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 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.
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.
|The yields displayed above are random returns used to show the impact of volatility within the sub–accounts. Cost of insurance is calculated by taking the prior year’s cash value, adding illustrated premium (if any), multiplying this result by the crediting rate or net investment yield, and subtracting the current year’s illustrated cash value.|
|*The cash value/death benefit ratio is lower than the targeted ratio range, but a “wait–and–see” approach is taken. If the ratio returns to range because of higher investment returns, then no reduction in death benefit will be needed.|
|**Assumes the insured is in good health, the ratio is considerably below range and the age is 70. The death benefit is reduced by $2,297,055 to pull the cash value/death benefit ratio to 50% and within range.|
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.
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.
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.