VUL Experts Want To Trim Blowup Exposure
Variable universal life insurance experts are keeping an eye on a problem they say could hurt VULs long-term viability.
This potential problem is the possibility that inadequately funded and/or poorly managed VULs might “blow up” some day, if and when certain conditions occur.
They are also proposing various preemptive strategies to help minimize chances the problem will ever occur.
“Blowup” is industry jargon for an actuarial no-no–i.e., a life policy “blows up” if its policy value drops to a point where it can no longer support the fees and charges needed to keep the coverage in force. Unless the owner sends in more money or takes other corrective action, the policy will crash, unleashing headaches for client, producer, and insurer.
It is important to note that no one is saying the wolf is at the door. But VUL leaders want to ensure it never gets there. When interest rates dropped in the late 1980s and early 1990s, they point out, the fixed universal life industry suffered a rash of blowups. “We dont want a repeat,” they say.
So far, “I havent heard of any lawsuits concerning VUL blowups,” reports Mark E. Thompson, principal of The Law Offices of Mark E. Thompson, APC, a Lancaster, Calif. firm that has dealt with many fixed UL blowups. But the point is, he says, “when policies are funded properly, the family comes out so much ahead, and its better for all.”
Notes Ben Baldwin, president and owner of Baldwin Financial Systems, Arlington Heights, Ill.: “Its a very complicated problem if we dont look at it, but its a very simple one if we do.”
This article highlights some key elements of that problem. The companion article lists some risk management strategies advisors and insurers might employ.
The blowup problem could surface anytime the policy value falls too low–say, in a stock market downturn and/or when key subaccounts yield poor results, says Baldwin. The risk is particularly strong if the VUL has been minimally funded, its assets have not been well diversified and monitored, and/or it has substantial policy loans.
Further, the threat rises as the policyowner ages, points out Richard M. Weber, president of The Ethical Edge, Inc., Carlsbad, Calif. Thats because the VULs cost of insurance (COI) charges rise with advancing age, and also with increased “net amount at risk.” The rising COIs eat into policy values, he explains.
Net amount at risk refers to the financial exposure insurers take on in covering a life–i.e., the difference between the specified amount and the cash value. Generally speaking, when VUL account values rise, the net amount at risk declines and so do the COI charges (because there is less exposure). But in a falling stock market (or, say, times of heavy policy loan activity) policy values fall, so the net amount rises and so do the COIs.
Other pricing mechanisms may help adjust for the rising charges–for instance, asset-based fees will decrease, experts point out. But over time, if COI increases become steep enough and no funds are added, threat of blowup increases.
An in-force “no lapse guarantee” would avert a crash, says John Fenton, principal with Tillinghast-Towers Perrin, in Atlanta. Thats because a guarantee assures the VUL will stay in force for a set period, regardless of account value, if required premiums are paid.
However, not all VULs offer such guarantees, Weber says, and price-conscious buyers typically “dont want them, because they are expensive.”
When threat of crash is imminent, the insurer notifies the owner and gives 90 days for deposit of additional funds, says Baldwin. But these notices often come as a surprise, he says. “People dont understand why the account value went down so fast.”
When fixed ULs suffered blowups a decade ago, he recalls, people would arrive at his office holding contracts he didnt sell. They demanded to know: “Why did this happen? I was told that if I paid premiums for so many years, Id never have to pay again!”
Others would say: “I exchanged my old policy for this one, and I was told I have plenty of money in the new contract–enough to last for the rest of my life!”
With VUL contracts, Baldwin maintains, companies typically send out annual notices that show the account values and policy status. But this information does not come frequently enough to help avert the sudden news of an imminent lapse, he contends. “As the stock market of 2001 proved, fund values can drop very fast,” he explains.
Weber says some VUL illustration systems, and some illustration percentages elected by producers, can lead to funding choices that set a policy up for trouble later on.
Many times, he explains, the producer may be in a competitive situation. Depending on the circumstances and the options the insurer has made available, this pressure may drive the agent to show the client the “best” illustration–i.e., the one producing the lowest premium. To do that, the rep “will illustrate, maybe, a 12% hypothetical return–as if it were a fixed return–and with current (not guaranteed) COIs,” he says.
