Many policies are underfunded as a result of the bear market.

Even though the bear market seems to have subsided, the fallout from those three years of losses may have yet to be dealt with if you have clients with variable universal life policies.

That, observers say, is because one of the problems the bear market left in its wake is a rash of variable universal life policies that are underfunded. In many cases, policyholders may not know the problem even exists, which means advisors should be scrupulous about doing periodic reviews of their clients' standing policies.

"That is the single biggest problem with variable universal life, period," says John Olsen, a CLU and ChFC licensee, who owns Olsen Financial Group in St. Louis, Mich. "If you go to a conclave of people who know what they're doing in this area, ask them if it's true the biggest problem with VUL policies is that most of them are underfunded. If you get one person who says, 'no,' I'd like to know his name."

In agreement is Chris Cooper, principal of Chris Cooper & Co., an advisory firm in Toledo, Ohio. Cooper says he's frequently seen clients walk into his office with underfunded policies.

"What I'm seeing is the cash value is not building up sufficiently to make the illustrations come true," he says. "They're not in trouble yet, but they will be from what I've seen."

Advisors cite a number of reasons why the holder of a VUL policy may still be feeling squeezed by the three-year bear market. Part of the problem, they say, is that policies are too often sold with minimal premiums, leaving policyholders with little wiggle room if market returns are significantly lower than projected. "People are buying them as though they're refrigerators, figuring the ones with the cheapest premiums must produce the best deal," Olsen says.

This problem is exacerbated by the fact that projections of annual investment gains used to draw up a policy, particularly if it was done in the bull market of the 1990s, were probably overly optimistic. What will typically happen is an out-of-whack market will lull people into believing the standard benchmarks have changed, says Herbert Daroff of Baystate Financial Services in Boston.

It was easy to expect annual returns of 12% back in the 1980s, for example, because interest rates were around 18% or higher. That type of thinking also spilled into the late 1990s, when the S&P 500 was churning out gains between 20% and 30% and the Nasdaq 100 was giving investors returns of up to 102%. "These policies were sold on some unrealistic assumptions," Daroff says.

Even with the bear market and pumped-up projections, VUL policyholders who are getting their cash value from a well diversified portfolio probably weathered the past few years intact. Others who didn't diversify, went with minimum premiums and overly optimistic projections are facing the possibility of having their policies lapse, he says. "Some people may have to put in 150% more than they're paying just to keep it afloat," Daroff predicts.

There is yet another reason why projections used to sell VUL policies are misleading-more so, advisors say, than they would be if applied to a mutual fund. This has to do with the fact that VUL policies are sold with straight-line projections that assume an average annual return, ignoring the fact that returns will actually vary greatly from year to year.

Notwithstanding the assumed percentage of the return, this type of projection is suitable for a mutual fund, where money just sits, and gains or losses will reflect the fund's average performance over a given span of years. It's a different story for variable universal life, however, because money flows into and out of the account during the life of the policy. Gains will not only be impacted by average market returns, but also how much money happens to be in the subaccounts during the peaks and valleys of performance in a manner not unlike retirement withdrawals.

"The real issue is that we not only have deposits going in from time to time, we also have withdrawals coming out," says Michael Kitces, director of financial planning with Pinnacle Advisory Group in Columbia, Md.

The withdrawals are in the form of insurance charges, administrative fees and all other expenses associated with the policy. These fees and expenses naturally go up over time to reflect mortality rates. They can also increase as cash value goes down.

If a policy was front-loaded, for example, a bear market in its initial years is going to hurt more than if deposits had been spread out more evenly, Kitces notes.

It will also be harder to recover the lost cash value, particularly with the snowballing expenses the policyholder will be hit with along the way, he adds. "The policy will not instantly blow up and run out of money. But it has essentially been irrevocably damaged," Kitces says. "It's sort of a hidden disaster."

It's a dynamic that can easily upend the straight-line projection a policyholder used as the basis to buy the policy. Olsen says, for example, you could take a VUL policy with an annual return projection of 11% and compare it to one in which a 10% return was guaranteed each and every year. In such a case, even if the 11% projection holds true, it's more likely the 10% policy will finish with greater gains.

The effect of variations in the market will also depend on the situation of a policyholder. A 35-year-old man, for example, would probably want the bad years to happen right away, Olsen says. By comparison, a 65-year-old man with the same policy, living off the investment, would want to put it off to the last year.

"The biggest problem with the projections is they don't let you model the impact of having really awful years at the wrong time," Olsen says. "Regular VUL illustrations turn out to be filed under science fiction. The only thing you can say about them is they are wrong."

The one tool that gives clients a way to somewhat measure their exposure to unforeseen fluctuations would be stochastic modeling, or Monte Carlo simulators, but they are rarely used. That situation could change, however. The NASD is considering rule changes that would lift restrictions that currently prevent registered reps from using the tool for VUL policies and other life insurance products.

Proponents of the change say Monte Carlo simulators would be ideal for VUL projections, giving clients an estimation of how likely it is that their policy will survive to the time of their death. "In the right hands, and with the right caveats, it's a much better tool for helping clients form reasonable expectations than any straight-line or historic presentation," says Richard M. Weber of The Ethical Edge insurance consulting firm in Carlsbad, Calif.

Analysis tools designed specifically for life insurance already do exist, and are in limited use by professionals who don't fall under NASD regulation. Financial Profiles, for example, launched a product called Insurance Insight about three years ago.

As with Monte Carlo analysis applied to other investments, the product uses historical market data to calculate a range of possible outcomes for a VUL policy and premium, says Charles Davidson, Financial Profiles' vice president of product management and marketing. "We think there will be a significant demand for it," he says. "It helps and assists the client in assessing risk and failure. That is the true value of this type of analysis."

If properly used, Weber says, it gives advisors and their clients substantive information with which to make decisions. If, for example, a Monte Carlo analysis were to show a 10% chance of the policy lapsing before the policyholder reaches the age of 90, "that doesn't make the policy wrong," he says. "The most important part is it helps us figure out whether or not the money the client is willing to put into the policy is sufficient to meet expectations," Weber says.

It's also useful for running checkups on existing policies that, without any changes, are on course to lapse, he adds.

In light of the underfunding problem, insurance companies are coming out with guaranteed premiums. The tradeoff for clients is the policies will use conservative investment return assumptions and carry heavier expenses.

MassMutual Financial Group, for example, launched a VUL Guard product in August of last year. The product has produced $9.1 million in sales year-to-date as of April 30, according to Jeff Carlton, the company's vice president of life sales.

The company also has a transition program that allows holders of MassMutual variable universal life policies to convert them into a VUL Guard policy, he says. "I think it's the right product at the right time," Carlton says. "There are a lot of underfunded policies."