Life Insurance: Managing Premiums and Policy Maturity
by Peter Katt
Explaining the implications of when and how a permanent life insurance policy matures can seem like a performance of Abbott and Costello’s “Who’s On First” routine.
But it is information you need to understand in order to make informed decisions regarding your permanent life insurance.
One way for a policy to mature is the insured’s death. Proper management of a policy depends on understanding how a policy matures other than death. But there isn’t a one-size-fits-all answer: How a policy matures depends on the type of policy.
Whole Life Policies
Until recently, participating whole life was set up to mature at age 100. Contract premiums and dividends were programmed for the death benefits and cash values becoming equal at age 100. For insureds living to age 100, the policy matures for its cash values, which will equal the death benefits. Most companies continue the policy until the insured dies and then pay out the cash value as an income-tax-free death benefit, although there is no certainty as to this outcome. Some companies pay out the cash values at age 100, and those payments would be subject to income taxes. The genius of participating whole life is that the increase in paid-up addition death benefits along with the guaranteed elements will always result in cash values equaling death benefits at age 100. As you will see below, this isn’t the case with many other types of policies.
More recent participating whole life policies have extended maturity to age 120. The same principles apply as in a participating whole life policy that matures at age 100, but there is a longer time horizon: Cash values and death benefits will be equivalent at age 120, not 100. Companies aren’t expecting a rash of insureds to live to 120, but this extends maturity and slightly reduces the contract premiums.
Universal Life Policies
Many universal life policies that were sold in the 1980s and early 1990s have age-95 maturities. However, unlike participating whole life, the funding goal (target premiums) of universal life is the responsibility of the policyowner, and without astute management this funding always gets messed up. Because crediting rates (interest paid on cash values) have fallen across the board from the levels they were at when the policies were purchased, most of these universal life policies are underfunded, and dramatic increases in target premiums or reductions in death benefits need to be made. (When the cash values are not large enough to cover the premiums, the policyholder must make up the difference in order to prevent the policy from lapsing.)
These policies mature for their cash values at age 95. Here’s an example of how that date affects policyholders. Tom’s $1 million universal life policy has $300,000 cash value as he turns 95. The policy’s value becomes $300,000, because the $700,000 death benefit is lost when the policy matures. Some companies would send out a $300,000 check, and that would be the end of it. Some would continue the $300,000 cash value at interest and send out the balance at Tom’s death as a death benefit. The important thing to know is that if Tom wants to count on a $1 million death benefit, even if he lives to 95, he needs help in managing target premium adjustments to do this. Unfortunately, managing such policies is very difficult and makes for gut-wrenching decisions.
A recent case involved a gentleman named John who is 89 years old and has dementia. He is insured for $6 million. The current cash values are $1.4 million. The $6 million death benefit will continue to age 95 with the payment of $107,000 in annual premiums. If John lives to age 95, the policy will have no death benefit value. Based on a best estimate of John’s health, he has a 10% chance of making it to age 95.
What to do? Should he cash in the policy now for a sure $1.4 million, or continue paying the $107,000 premiums with a 90% probability of the death benefit being worth $6 million? This is not a situation where an expert can make the decision. The expert can describe the options, but the family needs to make this difficult decision. With proper management of the premiums, this situation would not have occurred in the first place.
Second-generation universal life policies have age-100 maturities with the same principles as those with age-95 maturities. Third-generation universal life policies have age-120 maturities. Current mortality patterns mean this has no practical effect, but it does reduce the target premiums because of extending the policy maturity age.
Variable universal life policies have the same maturity principles as universal life policies. (Variable universal life differs from universal life in that the policy’s assets are invested in one or more funds, with the objective of achieving higher investment returns.)
Some universal life and variable universal life policies have lifetime extension riders. With this rider, a policy’s death benefit continues for the insured’s lifetime as long as it is in force at the maturity age.
To refer back to Tom with his $1 million policy that matures for its $300,000 cash values at age 95: A lifetime extension would continue the $1 million death benefit no matter what the cash value is at age 95. Therefore, target premiums should be set that will generate $1 of cash value at policy maturity—usually age 100.
A recent situation has two 75-year-olds as insureds on a survivorship universal life policy. This policy’s lifetime extension was not picked up by their national financial institution trustee; therefore, the bank had set the annual target premiums at $55,000 so that the cash value would equal the death benefit at age 100. This amount of premium is completely unnecessary. I reset the target premiums to $30,000 to generate the minimum cash value at age 100. The policy will continue the lifetime extension at the original death benefit, producing about a $270,000 present value savings (a $25,000 difference in target premiums to their joint life expectancy, discounted at 4.5%).
Another version of universal life has secondary no-lapse guarantee riders. As long as a specified premium is paid, the policy will remain in force as per the contract, regardless of whether there is any cash value. (Usually these no-lapse universal life policies have low to zero cash values.) Depending on the specified amount of premium, a policy’s death benefit can be guaranteed to between ages 100 and 120. Setting the premiums for age 120 is not justified. But setting them to, say, age 105 is. There may be some flexibility with managing these premiums, but it depends on each policy, and it is complicated.
A recent case will provide a sense of how policy maturity plays into final decisions. Sam and Mary wanted estate tax liquidity life insurance of $5 million, and they decided on universal life whose premiums depend on future policy crediting rates. I refer to these policies as market-priced universal life. Sam and Mary qualified for preferred ratings. At ages 57 and 53, their joint life expectancy is 40 years. Perhaps more to the point, there is a 16% probability that Mary will make it to 100. Therefore, I presented them with a target premium for their policy of $35,500 to carry the policy to Mary’s age 105 (assuming the current crediting rate of 5.55%).
This policy will need premium management until it matures; therefore, Sam and Mary should contact me every few years. The dominant factor is the crediting rate. I calculated that the target premiums will range between $23,000 (at a 7.7% sustained crediting rate) and $55,000 (4.0% sustained rate). Of course, we won’t have a sustained crediting rate, so the target premium will fluctuate. But another important factor is the future health of Sam and Mary. Let’s say that Sam dies at 80 and seven years later, at age 83, Mary has developed serious health issues, such that it is nearly conclusive she won’t live beyond age 90. This then becomes the maximum policy maturity age, and premiums should be adjusted downward accordingly. In this case, astute policy premium management has generated enough cash value to carry the policy without the further payment of premiums to the adjusted maximum maturity target age of 90. This would be a huge savings and provide the most efficient use of life insurance.
As presented by life insurance agents, life insurance policies may seem quite simple. But for many types of policies, complexity is a given. Among the complexities is properly managing a policy’s maturity. This can be handled with experience, good sense and patience.