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Adjustable life insurance: Pros and cons

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Adjustable life insurance is a “flexible premium” “adjustable death benefit” type of permanent cash value insurance. It is essentially a hybrid combination of universal life and ordinary level premium participating life insurance.

See also: Whole life vs. term: There’s a clear winner here

In contrast with ordinary level premium, level death benefit policies and similar to universal life, adjustable life insurance gives the policyowner the flexibility to change the plan of insurance.

That is, within limits, the policyowner may change the premium and/or the level of death benefit. Note that when policyowners make changes to an adjustable life insurance contract, the guarantee period will also change. In general, the policyowner may:

    • increase or decrease the premium;
    • increase or decrease the face amount;
    • lengthen or shorten the guaranteed protection period; and/or
    • lengthen or shorten the premium payment period.

Increases in the face amount usually require evidence of insurability. Also, an increase in premiums requiring an increase in the face amount to stay within the definition of life insurance guidelines of Code section 7702 usually will require evidence of insurability.

Despite its similarities, do not confuse adjustable life insurance with universal life, which is often called flexible premium adjustable life. Direct-recognition, current assumption policies, such as universal life, “unbundle” the policy elements and explicitly show mortality and expense charges and interest credits. In addition, they credit interest directly to cash values.

In contrast, most adjustable life insurance policies’ elements are bundled. Like traditional participating policies, the pure protection and savings components are not segregated or stated separately. However, policyowners may make partial surrenders, up to the sum of premiums they have paid, without surrendering the entire policy, or paying income tax (assuming the policy is not treated as a modified endowment contract).

Like many participating policies in the market today, most adjustable life policies are “indirect recognition interest sensitive” or “indirect recognition current assumption” policies. The insurance company’s favorable investment, mortality, and expense experience are indirectly reflected in the level of dividends that the company actually pays, or directly reflected as additional credits to cash values.

In addition to the bundled nature of its policy elements, adjustable life has all the usual features of ordinary level premium whole life insurance including:

    • a minimum interest guarantee;
    • guaranteed maximum mortality charges;
    • cash values;
    • nonforfeiture values;
    • a policy loan provision;
    • dividend options;
    • a reinstatement period; and
    • settlement options.

Similar to other traditional forms of insurance, various options or riders are available including:

    • waiver of premium;
    • guaranteed purchase or insurability;
    • accidental death benefits; and
    • cost of living adjustments.

Although the policyowner has flexibility in selecting the plan of insurance, changes are generally permitted only at specified intervals and with advance notice to the insurer. Between adjustment periods, the policy is a level premium, level death benefit policy. Depending on the particular premium and death benefit levels chosen, the policy can assume the form of almost any traditional term or whole life policy from low-premium term through ordinary whole life to high premium, limited pay whole life.

Policyowners generally may ask to set premiums to zero without the policy lapsing (or without invoking the automatic policy loan provision), although this virtually always requires notice to the insurer. The minimum annual premium is typically equivalent to the premium for a five-year term policy. In contrast with UL and similar to ordinary level premium policies, once a policyowner has selected a given plan of insurance, the policyowner must pay premiums as scheduled unless the policyowner notifies the insurer of his or her desire to change the plan of insurance. The plan of insurance defines the length of the guarantee at any point in time. The insurance company computes the schedule of cash values based on the current program of premium payments, the face value, and the term or duration of coverage. The insurance company recomputes the cash value schedule each time the policyowner opts to change the plan of insurance.

Tools & Techniques of Life Insurance PlanningContinue reading to explore when adjustable life insurance is necessary, as well as its pros and cons, from the 6th Edition of ”The Tools & Techniques of Life Insurance Planning” (2015, The National Underwriter Company).

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15 legal issues every life insurance policy should address

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Who is well-suited to adjustable life insurance?

Insurance shoppers can consider adjustable life for almost any life insurance need. Initially, the policyowner can have the insurance company configure an adjustable life policy’s death benefit and premium level to resemble virtually any type of life insurance policy from five-year term insurance to single premium whole life. However, because of policy costs, AL is generally best suited for longer-term coverage needs.

For short-term coverage needs where future insurability is not a factor, a nonrenewable term policy generally would be more cost effective. Here are three specific scenarios in which adjustable life may be a solution.

Reason No. 1: Adjustable life is indicated whenever insureds need or desire greater flexibility over time in life insurance coverage, need or want guaranteed protection, and prefer the forced savings feature of ordinary level premium whole life insurance. Policyowners whose circumstances change can later reconfigure the policy by changing the schedule of premium payments and/or the face amount or duration of coverage.

