unexpected, large premiums that suddenly appear when the insured has reached an advanced age. Blended policies can be useful, but they should be approached with great caution.
MODIFIED ENDOWMENT CONTRACTS
When Congress tightened the rules on tax shelters a few years ago, insurance salespeople spotted an opportunity. Put all the dollars you can into life insurance, they said, and defer taxes on policy cash values. But Congress takes as it gives: It promptly introduced the modified endowment contract rules.
Basically, a whole-life policy becomes a modified endowment contract when the cash value is too high in relation to the death benefit. How high is too high? Only an actuary knows for sure. The test is very complex and depends on various factors, so you'll have to ask the insurance company for this information.
If a policy is classified as an MEC, it is life insurance nonetheless, and the death benefit remains free of income tax (or should, if you've planned properly). But once a policy is classified as an MEC, withdrawals of cash for reasons other than death are subject to harsh tax rules, including a possible 10-percent penalty if the policy owner is under age 59-1/2. Note, especially, that policy loans, which are generally not taxable, can trigger income tax if the policy is an MEC. So, when you buy whole-or universal-life insurance, you should ask the agent to specify whether the contract as illustrated would be an MEC in any year.
DEALING WITH COMMISSIONS
There are ways in which the savvy insurance shopper can hold down the costs of buying insurance.
One common approach is to buy a reduced amount of whole-life insurance together with a large amount of paid-up additions in the early years of the policy. The paid-up additions carry a much lower commission and, therefore, leave the policy's cash surrender value much higher in the early years. Generally, this means better long-term performance for policyholders, but some companies do shift the costs to later years and subtly recapture the benefit for themselves or the agent. When you restructure a policy to reduce agent's commissions, you should see higher death benefits in the long term for a given amount of premium. If you don't, chances are you're not receiving any benefit for the lower up-front cost.
Some companies have introduced low-load or no-load insurance products for both the corporate and individual markets. These products typically show very high cash values in the early years, but again, the long-term benefit to the customer varies from insurer to insurer. Many of the top companies do not want to undercut their sales forces by offering these low-load products. Remember, the company is key. Having your insurance underwritten by a reliable insurer is more important than reducing the cost of buying the insurance.
Some insurance products--particularly universal-life policies--carry surrender charges or back-end loads. These charges can be high initially, but usually decline to zero between seven and 10 years after the policy is issued. Since surrender charges tend to lock the customer into the insurance purchase, you'll need to understand any such charges before you buy.
THE PROPER PERSPECTIVE
Each insurance product has its pros and cons. The point is to take nothing for granted when you buy an insurance program and to understand fully how future developments could affect your policies. Be a savvy insurance shopper. Do your homework before you buy.
[Mr. Head is national director and Mr. Elkin is senior manager of Personal Financial Planning Services for Arthur Andersen & Co.]
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|Title Annotation:||Personal Financial Planning|
|Date:||Sep 1, 1992|
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