No-Lapse Premium Guarantee Policies: The Risks Revealed
by Peter Katt
In a column last year, I discussed universal life policies with no-lapse secondary guarantees. I referred to them as no-lapse premium guarantee (NLPG) policies [The Potential Problems With No-Lapse Premium Guarantees, July 2003].
These policies have very exaggerated guarantees and most likely rely on policy lapses to provide a margin of safety for the companies selling them. If the companies dont get the number of lapses they have anticipated and interest rates dont soar, these policies wont be profitable for the companies selling them. This is especially true for the most aggressively priced NLPGs.
Last year, the only coverage I saw about these kinds of policies appeared to be press releases from the companies themselves touting their wonders. I spent time lobbying other influential life insurance voices to join me in a critical analysis of NLPGs because it appeared that they were (and are) dominating new and replacement policy sales. It continues to be my opinion that understanding the solvency implications connected to NLPGs is by far the most important issue in the life insurance world.
Finally, help has arrived in the form of penetrating and critical pieces from, most importantly, Moodys Investment Services and Fitch Ratings and Joseph Belths The Insurance Forum.
These articles reinforce the concept that the dangers the most aggressively priced NLPGs pose arent hysterical speculationthey are real, and notice of the dangers is becoming widespread. That said, I dont know how to quantify the chances of insolvencies associated with NLPGs, and I note that Moodys and Fitch havent downgraded their ratings for the top NLPG sellers.
Nonetheless, given the widespread use of these policies, it is an issue that is worth revisiting.
Increased risks dont mean that you should avoid NLPGs. However, you should be advised of the possible risks so you can make informed decisions about whether the potential advantages are more important than the increased risk.
The presentation of NLPGs as an option has become a staple in the life insurance business. However, your view of an NLPG policy should be based on a risk/benefit assessment. Several brief examples may provide some clarity. First, however, two concepts need to be understood.
One concept has to do with death benefit designs. One policy design is to provide level death benefits from the time of purchase until the policy matures. The other policy design is to initially provide lower death benefits that increase over time. NLPGs can only have level death benefits; they cannot have increasing death benefits. When these two death benefit designs are evaluated and compared, the same premium payments should be used.
The second concept concerns pricingwhat I refer to as market-priced vs. static-priced. As I explained in my earlier column, NLPGs are static-pricedthe premiums and death benefits are guaranteed what-you-buy-is-what-you-get. Think of this as term-insurance-for-life. This form of pricing is in stark contrast to market-pricing, which was the only pricing used for permanent insurance from 1980 to 2002. In conjunction with a level death benefit design, a market-priced policys premiums will fluctuate with investment and mortality experience. Compared with market-priced policies, static-priced policies will either be overpriced or underpriced, as measured from the time of purchase until the insureds deaths.
Unlike a static-priced NLPG, market-priced policies can have either level or increasing death benefits. Only a very few companies have true market-priced policies whose pricing is nearly the same for both new and old policies. Almost all other companies give more favorable pricing treatment to newer designed policies and the older policies pricing falls below market. Of course, giving poorer pricing to older policies negates the concept of market-pricing. Also, you should not buy market-priced policies from companies that are also selling aggressively priced NLPGs. Not only is it likely they are not giving true market-pricing to older policies, but also if the NLPGs become unprofitable, the market-priced policies without the exaggerated guarantees may be tagged to make up for NLPGs losses with very poor pricing.
Now lets look at several examples in which the use of NLPGs is being considered.
Benefits Outweigh Risks
In the first example, Howard is 74 years old with a history of heart disease. He has an existing $3 million market-priced policy from ABC Life that has an annual target premium of $67,000 and a cash value of $1 million. Of the new insurance policies that companies were willing to underwrite on Howard, only one, offered by XYZ Life, has the standard rating (the others ranged down substantially). It also has very aggressive static-pricing. XYZ Lifes static-priced NLPG policy has two premium optionsone with guaranteed premiums of $47,000 to age 100, the other with a $17,000 premium for 15 years followed by premiums of $206,000 from age 90 to 100.
