What do you do if you have new clients burdened with severely underfunded variable universal life policies?
It's a problem that tends to rear its ugly head in a bear market. In fact, individuals, who purchased variable universal life (VUL) at the market peak in 1999 and bet heavily on the stock market saw their investments drop at least 20% in 2000 and 2001. And those who underfunded their policies and relied on market appreciation of the cash value may have had to kick in higher premiums to keep their policies in force.
It can be a particular problem when combined with the high cost of some VUL policies, says James Hunt, a former Vermont state insurance commissioner who runs an insurance policy evaluation service for the Consumer Federation of America. Mortality and expense charges, commissions, administrative fees and fund expenses can take a big bite out of cash-value total returns, Hunt says. There also are state premium taxes. The internal rates of return on a policy's cash value can be as high as 500 basis points with an unfavorable policy. At the low end, internal rates of return run about 200 basis points less.
Paula Hogan, a Milwaukee-based financial planner, says she has worked with a couple of new clients who were hit badly with variable universal life policies. Fortunately, the policies had sufficient cash surrender values. She did 1035 tax-free exchanges out of the variable universal life policies into low-cost deferred variable annuities.
When the policyholder annuitizes the contract, she notes, capital is withdrawn from the immediate annuity at a tax loss. "The caveat is if you leave the life insurance policy intact, the stock market may turn around and policyholders will profit," she says.
Given the outlook for the stock market today, Hogan says it may be wise to keep a client in an underfunded policy. Ordinarily, Hogan favors term insurance. But for clients who want a cash-value policy, she recommends whole life. "They don't need to take risks with their life insurance," she believes. "They can invest in stock funds in their retirement plans."
However, Peter Katt, a Mattawan, Mich.-based CFP and insurance agent, believes that defined-benefit variable universal life policies should be changed. Otherwise, over the years, policyholders will underfund or overfund their policies.
He believes that they may be changed to defined-contribution designs with high premium payments relative to the low initial death benefits. This way, the benefits are almost certain to increase significantly without any changes to the premium payments. Another option, he says, is to convert to a special premium management system.
Insurance analysts say that underfunding of variable universal life isn't as widespread as it may appear. Nevertheless, some of those affected by policy losses are concerned that they will lose their life insurance coverage after sinking a fortune into their policies. "I've looked at quite a few variables (VUL) for consumers as well as financial advisors," Hunt says. "I haven't heard about it being a major problem."
James Finnegan, senior vice president of Moody's Insurance Group, N.Y., agrees that for the most part the policies are being properly funded. Nevertheless, a physician recently contacted Hunt about a high-cost $2 million policy. The insurance costs ran $1 per $1,000 over coverage. By contrast, similar term insurance would have cost just 25 cents per $1,000.
She purchased the policy in October 2001, and paid monthly premiums of $1,250 for 30 months. The cash value was invested in 15 different stock funds as directed by her financial advisor. But the surrender value of the policy was $6,000 below the surrender charge. If she had cashed out the policy she would end up with nothing.
"It was a serious mistake to buy a $2 million policy at a level premium," Hunt says. "The risks are great in the early years of the policy."
This physician is not alone. Since the beginning of 2001, the National Association of Securities Dealers has taken disciplinary actions against eight brokerage firms for the sale of variable life insurance. There were none in 2000.
The brokerage firms and individual brokers settled charges without admitting or denying NASD Regulation allegations. Monetary sanctions in the settled actions totaled in the hundreds of thousands of dollars, according to a NASD spokesperson.
The firms were charged with lack of supervision, unsuitable sales and failure to communicate material facts about the VUL policies they sold. There also have been a number of class action lawsuits filed against brokers and insurance companies.
"There is a lot of litigation involving the sale of variable life products," says John Yanchunis, partner with James & Hoyer, a Tampa, Fla.-based law firm. "The illustrations are not supported by the facts. The elderly were put in unsuitable investments."
Yanchunis says his firm is involved in 50 class action lawsuits. Elderly clients allegedly were switched out of their whole-life policies into variable universal policies. The seniors were told they were buying vanishing-premium policies. Meanwhile, younger people were allegedly sold VUL as retirement-savings accounts with level premiums.
In both instances, Yanchunis says the policies are beginning to explode. The premiums and cash values are insufficient to cover the cost of the insurance. The problem with VULs may rest with the hypothetical policy illustrations, stresses Norse Blazzard, chairman of the National Association of Variable Annuities' committee on variable life. Regulations require that policyholders review illustrations based on hypothetical returns. During the bull market of the 1990s, premiums were often based on 10% to 12% annual rates of return.
"The SEC (Securities and Exchange Commission) requires the illustrations, but they are meant to show people how the policy works," Blazzard says. "Most people don't minimum fund, but there are always bound to be problems."
Ted Kilkuskie, chief marketing officer with Hartford Life Insurance Co., says that the few problems that arise industrywide with variable universal life insurance are blown out of proportion by the media. Hartford deals with affluent clients who typically fund their policies to the maximum allowable limit.
The company's average annual VUL premium is $10,700 with a face amount, or death benefit, of $520,000. He stresses that his firm's 200 wholesalers work closely with account executives to make sure that VULs are properly funded and diversified.
"We have seen no significant increase in VUL complaints by our policyholders," says Kilkuskie, whose company is the second-largest seller of VUL policies, according to Tillinghast-Towers Perrin, a New York-based consulting firm. "We have had no problems with policies being underfunded or blowing up."
At Nationwide Financial, the sixth-largest seller of VULs, there are few problems, says John Keenan, vice president of brokerage life. That's because a number of safeguards limit policyholders' risks. Premiums for many policies are invested first in a money fund subaccount, he says. Insurance fees are deducted from the money fund account. Then money is invested in the stock funds, free and clear of any charges.
Policyholders also can set up an automatic dollar-cost-averaging program that moves money into stock funds. In addition, Nationwide's average VUL premium is $18,000, while the face amount is just $350,000.
"It's [underfunded policies] pretty rare," Keenan says. "Our average premiums are large, and the average policy size is relatively small. There are sufficient values to maintain the policies."
Even though insurers stress that VUL should be funded to the maximum allowable limits, Blazzard stresses you can't assume policyholders will earn the illustrated policy rate.
"What is needed is a random walk or Monte Carlo simulation to show the volatility of the policy," Blazzard says.
These types of illustrations help policyholders understand the volatility of a VUL. The analysis, he says, would help them properly fund their policies.
CFP and insurance agent Katt believes that in some instances, variable policies are sold the wrong way.
"Tumbling stock values can cause poorly designed variable life policies to become so underfunded that they require the equivalent of a margin call," Katt says. "A defined-benefit policy type is a very poor design.
"Defined-benefit type policies have level-to-maturity death benefits that purport to also define the premium costs via comforting pre-sale and in-force illustrations." But, he adds that "the illustrations are an illusion because they are based on assuming a constant investment yield that in reality will be very volatile, as we have recently experienced. A defined-benefit policy's premiums cannot be known in advance. It will need to be managed to avoid overfunding and underfunding."
Katt says a better alternative is to set up a VUL as a defined-contribution plan based on a modified premium payment schedule using Option B of the VUL policy. With Option B, the death benefits fluctuate with the growth of the cash value. By contrast, most VUL policies are sold with Option A-the premium payments can fluctuate within allowable limits and the death-benefit coverage remains unchanged. Assuming the financial markets do well, Option A will give policyholders higher cash values. By contrast, Option B may provide higher death benefits.