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Variable Universal Life: Astute Management Required

by Peter Katt

Variable universal life is a complex and difficult to manage life insurance asset. This column describes the issues, but purchasing such a policy requires astute guidance.

Variable universal life allows policyholders to control how their policies’ premiums are invested. Policyholders choose from a preset set of various sub-accounts, which are mutual funds. Due to the higher expenses, most variable universal life buyers select equity-based funds. Though this does provide the opportunity for higher returns, variable universal life policies invested in equities will have investment results that are volatile and unpredictable—with occasional dramatic cash value losses. This plays havoc with trying to select a premium schedule to follow.

This is an important distinction to pay attention to. Whole life and universal life policy premiums are mostly invested by the insurance company in investment-grade bonds held for yield. Therefore, investment results for whole and universal life policies will change relatively slowly and are backed by a minimum guarantee, which means the cash values can never take a loss. (However, the cash values can go down when policy expenses exceed the crediting amount.) In contrast, the cash values associated with variable universal life policies can suffer dramatic losses.

Variable Universal Life Risks

Variable universal life has often been treated as just a better-performing version of whole or universal life, even though the inherent investment volatility of the equity exposure makes it a very different kind of life insurance. The major reason why the unique risks are not understood is due to variable universal life illustrations. Agents and buyers get their primary understanding about life insurance by viewing illustrations provided by the insurance company. Illustrations show how a policy is designed to perform based on the premiums, insurance costs and constant investment yields. This presentation creates the illusion of certainty. However, the investment volatility of the equities funding a variable universal life policy can produce large losses in a very short period of time—with no guarantee that subsequent gains will offset the losses any time soon. There is also the additional possibility that a policyholder will exit the equity funds near the bottom of the market, thereby removing any participation in a stock market recovery. These possibilities simply cannot be seen by viewing variable universal life illustrations.

By far the largest problems with variable universal life involve policies with level death benefits. It is impossible to know the amount and the timing of premiums with such investment volatility. The extent of this target premium malfeasance can be seen by doing probability studies such as Monte Carlo testing. (Monte Carlo is a statistical technique that uses random numbers to simulate a particular phenomenon—in this case, gross annual investment returns funding a specific life insurance policy—over and over again in order to make an educated assessment about the likelihood of particular events occurring.)

If measuring outcome probabilities were routinely used when considering the purchase of level death benefit variable universal life policies, few such policies would be purchased. This is because it would become obvious that there is no way to manage premiums with the inherent investment volatility.

Policyholders have approached me with variable universal life policies that have fallen apart due to significant equity sub-account losses. The losses caused the current cash values and illustrated target premiums to become incapable of properly supporting the policy. As a result, policyholders face the prospect of paying large premiums, which seem like the equivalent of a margin call, in order to maintain a certain level of death benefit. This is when they seek help.

Using Variable Universal Life

Despite the risks, variable universal life can be used for an individual’s life insurance needs. Specifically, there are two reasonable options when a client wishes to use variable universal life in their life insurance portfolios. One is a design with much lower death benefits relative to premiums combined with a unique policy management approach. The other option is a new guaranteed premium variable universal life policy that I briefly discuss at the end of this article.

Variable universal life can be part of the life insurance portfolio with astute management. A case study and demonstration explain why. A client with a $15,000,000 level death benefit variable universal life policy and $2,900,000 of cash value was underfunded because the actual investment performance was much less than illustrated. We also had no idea what future premiums should be because of investment volatility.

To determine a strategy, I did a Monte Carlo test and determined a 50% failure probability, measured around the life expectancy of the policyholder without the payment of large premiums at some unknown time. The client decided to retain the variable universal life policy but not pay any additional premiums. The solution was to reduce the death benefits relative to the current cash values.

Specifically the death benefits were reduced from $15,000,000 to $6,000,000, while maintaining the $2,900,000 cash value. The death benefits were changed to the specified amount plus the cash values, or total initial death benefit of $8,900,000. This amount of initial death benefit and cash value allows the policy to become paid-up at age 100 at a constant assumed fixed-income rate of 4%, making it a conservative ratio of cash values to death benefits, and allowing for the potential that the death benefits will experience a significant increase over time. I calculated the ratio of cash values to death benefits for every year to 100.

