Some life insurers could have serious universal life insurance pricing problems.[@@]

Analysts at Moody’s Investors Service, New York, come to that conclusion in a report on “secondary guarantees” sold with aggressively priced UL policies that emphasize death benefits rather than cash value.

A UL policy is a flexible-premium life insurance policy. The issuing insurance company deducts mortality expenses from policy values and increases accumulated cash values by applying a crediting rate based on the interest rates that the insurer earns on its own investments.

The secondary guarantees discussed in the report include no-lapse guarantees and “shadow account” guarantees that keep policies from lapsing even when high mortality costs and poor insurer investment performance drive policy cash values to 0.

Life insurers hope that interest rates will be high enough to help them support the guarantees, and that some policyholders will drop their coverage and let surrender charges flow into the accounts that back other policies.

Under most conditions, life insurer UL assumptions should work well, but, if interest rates stay low and low interest rates encourage customers to hold on to their policies longer than expected, aggressive “insurers writing these policies could suffer potentially large losses,” the Moody’s analysts warn.

Most insurers are assuming that they will earn at least 4% interest per year on their investments and experience lapse rates of at least 4% per year, the analysts write.

“Because of the long-term nature of the product, an error of even 1 [percentage point] in the lapse rate can have a material impact on product profitability,” the analysts write.

Lower-than-expected interest rates also can have a big effect on product profitability, and policyholders are more likely to keep their UL policies when low interest rates make other investment opportunities seem unattractive, the analysts write.

Moreover, investors are starting to buy poorly performing UL policies from unhappy policyholders through life settlements, and the expansion of the life settlement market could increase persistency even more, the analysts write.

The analysts describe several UL policy scenarios. If the insurer’s investment yield were 7%, its lapse rate were 6% and its mortality were 100% of the expected level, it might earn about $20,000 on a $1 million “sum assured” UL policy, the analysts estimate.

If the insurer had an investment yield of only 3%, a 2% lapse rate and mortality that was 200% of the expected rate, it might lose more than $100,000 on the same policy, the analysts write.