Too Many Loans Out On A Policy? An Overloan Feature Could Help
A special “overloan provision” can provide real comfort and assurance to producers and their clients who plan to access their policy values at some time in the future.
This article discusses how such a provision can work in a variable universal life policy. But first, well review the problem the feature addresses.
This problem is the one that occurs if a policyholder takes too much money from the policy, creating a situation in which the owner must deposit more funds, take other policy management steps, or lapse the policy altogether.
Heres the background: A prominent application of universal life and VUL products enables such contracts to favorably grow account values. If the product is a non-modified endowment contract (non-MEC), the owner can also access these values on an attractive basisi.e., have the policys value distributed to the policyholder free of immediate recognition of income tax if certain rules are followed.
The general approach, when accessing these values, is to withdraw the basis first and then switch to policy loans (which, as you may recall, are not considered distributions subject to income tax).
However, since it is highly desirable for a life policy having a sizable loan to remain in force until the death of the insured, the policy needs to be managed properly. If the loan grows to the point where it equals the policy maximum loan, the policyholder has little, if any, net equity in the policy and the contract will be terminated.
Termination will trigger a taxable event that could far exceed the available cash, with very negative results to the client. The entire gross cash value must be recognized as gain, yet there is minimal or no real cash to pay the resulting tax. And, of course, death benefit protection, or what was left of it, then will have entirely disappeared.
The potential for this adverse situation can perhaps be seen most readily in a flexible premium VUL contract, but the implications are similar for other structures as well.
In such VULs, a company typically imposes a maximum ratio of loan to total cash value. Its typically 90%. Should the 90% be exceeded, then the company will either demand more money to reduce the ratio back below 90%, or it will lapse the contract. That leads to the onerous consequences described earlier.
It is possible, however, with use of careful design, to protect the client from such an adverse outcome.
An insurer can, at minimal cost, set up a structurethe overloan provision mentioned above–which makes it so that, if the critical ratio is breached, the insurer will maintain the policy in force without future cash outlay from the client. The feature would impose some limitation on the clients part, including a requirement that all funds be deposited into the fixed accounts.
What is the impact on the company of such a guarantee? The reality is that it is modest.
In assessing considerations for use of such a feature, we observe the following:
- The desired structure should have this feature included with the policy at time of issue, but not added post-issue. (Note: It may be possible to add it to an in-force block, but a number of issues outside the scope of this discussion must be addressed. Well cover that another time.)
- Set a minimum age at which the provision will become operative. In corporate owned life insurance scenarios, it might be 80. In individual life sales, it might be 85.
- Profits will continue to emerge for the company under most, if not all scenarios. Any negative impacts, should they occur, are negligible on a present value of profits basis.
- The structure works well under both the Guideline Premium Test and Cash Value Accumulation Tests, as defined in Section 7702 of the Internal Revenue Code.
- The desired structure discussed here works under both traditional life and UL insurance structures.
This is a special kind of no-lapse provision. Traditional no-lapse features typically keep coverage in force, as long as premiums (net of withdrawals on policy loans) meet or exceed certain required levels. With the overloan provision, however, the companys guarantee is to keep the policy in force should the ratio of loan to debt rise to levels that, without the guarantee, would force a termination.
In sum, adding an overloan feature to policies at point of sale is a way to enhance financial security, especially for customers who intend to access their policy values later on.
, FSA, MAAA, CLU, is president of Actuarial Strategies, Inc., Bloomfield, Conn. E-mail him at email@example.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, July 15, 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.