The premium to endow at age 100 then becomes a very low minimum premium, he continues.
That may be attractive to the client, he says, “but the markets dont respond that way–with a fixed 12% return. And, even though the broad markets have averaged 13% over the past 50 years, the ups and downs create an increasing net amount at risk at the older ages–at the very time when what is required is a decreasing net amount at risk.”
Weber thinks illustrating an 8% gross assumed rate of return is much more realistic.
He says his studies show that there is barely a 10% chance that a policy on a 50-year-old written at the minimum premium (using that 12% rate) will sustain the coverage to age 100.
In one scenario–for a male nonsmoker, age 50, rated preferred–Weber found “youd have to increase the minimum premium by 40% to increase the probability of the mans policy successfully endowing at age 100, and youd have to double it to get near 100%.”
His concern is that clients who see such huge premium differences may opt to take the lower (minimum) premium, thereby paving the way for potential blowups later on.
Compounding matters is the tendency of people to think their VUL has guarantees when it doesnt, he says.
Weber blames some of this misconception on policy nomenclature. “For example, we are required to use the word premium to mean payments, just as with whole life insurance. This may lead owners to think premium in a VUL implies guaranteed coverage, as with WL.” VUL materials dont say that, he allows, but the wording may contribute to inaccurate expectations about what the VUL is likely to do.
Confusion about what is guaranteed and what is not can come from another area, too. This can happen when the producer presents two premium options, says Fenton of Tillinghast. These would be a higher premium, which is priced for the no-lapse guarantee feature, and a smaller premium, but without the guarantee.
In such situations, the client may elect the lower premium but “forget” the death benefit is not guaranteed under that option, he says. The prospectus and policy materials do discuss this, he says, but some clients may “think” the agent implied the policy death benefit is still guaranteed, as long as the premium is paid.
“So, what the customer thinks becomes the issue.”
This “thinking” can set the stage for policy funding decisions that may invite blowups later on, experts say.
Another contributing factor to blowups can be purchase of a VUL with a lump sum payment, says Robert Dehais, vice president-MetLife Financial Services, Bridgewater, N.J. Over time, that exposes the account value to stock market volatility more so than periodic payment would do, he contends.
Policies that dont have diversified assets and/or use automatic rebalancing can also be at risk later on, Dehais says. This could happen if one subaccount grows very large but then implodes in a big market downturn, leaving policy values severely depleted.
Fenton points out a related problem. “Say the owner puts most of the VULs money in a tech fund because it is doing well. Then, if the tech fund value drops by, say, 60%, assume the owner switches this money to the money market account. This switch effectively locks in the loss.”
That could make it harder for the owners poorly performing policy to recover, opening the door to possible threat of lapse.
Thompson, the attorney, worries that not enough people are looking at VUL illustrations closely enough or objectively enough. “I dont see many that are illustrated at 12% any more. But Im seeing a lot at 10%, and I dont think thats realistic,” especially when the policy is being used in a trust for estate planning purposes.
“We need to ask, what premium is realistically required for the policy to achieve its goals,” he says.
Some producers may be reluctant to ask the client to increase the premium a bit more to assure the that result, he says, “but I think its the only ethical way to do things.”
That can be difficult to do when the producer doesnt have all the data, says Baldwin. “The agent and the customer both need to be able to see the current net amount at risk on the policy and the monthly cost per $1,000 of specified amount, for instance. This should be accessible on a password- protected part of the Web site, and the agent should be allowed to discuss this information with the client.”
Right now, he says, many agents cant get this data. And “everything we show the customer has to be approved by the National Association of Securities Dealers, and NASD only approves sales and advertising material, not education material. That means, even if the agent can get this information, he or she cant use it with clients.”
Lacking that information, agents often struggle to explain to the client why or when they should consider making additional deposits or taking other defensive actions, says Baldwin. “This has got to change.”
Finally, he says, agent education about managing VUL needs to continue. “The flexibility we get with VUL is wonderful for the customers who want, and can live, with the risks. But, in return, people have to take responsibility for managing the policy, including the net amount at risk issues.”
In sum, he adds, “having information about the exposure (to blowups) and building client understanding–thats what will make the difference.”
Reproduced from National Underwriter Life & Health/Financial Services Edition, April 8, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.