The present value of the premiums for the ABC and XYZ policies were compared using Howards life expectancy, and under both premium options the XYZ policy had a present value premium advantage. However, the present value premium advantage for the XYZ policy using the steady $47,000 premium is $175,000, while the premium advantage for the two-tiered premiums ($17,000 for 15 years and $206,000 for the next 10 years) is $435,000. (Because of Howards life expectancy the probabilities are strongly in favor of using the two-tiered premium mode.)
I fully disclosed the risks associated with static-priced NLPGs to Howard.
On the other hand, ABC Life also sells static-priced NLPGs, so retaining this policy may not be much of a safe haven. Howard decided to replace his ABC policy with the XYZ Life NLPG. The standard offer with very aggressive static-pricing does increase XYZ Lifes financial risk. However, the reduction in guaranteed costs compared to the ABC policy are so great that even if XYZ Life is seized due to solvency concerns, the probable resulting premium adjustment may very well be no higher than if Howard retained his ABC Life policy.
Not Worth the Risk
The second example involves an older couple with a family business. Paul is 71 and Irene is 70; Paul is a sub-standard risk and Irene is preferred. They own a family business and have four children, two working in the business. They want to distribute the business only to the children who are working in the business, but equalize the inheritance to the others. Paul and Irene want a level $10 million life insurance policy.
I provided Paul with a report describing and comparing static- and market-priced policies. Because the market-priced premium for a level death benefit policy will fluctuate, the critical issue is the potential premium difference with a static-priced policy.
XYZ Lifes guaranteed annual static-priced premium for its NLPG policy is $195,000. Table 1 shows the market-priced premium based on different average dividend-interest-rates for Premiere Mutual Life.
Premiere Mutuals average dividend-interest-rate since 1992 has been 8.6%, which may represent an era of higher interest rates than we will have in the future. You can see from the table that Premiere Mutuals average dividend-interest-rate must be 8.0% to match the guaranteed XYZ Lifes static-priced premium of $195,000. Premiere Mutuals current dividend-interest-rate is a bit below 8.0%. It is very likely that it will decline for a few years at least.
Without taking into consideration the potential solvency risks associated with static-pricing, Paul may very well have gone with the XYZ Life NLPG policy.
However, once those risks were fully disclosedand since he got burned by Executive Lifes failurehe has no interest in taking any additional risks with his life insurance program. Premiere Mutual is his choice.
Not Worth the Risk
The last example concerns Bruce, 78 and in excellent health. His estate assets are almost entirely marketable securities, since he sold his business some years ago. Bruce is insured with a $1.6 million universal life policy with $605,000 of cash values from Acme Life.
Bruces Acme Life policy is very poorly priced and he will need to pay significant premiums to continue the $1.6 million death benefit. An insurance agent recommended that he replace the Acme policy with a XYZ Life NLPG static-priced policy with level guaranteed death benefits of $1,273,041, which would be funded with only the $605,000 cash values and require no further premiums.
Bruce wanted a second opinion. The agent had not explained the risks associated with static-priced policies and also had not explored the option of having an increasing death benefit policy that could also be funded with only the $605,000 cash values.
Table 2 shows a comparison of having an XYZ Life NLPG policy with level death benefits of $1,273,041, or a Premiere Mutual Life paid-up policy. Both approaches are guaranteed to have no future premiums.
The Premiere Mutual paid-up policy is a market-priced policy, and the actual increase in death benefits will depend on future dividends. Table 2 uses a dividend-interest-rate of 7.0%, which is considerably below Premiere Mutuals current rate. Table 2 also shows the probabilities that Bruce will be alive at various ages.
Bruces immediate response was to replace his Acme Life policy with a paid-up Premiere Mutual policy because there is a fair chance it will produce better value, and it eliminates any risk.
If you are considering the purchase of an NLPG life insurance policyeither as a new policy or as a replacement for an existing policyyour own individual circumstances will dictate whether the additional risks are worth the possible benefits.
However, this can only be done if you understand the risks that these policies can bring to the life insurance companys solvency. If the sellers of NLPGs do not disclose the risks by presenting such documents as published by Moodys and Fitch, you should at the very least try to get the information on your own.
Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advising firm located in Kalamazoo, Michigan (269/372-3497); www.peterkatt.com.