Chapter 19 Mortality Risk Management: Individual Life Insurance and Group Life Insurance

Effects of the Level Premium Plan

From an economic standpoint, the level premium plan does two things. First, the insurer offers an installment payment plan with equal payments over time. Second, the level premium policies are made up of two elements: protection and investment.

As discussed, although the periodic premium payments exceed death benefits and other expenses for an insured group during the early years of the policy, they fall short during later years (see Figure 19.2 "Yearly Renewable Term Premium and Level Premium for Ordinary Life (Issued at Age Twenty-Five)"); consequently, the insurer accumulates a reserveIn life insurance, funds accumulated to offset the deficiency of periodic premium payments falling short of providing promised death benefits in later years of a policy. to offset this deficiency. The insurer’s reserve is similar in amount, but not identical, to the sum of cash values for the insured group. The reserve is a liability on the insurer’s balance sheet, representing the insurer’s obligation and reflecting the extent to which future premiums and the insurer’s assumed investment income will not be sufficient to cover the present value of future claims on a policy. At any point, the present value of the reserve fund, future investment earnings, and future premiums are sufficient to pay the present value of all future death claims for a group of insureds. When an insured dies, the insurer is obligated to pay the beneficiary the face amount (death benefit) of the policy. Part of this payment is an amount equal to the reserve.

The difference between the reserve at any point in time and the face amount of the policy is known as the net amount at riskFor the insurer, the difference between the funding reserve at any point in time and the face amount of the policy. for the insurer and as the protection elementFor the insured, the difference between the funding reserve at any point in time and the face amount of the policy. for the insured. As Figure 19.2 "Yearly Renewable Term Premium and Level Premium for Ordinary Life (Issued at Age Twenty-Five)" illustrates, this element declines each year because the reserve (investment or cash value) increases. The protection/net-amount-at-risk element is analogous to decreasing term insurance. All level premium life policies have a combination of cash value and protection.

The amount at risk for the insurer (that is, the protection element) decreases as the cash value element increases with age; thus, less true insurance (protection) is purchased each year. This decreasing amount of insurance is one of the reasons why the annual cost of pure insurance (that is, the protection element) to the insurer is less than the sum of the level premium plus investment earnings, even at advanced ages when mortality rates significantly exceed the premium per $1,000 of death benefit. Over time, the growing amount of investment earnings (due to increasing cash value) more than offsets the inadequacy of the level premium. The periodic addition of part of these investment earnings to cash value explains why the cash value in the policy continues to grow throughout the life of the contract (see Figure 19.3 "Proportion of Protection and Cash Value in Ordinary Life Contract (Issued to a Male Age Twenty-Five)").

Figure 19.3 Proportion of Protection and Cash Value in Ordinary Life Contract (Issued to a Male Age Twenty-Five)

This graph shows the cash value (investment) figures for a selected ordinary life policy. The insurer’s reserve would be slightly higher than the cash value in the early contract years.

From an insurer’s perspective, the reserve is a liability that will have to be paid when the insured either dies or surrenders the policy. The separation of a whole life policy into protection and investment elements is an economic or personal finance concept rather than an actuarial one. Actuaries deal with large groups of insureds rather than individual policies; they look at an individual policy as an indivisible contract.

The cash value is classified as an asset on the policyholder’s personal balance sheet because it is the policy owner’s money. There are three ways to realize the cash value:

1. Surrender (discontinue) the policy and receive the cash value as a refund
2. Take a loan for an amount not to exceed the cash value
3. Leave the cash value in the contract and eventually let it mature as part of the death claim

Duration

The length of term policies varies; common terms are one, five, ten, fifteen, and twenty years. Term policies are often not renewable beyond age sixty-five or seventy because of adverse selection that increases with age. Increasingly, however, yearly renewable term policies are renewable to age ninety-five or one hundred, although it would be unusual for a policy to stay in effect at advanced ages because of the amount of the premium. Yearly renewable term policies are subject to high lapse ratesIn term life insurance, failure to renew policies. (that is, failure to be renewed) and low profitability for the insurer.

Short-term life insurance policies involve no investment element. Long-term contracts (e.g., term to age sixty-five), when accompanied by a level premium, can accumulate a small cash value element in the early years, but this is depleted during the latter part of the term because then the cost of mortality exceeds the sum of the level premium and the investment earnings. Two options are typically available with term insurance sold directly to individuals: renewability and convertibility.