My variable universal life management system relies on establishing these cash value/death benefit ratios. It also creates death benefit flexibility by allowing death benefits to change in response to the level of investment returns plus cash values.

Three components are important because of the inherent level of volatility in equities. One is establishing the cash value/death benefit ratios. The second is a design that allows the death benefits to increase when investment results are positive, but to decline when investment results are negative. The third component is the ability to reduce death benefits when the cash value/death benefit ratios become too low over several years.

Table 1 shows a demonstration of my variable universal life management system using randomly selected investment yields that average 10.83%, net of direct investment expense. The cash value/death benefit ratios were established using variable universal life’s illustrated cost of insurance and a fixed 4% yield. This pricing supported level death benefits of nearly $9,000,000. The cash value/death benefit ratio increases with an insured’s age so that it is 100% at age 100 for this particular policy. The goal is for the cash value to equal the death benefit at age 100. This is the definition of permanent insurance.

Age Beginning
Cash Value
($)
Yield
(%)
Cost of
Insurance
($)
End
Cash Value
($)
Death
Benefit
($)
Ratio
Range
(%)
Cash Value/
Death Benefit
Ratio 
(%)
55 2,703,096 8.62 51,360 2,884,743 8,884,743 34–38 32
56 2,884,743 35.49 68,400 3,840,138 9,840,138 34–38 39
57 3,840,138 40.61 77,340 5,322,278 11,322,278 34–38 47
58 5,322,278 –11.42 80,040 4,634,434 10,634,434 34–38 44
59 4,634,434 –27.90 85,140 3,256,278 9,256,287 34–38 35
60 3,256,278 –46.34 90,360 1,656,959 7,656,959 38–45 22*
61 1,656,959 –11.19 96,000 1,375,545 7,375,545 38–45 19*
62 1,375,545 50.99 101,580 1,975,355 7,995,355 38–45 25*
63 1,975,355 –4.44 68,400 1,819,249 7,819,249 38–45 23*
64 1,819,249 44.67 72,540 2,559,368 8,559,368 38–45 30*
65 2,559,368 30.92 76,980 3,273,745 9,273,745 45–52 35*
66 3,273,745 36.03 81,600 4,371,675 10,371,675 45–52 42*
67 4,371,675 28.12 87,540 5,513,450 11,513,450 45–52 48
68 5,513,450 –3.41 93,900 5,231,541 11,231,541 45–52 47
69 5,231,541 –12.78 100,740 4,462,210 10,462,210 45–52 42*
70 4,462,210 –14.59 108,240 3,702,934 9,702,934 52–60 38**
71 3,702,934 17.34 71,912 4,273,111 7,976,045 52–60 54
72 4,273,111 33.44 77,726 5,538,851 9,241,785 52–60 60
73 5,538,851 –11.07 84,169 4,841,531 8,544,465 52–60 57
74 4,841,531 2.71 91,575 4,881,161 8,584,095 52–60 57
75 4,881,161 2.50 99,907 4,903,283 8,606,217 60–68 57*
76 4,903,283 15.79 109,350 5,568,161 9,272,095 60–68 60
77 5,568,161 28.71 120,014 7,046,766 10,750,700 60–68 66
78 7,046,766 21.02 132,012 8,395,984 12,098,918 60–68 69
79 8,395,984 15.37 145,680 9,541,067 13,244,001 60–68 72
80 9,541,067 –3.99 160,118 9,000,260 12,704,194 68–75 71
81 9,000,260 49.62 176,337 13,289,852 16,992,786 68–75 78
82 13,289,852 28.56 196,815 16,891,619 20,594,553 68–75 82
83 16,891,619 3.56 212,700 17,280,261 20,983,195 68–75 82
84 17,280,261 –13.78 232,993 14,666,048 18,368,982 68–75 80
85 14,666,048 –11.73 254,692 12,691,029 16,393,963 75–82 77
86 12,691,029 –13.06 277,688 10,755,893 14,458,827 75–82 74*
87 10,755,893 –2.53 302,091 10,181,678 13,884,612 75–82 73*
88 10,181,678 23.89 327,790 12,286,291 15,989,225 75–82 77
89 12,286,291 40.36 354,858 16,890,180 20,593,114 75–82 82
90 16,890,180 19.80 383,298 19,851,138 23,554,072 82–89 84