Reason No. 2: The insurance industry has marketed adjustable life as the only policy a person will ever need. The flexibility makes it very useful in the family market. For example, a young parent with a growing family and modest income can acquire an AL policy that is initially configured with low premiums and a high death benefit to resemble a traditional term policy. As the parent’s income grows, they can increase the scheduled premiums to build up tax-sheltered cash within the policy. At later times when they need cash, such as to pay for children’s educations, they can reduce the scheduled premiums. The policyowner can use partial surrenders or policy loans to help pay the school expenses. After a time, the policyowner can increase scheduled premiums, once again, to build cash values that policyowner and spouse can use for their retirement. Similarly, if the amount of death protection that is needed changes, the policyowner may increase or decrease the death benefit or reduce or extend the term of coverage. Keep in mind, increases in death benefits usually will require evidence of insurability. Each time the policyowner requests a change, the insurance company recalculates the guarantee period.

Reason No. 3: The flexibility of adjustable life also makes it suitable for many business life insurance needs. adjustable life offers a conservative and guaranteed vehicle for all sorts of business applications where the policyowner may frequently require adjustments in death benefits and/or cash accumulations, including split-dollar plans, nonqualified deferred compensation plans, death benefit only plans, key person insurance, buy/sell agreements, retiree benefits funding, and in qualified retirement plans that use insurance.

Continue reading to explore to advantages and disadvantages of adjustable life insurance.

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Advantages of adjustable life

Advantage No. 1: Policyowners have discretion or flexibility in selecting the schedule of premiums that they will pay until they next request a change in the plan of insurance.

Advantage No. 2: Similar to ordinary level premium whole life policies, once a policyowner has chosen a premium payment plan, the policy has an element of forced saving until the policyowner requests a change in the premium payment plan. Many people who lack the discipline to continue a regular savings program will find this feature attractive.

Advantage No. 3:  The policyowner may change the face amount of coverage or the term of coverage. The insurance company will permit decreases in the face amount of coverage at virtually any time. Policyowners who reduce death benefits within the first seven years of issue should do so only with the advice and counsel of their insurance advisers because such death benefit reductions may subject them to adverse tax consequences under the Modified Endowment Contract (MEC) rules. Insurance companies generally permit increases in face amounts, subject to evidence of insurability. Increases in the death benefit may also subject the policy to a new test period under the MEC rules. (See discussion under “Tax Implications” below).

Advantage No. 4: Most AL policies offer a cost of living agreement that automatically increases the face amount in response to increases in the CPI without evidence of insurability. Commonly, the premium is also correspondingly adjusted upwards.

Advantage No. 5: Cash value interest or earnings may accumulate tax-free or tax-deferred, depending on whether gains are distributed at death or during lifetime.

Advantage No. 6:  The cash values are not subject to the fluctuations in market value characteristic of longer-term municipal bonds and other longer-term fixed income investments when market rates change.

Advantage No. 7:   Policyowners can borrow policy cash values at a low net cost. Although policyowners must pay interest on policy loans, cash values continue to grow and are credited with at least the minimum guaranteed rate in the policy. Consequently, the actual net borrowing rate is less than the stated policy loan rate.

See also: 

10 advantages of term life insurance

9 more things to know about whole life insurance

Disadvantages of adjustable life

Disadvantage No. 1:  Some adjustable life policies, similar to many ordinary whole life policies, use what is called the direct recognition method to determine how favorable investment, mortality, and expense experience is allocated to dividends on policies with policy loans. Under this method, the insurance company reduces the amount of dividends allocated to policies with policy loans to account for the generally lower yield the company earns on policy loans relative to other investments in their general portfolio. Companies most commonly use the direct recognition method in policies with fixed policy-loan rates. Typically, policies with variable-loan rates, and some others with fixed-loan rates, do not employ the direct recognition method and instead allocate dividends without regard to loans. There are also some AL policies that do not have dividends, but credit current mortality and interest to cash values, similar to UL.

Disadvantage No. 2: Lifetime distributions or withdrawals of cash values are subject to income tax to the extent attributable to gain in the policy.

Disadvantage No. 3:  Surrender of the policy within the first five to ten years may result in considerable loss because cash surrender values reflect the insurance company’s recovery of sales commissions and initial policy expenses.

Disadvantage No. 4: Interest paid on policy loans generally is nondeductible.

Disadvantage No. 5: The flexibility with respect to premium payments and death benefits permits policyowners to change the policy in such a way that it may inadvertently become a modified endowment contract (MEC) with adverse tax consequences.

See also:

How to compare life insurance policies

5 alternatives to Indexed Universal Life insurance

7 things you need to know about term life insurance

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