Renewability

If the policyholder wishes to continue the protection for more than one term, the insurer will require a new application and new evidence of insurability. The risk of being turned down may be handled by purchasing renewable term insurance. The renewability optionIn term life insurance, gives the right to renew the policy for a specified number of additional periods of protection at a predetermined schedule of premium rates without new evidence of insurability. gives the policyholder the right to renew the life insurance policy for a specified number of additional periods of protection, at a predetermined schedule of premium rates, without new evidence of insurability. Renewability protects insurability for the period specified. After that period has elapsed, the insured must again submit a new application and prove insurability.

Each time the policy is renewed, the premium increases because of the insured’s increasing age. Because the least healthy tend to renew and the most healthy tend to discontinue, the renewable feature increases the cost of protection. The renewable feature, however, is valuable in term life insurance.

Convertibility

A term life policy with a convertibility optionIn term life insurance, provides the right to convert the policy to a whole life or another type of insurance before a specified time without proving insurability. provides the right to convert the term policy to a whole life or another type of insurance, before a specified time, without proving insurability. If, for example, at age twenty-eight you buy a term policy renewable to age sixty-five and convertible for twenty years, you may renew each year for several years and then, perhaps at age thirty-six, decide you prefer cash value life insurance. Your motivation may be that the premium, though higher than that of the term policy at the age of conversion, will remain the same year after year; the policy can be kept in force indefinitely; or you may want to include cash values among your investments. If you become uninsurable or insurable only at higher-than-standard (called substandard) rates, you will find the convertibility feature very valuable.

Most life insurance conversions are made at attained age premium ratesIn life insurance conversion, when the premium for the new policy is based on the age at the time of the conversion., meaning that the premium for the new policy is based on the age at the time of the conversion. The insured or policyowner pays the same rate as anyone else who can qualify for standard rates based on good health and other insurability factors. The option results in no questions about your insurability.

Death Benefit Pattern

The death benefit in a term policy remains level, decreases, or increases over time. Each pattern of protection fits specific needs. For example, a decreasing term policy may be used as collateral for a loan on which the principal is being reduced by periodic payments. An increasing amount of protection helps maintain purchasing power during inflation. The increasing benefit is likely to be sold as a rider to a level benefit policy.

Mortgage protection insuranceDecreasing term insurance; with each mortgage payment, the face value of the insurance decreases to correspond to the amount of the loan that is outstanding. is decreasing term insurance; with each mortgage payment, the face value of the insurance decreases to correspond to the amount of the loan that is outstanding. Otherwise, mortgage protection is like other decreasing term policies.Before buying a mortgage protection policy, consider the pros and cons of paying off your mortgage at the time of death. Will your spouse’s income be sufficient to meet the mortgage payments? Is the interest rate likely to be attractive in the future? Will the after-tax interest rate be less than the rate of growth in the value of the house, resulting in favorable leverage? Credit life insurance is similar to mortgage protection. In credit life insuranceProvides that the death benefit changes, up or down, as the balance changes on an installment loan or other type of consumer loan., the death benefit changes, up or down, as the balance changes on an installment loan or other type of consumer loan.

Premium Patterns

An insurer’s rates for nonsmokers may be 40 percent or so lower than those for smokers. Rates for women are less than for men (see the box “Should Life Insurance Rates Be Based on Gender?” in Chapter 17 "Life Cycle Financial Risks"). The yearly renewable term contract usually has a table of premiums that increase each year as the insured ages and as time elapses since insurability was established.

Reentry termIn life insurance, allows the insured to re-demonstrate insurability periodically, perhaps every five years, and qualify for a new (lower) select category of rates that are not initially loaded for adverse selection. allows the insured to demonstrate insurability periodically, perhaps every five years, and qualify for a new (lower) select category of rates that are not initially loaded for adverse selection. If the insured cannot qualify for the new rates, usually because of worsening health, he or she can either pay the higher rates of the initial premium table (ultimate rates) or drop the policy and try to find better rates with another insurer.

Summary: Features of Term Life

In summary, in term life we see the following features (see also Table 19.1 "Characteristics of Major Types of Life Insurance Policies"):

• Death benefits: level or decreasing
• Cash value: none
• Premiums: increase at each renewal
• Policy loans: not allowed
• Partial withdrawals: not allowed
• Surrender charges: none

Straight Life

The premiums for a straight lifeForm of whole life insurance where premiums are paid in equal periodic amounts over the life of the insured. policy are paid in equal periodic amounts over the life of the insured. The rate is based on the assumption that the insured will live to an advanced age (such as age ninety or 100). In effect, the insured is buying the policy on an installment basis and the installments are spread over the balance of the lifetime, as explained earlier in our discussion of the level premium concept. This provides the lowest possible level outlay for permanent protection.