The calculations using the cash value/death benefit ratios are relevant as long as the insured’s health is good. If an insured’s health were to substantially deteriorate, maintaining the correct ratio may no longer be important because the death of the insured may be highly predictable within some specified number of years.

Should a cash value/death benefit ratio deficit occur, the shortfall can be made up for with additional premium payments. Anytime a correction in the calculations is needed due to a shortfall in actual returns, reducing the death benefit or paying additional premiums will be considered, and sometimes a combination can be used.

Understand that a variable universal life policy requires constant monitoring. Real problems occur when the policy is left unattended, but with astute management, these policies can be handled.

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Guaranteed Premium

Some companies are now offering variable universal life policies with guaranteed premiums and death benefits. This takes away the possibility that poor investment results can cause variable universal life policies to terminate as long as the guaranteed premiums are paid. But the cost for this benefit is very high compared with universal life guarantees.

In a case I recently worked on, the difference in guaranteed premiums between variable universal life and universal life was 87%. For clients with confidence in the long-term health of stocks and the ability to pay the much larger premiums, guaranteed variable universal life may be an ideal life insurance asset. But it is my suspicion that there won’t be many takers for them.

Conclusion

Variable universal life is a particularly difficult life insurance asset because there is a large gap between buyer expectations and reality. This is due to investment volatility that is not shown in sales presentations. My contact with variable universal life policyholders has been unanimously negative. However, clients with significant confidence in long-term stock performance can use these policies in their life insurance portfolios. One option is to use the management system described in this column, the other is to purchase the new, high-priced guaranteed variable universal life policy.

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.


Discussion

Ken from GA posted over 4 years ago:

Very interesting article. I find it interesting that there is no mention of the impact of "tax free" loans and withdrawals -- often the major emphasis from agents in pitches for these types of policies -- and the author focuses on life insurance, in fact, being life insurance. So that does beg the age old question -- would a policy holder have been better off buying term or more conventional whole life insurance and avoiding the risk associated with variable life. On a personal note, I do own one of these types of polices, albeit much, much smaller than the example given. Although I have not been terribly happy with cash values performance, I have tried to make "lemonade out of lemons" by taking loans for purposes such as IRA contributions and premiums on other insurance policies while monitoring the account to make sure it is adequate to maintain the policy (I do pay back the loans).


Ryan from WA posted over 3 years ago:

I don't understand. Why would anyone ever buy universal life insurance?

Term insurance costs a tiny fraction of what universal costs (for identical coverage), and if I invest the difference that I've saved, I'll make WAY more money than the policy ever will.

Plus, under some policies, your benefitiaries don't even get to keep the "cash value" when you die. The insurance company just pockets it!


J Altenburg from NJ posted about 1 year ago:

I am still struggling to understand this product years after someone first tried to sell it to me. My view is that for most people, including myself, life insurance products should be straigtfoward and provide a high degree of certainty in both payments and proceeds. That is certainly not the case here. There are tax advantages, but after commissions to the insurance agent and management fees on a limited number of investment fund choices, I'm doubtful that those tax advantages make it worthwhile. As for the guaranteed variable universal life premium product, I would rather by a 10 to 20 year level premium term policy and a deferred annuity policy, each from different companies. At least you know what you are getting and you can obtain the coverages at the lowest price.


John Kollhoff from KS posted about 1 year ago:

@J Altenburg- You are not limited on investment choices. My wife and I are using the cash value in our life insurance for multiple investments: rental properties, purchasing a small business, and soon we will be using it to invest in a hotel project. Each of these investments is returning over 10%, which is a leveraged return, so cash-on-cash return is almost 100 percent. I'll get back to you on the hotel once it is operating.


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