Thank goodness for life insurance. There might be areas of the financial services industry other than this one that people are more interested in talking about, especially during the economic crisis. But I don't have any secrets for you about which stock to buy. Also, I'm forever hopeful that we might find some new products and services that make the insurance marketplace more efficient for financial advisors and their clients.
Last month I wrote about the plans of Legacy Funding Group to create a loan program that could dramatically change the life settlement market, making it more efficient and more attractive to policyholders, insurance companies and investors. The Legacy program would offer loans to customers over a certain age wanting to get the money out of their life policies. The only problem with this new marketplace is that, like many other financial services, it's on hold right now because of the lack of available credit during this deepening financial crisis.
As I wrote last month, there is a second part to this story. Glenn Daily, a fee-only insurance consultant in New York who is part of the Legacy program, has meanwhile put together a policy model to analyze and manage no-lapse universal life policies.
This is important because these relatively new policies are growing like gangbusters. They represent nearly half the market now, Daily says. And yet few policyholders understand them. Some people buying the policies think they're getting an entirely different product, and only a handful of advisors understand the policies' intended use. Using them efficiently requires a rigid analysis. Because the policies are designed to provide no-lapse coverage, an advisor could help the client pay much less when using them.
The most important point is that these policies are not a vehicle for cash accumulation. Indeed, you should avoid paying any excess premium, for which you can be penalized, since the load on extra premiums can be much higher than what's paid in the minimum premium that would keep the policy from lapsing.
There's a particular danger here if you dump in a large amount in a 1035 exchange (a transfer of cash between policies protected from taxation under the Internal Revenue Code). Because you won't know how the excess premium is handled until after you've received the contract, lump dumps should be approached with caution. You might find later that 85% of this lump sum is gobbled up by the excess premium load.
If the policyholder is to get the most out of a no-lapse, universal life policy, his advisor must determine precisely how much he must pay to keep the policy in force. Paying more than the minimum amount means the policyholder is handing over a large amount of money to the insurance company and getting nothing in return. That could be considered malpractice on the part of his advisor.
Daily discovered all of this while training people to help him evaluate policies for the Legacy loan program. These trainees may have never seen a policy contract before, so his materials needed to be very basic to help his staff see the patterns in contracts and to discover the minimum necessary premium.
He claims that financial advisors can use the same model to help clients save money and get the same policy for less money. "Think about it like you're playing a game and you want to maintain the policy in force," he says. "You're buying it because you want a guarantee and you want to know how much it will cost you to keep the policy in place. Think about how you can take advantage of the rules to win the game."
No-lapse universal life, also called guaranteed universal life or universal life with a secondary guarantee, is functionally equivalent to term insurance. The cash values are relatively low-there may even be no cash value in the early or later years, Daily says.
That's OK. Because no one should be buying this product in order to accumulate cash value. "You buy it because you are attracted to the low-cost guarantee," Daily says. What's more important is discovering how to keep the no-lapse policy in force at the lowest possible cost. It's difficult to find this, though, because it is laid out nowhere.
"It's useless to look at the annual statement or the illustration," Daily says. And it's useless to ask the agent because he probably doesn't know. What you must do is read the contract, which does not spell out the figure but which does give you the formula you can use to figure it out. The company tells you to pay the premium as illustrated, but you might pay too much up front or too little up front by doing that, and the contracts are actually much more flexible than the illustrations indicate, Daily says.
When I spoke with him in early December, Daily was evaluating a $2.5 million Union Central policy sold to his client in 2006. (He had no role in the original transaction.) The client had rolled in $360,000 in a 1035 exchange. Depending on the contract terms, the lump sum could have been a bad decision, but that was water over the dam. What his client wanted Daily to tell him by that point was if the policy was worth keeping.
In addition to the lump sum, the policy illustration showed that the client should contribute $8,100 for each of the next nine years. The policy will be in its fourth year in 2009, and it will be paid up in the tenth year under this illustration, which Daily says is a legitimate use of the term since no more premiums would be required to keep the policy in force. The question is, what is the smart way to pay the premiums? "Sometimes it's better not to pay level annual premiums," Daily says.
Daily studied the pages that provided information on the lapse protection benefits. "At all times, make sure that the premium you pay accumulates at as great a pace as the accumulated no-lapse monthly premiums," he says. His client's policy shows the no-lapse monthly premium to age 99. So you compound those premiums at no-lapse interest rates.
The interest rate in this policy is 17.17% on premiums paid. The policyholder must pay the minimum no-lapse premium to keep the policy in force. If he pays more than the stated premium, he must pay a load of 75% on all the excess premium. Because the interest rate of 17.17% is high, Daily believes the policy is worth keeping. "It would be very hard to duplicate in today's market," he says. "I don't know if it was a good deal in 2006."
Once he's decided the policy is worth keeping, Daily must find the most efficient way to pay it off. Although the illustration suggests the client pay $8,100 each year until the policy is paid up in year ten, Daily discovers that his client can actually pay $10,240 each year without getting hit with the 75% excess premium load. Although that would require a larger annual payment over the next several years, it would turn out to be less overall.
When his client dumped in the initial lump sum of over $300,000, he would have been forced to pay the 75% excess premium load on much of that money. Still, Daily says, because the interest rate on the premium he paid is 17.17%, the overall deal is still reasonable.Because of the 17.17% interest combined with the 75% excess premium load, "I don't have a problem with the rollover in this case," Daily says. "What's not OK is the $8,100." He can add $2,140 a year to the premiums without getting hit with the load. "Where else can you earn 17%?" Daily says. "The way to play this game is you roll over the amount in year one and then in year two you begin to pay $10,240 until it's paid off because you are getting 17% interest."
But in this case, years two and three are already history. So Daily will advise his client to pay $10,240 in years four, five, six and seven and then a stump premium of $6,200 in year eight. That is enough to satisfy the test for life. Under Daily's plan, the total remaining premium payment is $47,160. If he continues to pay the $8,100, however, he will instead pay a total of $56,700.
Naturally, there are other questions and circumstances. If the policyholder dies in the next few years he will have paid more under Daily's formula. But once he has the formula, Daily says he looks at other factors such as the policyholder's health, the opportunity cost of money and so forth. "The policy must be managed every year," Daily says, to make decisions about how to reach the destination most efficiently.