- In place of term insurance;
- For designs that require large cash values;
- When increasing death benefits are needed; or
- When there is much of a chance that future premium payments will be missed.
- The static-pricing of NLPGs provide premium certainty. Future pricing factors (primarily fixed-income yields), in retrospect, may cause market-priced policies premiums to be consistently higher than NLPG guaranteed premiums. Advantage NLPG.
- If fixed-income yields increase, market-priced policies may turn out to be a much better value. Advantage market-priced policies.
- Market-priced policies have much higher cash values that can be withdrawn, borrowed, or available upon termination. Advantage market-priced policies.
- NLPG policies can become such a good deal that the company becomes insolvent and is seized. NLPG disaster.
The Potential Problems With No-Lapse Premium Guarantees
by Peter Katt
Like Pac-Man, a new policy-type is trying to gobble up as much existing permanent insurance as possible. And why not, who wouldnt want to buy (either as new or replacing existing policies) a permanent policy with excellent guaranteed premiums? So-called no-lapse-premium-guarantee (NLPG) policies have become a hot concept with many agents promising rock-solid, unconditional guaranteed premiums.
No-lapse premium guarantees are impressing agents, insurance buyers and their advisors. And the financial media are cheering them on as ideal for consumers because of lost confidence in permanent insurance due to poorly performing universal life and vanishing-premium and variable-life promises that have not come true.
But NLPG sales rhetoric ignores important implications. Informed consumers and advisors need to understand that NLPGs have very limited uses, and when they are an appropriate option, consumers need to clearly understand that they have one potential advantage, two potential disadvantages and one potential disaster. If you know these things, you will be way ahead of insurance salespersons who are trying to cram everyone into their one-size-fits-all NLPGs.
All permanent insurance policies have built-in guarantees. The basic guarantee is that the insurance company will pay the stated death benefit when the insured dies. In order for that guarantee to be honored, the insurance company must remain financially solvent.
NLPG guaranteed premiums are severely lower than conventional guarantees. One way of expressing this difference is that participating whole life guaranteed premiums are generally two to two-and-a-half times larger than NLPGs. For example, a representative NLPG guaranteed premium for a preferred male, age 60 ($1 million death benefit), is $16,976, whereas a representative participating whole life guaranteed premium is $37,410.
|TABLE 1. Premium Comparison: NLPG vs. Whole Life|
|Premiums for Males Aged:|
|No-Lapse Premium Guaranteed||$6,846||$10,266||$16,976||$29,526||$55,946|
|Participating Whole Life Current*||5,829||9,546||15,480||26,840||56,212|
|Participating Whole Life Guaranteed||13,710||22,490||37,410||66,830||129,250|
|Premiums for Females Aged:|
|No-Lapse Premium Guaranteed||$5,296||$8,046||$13,236||$22,326||$42,756|
|Participating Whole Life Current*||4,644||7,429||12,448||22,630||47,360|
|Participating Whole Life Guaranteed||10,980||17,830||30,240||55,790||116,300|
|Premiums for Survivorship Policy for Couples Aged:|
|No-Lapse Premium Guaranteed||$4,260||$6,698||$9,582||$14,806||$28,853|
|Participating Whole Life Current*||2,874||5,595||10,749||20,331||39,552|
|Participating Whole Life Guaranteed||9,070||13,640||23,260||40,880||73,570|
|* Actual first-year premium is a bit higher, but has been amortized to create a single premium for easier comparison.|
The very conservatively set guarantees for conventional permanent policies have never been breached in the United States (although there may have been some shuffling around at some companies during the 1930s). It is a near certainty that their failure would only occur on a systemic basis—affecting all life insurance companies similarly—due to some cataclysmic mortality and/or economic event or series of events. In fact, it is more correct to think of conventional guarantees not as a promise made by the insurer that policyholders will never be charged more or credited with less, but as an indication of the worst situation the insurer has prepared for through reserving.
NLPGs have a much smaller margin for error than conventionally set guarantees. NLPG insurers could experience non-systemic solvency strains that only affect some insurers selling NLPGs. If NLPGs are generally underpriced, it could cause the pricing for that companys non-NLPG policies to be adversely affected. It is also possible that a company aggressively pricing and selling NLPGs could end up under-reserved and seized by regulators.
Agents doubting the dangers of setting guarantees too aggressively should do a little research on the failures of Baldwin United (annuities) and Mid-Continent (life insurance with quasi-guaranteed premiums), the severe problems experienced by Prudential plc in the United Kingdom (annuities), and the recent problems associated with death-benefit guarantees embedded within variable annuities.
NLPGs use the universal life form of insurance. Essentially NLPGs promise that the specified death benefit will be paid if the policyholder pays the stipulated premium for a stated period of time. NLPGs have varying guaranteed periods, but the only relevant period for them is to age 100.
NLPG policies have very low to zero guaranteed cash values with higher illustrated current cash values. NLPG policy performance is subject to current-pricing that may be better. In theory, NLPGs promise to dramatically limit a policys downside while giving policyholders access to a possible upside. In practice, however, the possibility of an upside is probably a mirage for aggressively priced NLPGs, making them static-priced policies in reality.
Table 1 shows premiums for a $1 million policy for males, females and survivorship policies, for ages 40, 50, 60, 70 and 80 from the same mutual company. All premiums are for preferred insureds. The NLPG premium is by definition guaranteed and supports a level-to-maturity $1 million death benefit. The participating whole life current premium supports a level-to-maturity $1 million death benefit based on current dividends remaining the same. Of course, current dividends wont remain the same, and this premium will need to be adjusted to continue to support $1 million without the policy becoming underfunded or overfunded. The participating whole life guaranteed premium for a $1 million death benefit will be augmented by non-guaranteed dividends that can either reduce the premiums or buy paid-up additions.
Static vs. Market Pricing
As previously noted, it is realistic to consider aggressively priced NLPGs as static-priced. In contrast, participating whole life and conventional universal life policies are market-priced. Although strictly speaking market-pricing refers to policy performance that is above conventionally set guarantees due to actual mortality experience and investment results being better, more realistically market-pricing is how actual pricing affects policy performance relative to expectations established via policy illustrations at various times.
Market-pricing is the only rational way of pricing for insurance companies with a commitment to fair treatment of all policies, because the factors that control pricing (mortality and investment yields) are going to change. Adjusting pricing as mortality and investment results are booked allows policies purchased 35 years ago or two years ago to receive essentially the same pricing during the times they are in force together.
Static-pricing can only have two aggregate outcomes. In retrospect, policies will either have been overpriced or underpriced because it is impossible to set pricing just right. Overpricing is a bad deal for NLPG policyholders. Underpricing is great, unless policies are too underpriced, causing the company to be seized by regulators because of solvency concerns.
We might think of NLPGs as constituting a defined-benefit policy design having level-to-maturity death benefits. For market-priced policies the premium costs associated with defined-benefit type policies can be estimated, but cant be known in advance and must change so that the policy does not become overfunded or underfunded. Although you may not have thought of this, most so-called vanishing-premium designs are defined-benefit in nature. The defined-benefit design can be distinguished from defined-contribution designs that have small initial death benefits relative to large fixed premiums with the expectation that the death benefits will increase at an estimated but uncertain rate. Participating whole life with dividend-buying paid-up additions are the prototype defined-contribution design.
While defined-contribution designs are trouble free, defined-benefit designs have been nothing but trouble. There are millions of defined-benefit designed policies (universal life, vanishing-premium and variable life) that are underfunded time bombs. This is why NLPGs, on first impression, are so appealing to agents, frustrated consumers and the media.
Defined-benefit universal life, vanishing premiums, and variable life are policy designs that favor the underfunding of permanent policies. This underfunding has had the implicit imprimatur of many companies. Informal underfunding with market-priced policies puts all of the risk on the policyholder (except for the occasional lawsuit). Now NLPGs are making underfunding an official strategy using static-priced policies. NLPGs are exciting because it is believed that they move the risk from policyowners to insurance companies.
NLPGs are static-priced defined-benefit designs that have relatively small or no cash values. Because of this, NLPGs have very limited uses. They should not be used:
Estate Planning Uses
It is liquidity for estate taxes that puts NLPGs on its natural turf. Compared to market-priced policies with a defined-benefit design, NLPGs have one potential advantage, two potential disadvantages and one potential disaster:
The Bottom Line
The marketing concept behind NLPGs promise of rock-solid, unconditional guarantees is a response to problems the life insurance business brought on itself with imprudent behavior that began in the early 1980s.
In response, many insurance companies have designed and are selling static-priced policies. Observation suggests that agents selling NLPGs rarely utter a discouraging word about them in pedal-to-the-medal selling. Thats too bad, because there is only one planning area where NLPGs are a good option, and even then it is probably a 50/50 proposition whether individual buyers would prefer a static-priced over a market-priced policy.
(For a report about the implications of replacing existing permanent insurance with a NLPG policy please go to www.peterkatt.com, Alerts, Tips & Information section, Vol. 5, No. 4 [May 2003] and click on the redacted report link embedded in the bulletin. Or, type the following address into your browser: http://peterkatt.com/ATI_newsletters/nolapsepremguarantees.html.)
Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advisor located in Kalamazoo, Michigan (269/372-3497; www.peterkatt.com). His book, The Life Insurance Fiasco: How to Avoid It, is available through the author.