As shown in Figure 19.3 "Proportion of Protection and Cash Value in Ordinary Life Contract (Issued to a Male Age Twenty-Five)", the level premium policy consists of a protection element and a cash value element. The cash value builds over time, and eventually, when the insured is ninety or one hundred, the cash value will equal the face value of the policy. If the insured is still alive at this advanced age, the insurer will pay the death benefit as if death occurred. By this time, no real insurance element exists. The options available with regard to this value are discussed later in this chapter. A basic straight life policy typically has a face amount (death benefit) that remains level over the lifetime. The pattern can change, however, by using dividends to buy additional amounts of insurance or by purchasing a cost-of-living adjustment rider.

Limited-Payment Life

Like straight life, limited-payment lifeForm of whole life insurance that offers lifetime protection but limits premium payments to a specified period of years or to a specified age; after premiums have been paid during the specified period, the policy remains in force for the balance of life without further premium payment. offers lifetime protection but limits premium payments to a specified period of years or to a specified age. After premiums have been paid during the specified period, the policy remains in force for the balance of the insured’s life without further premium payment. The policy is “paid up.” A twenty-pay life insurance policy becomes paid up after premiums have been paid for twenty years, a life-paid-up-at-sixty-five becomes paid up at age sixty-five, and so on (see Figure 19.4 "Protection and Cash Value Elements for Single-Premium and Installment Forms of Cash Value Life Insurance"). The shorter premium payment period appeals to some buyers. For example, a life-paid-up-at-sixty-five policy ends premiums around the time many people expect to begin living on retirement pay. If the insured dies before the end of the premium-paying period, premium payments stop and the face amount is paid. These policies are mainly sold as business insurance where there is a need to pay fully for a policy by a certain date, such as the time an employee will retire.

Single-Premium Life

Whole life insurance may be bought for a single premium—the ultimate in limited payment. Mathematically, the single premiumForm of life insurance where the only premium paid is an amount equal to the present value of future benefits, with discounts both for investment earnings and mortality. is the present value of future benefits, with discounts both for investment earnings and mortality. Cash and loan values are high compared with policies bought on the installment plan (see Figure 19.4 "Protection and Cash Value Elements for Single-Premium and Installment Forms of Cash Value Life Insurance"). Single-premium life insurance is bought almost exclusively for its investment features; protection is viewed as a secondary benefit of the transaction.

Figure 19.4 Protection and Cash Value Elements for Single-Premium and Installment Forms of Cash Value Life Insurance

Note: Hypothetical values not drawn to scale.

Investment Aspects

The typical buyer of life insurance, however, does not expect to pay income taxes on proceeds from his or her policy. Instead, the expectation is for the policy to mature eventually as a death claim. At that point, all proceeds (protection plus cash value) of life insurance death claims are exempt from income taxes under Section 101(a)(1). In practice, most policies terminate by being lapsed or surrendered prior to death as needs for life insurance change.

Life insurers offer participation in portfolios of moderate-yield investments, such as high-grade industrial bonds, mortgages, real estate, and common stock, in which cash values are invested with potentially no income tax on the realized investment returns. Part of each premium, for all types of cash value life insurance, is used to make payments on the protection element of the contract, but the protection element also has an expected return. This return is equal to the probability of death multiplied by the amount of protection. Thus, the need to pay for protection in order to gain access to the cash value element of a single-premium or other investment-oriented plan should not be viewed as a consumer disadvantage if there is a need for additional life insurance protection. The participation (dividend) feature of a policy has a major effect on its cost and worth.

Participation Feature

Mutual life insurers have always sold their term and cash value life products on a participation basis. Stock life companies have also made limited use of participating policies. Participating whole life contracts pay dividendsPaid by participating whole life contracts to insureds for the purpose of refunding higher-than-necessary premiums and sharing company profits with policyowners. for the purpose of refunding higher-than-necessary premiums and sharing company profits with policyowners. Thus, as investment returns escalate above previous expectations, or as mortality rates decline, the policyowners share in the success of the insurer.

DividendsPaid by participating whole life contracts to insureds for the purpose of refunding higher-than-necessary premiums and sharing company profits with policyowners. allow the sharing of current profits from investments, mortality assumptions, expense estimates, and lapse experience with the policyholder. Investment returns usually have more influence on the size of dividends than do the other factors. The fact that insurer investment portfolios tend to have many medium- and long-term bonds and mortgages that do not turn over quickly creates a substantial lag, however, between the insurer’s realization of higher yields on new investments and the effect of those higher yields on average portfolio returns that affect dividends.

Participating whole life insurance continues to be a major product line for mutual insurers. Sales illustrations are used by agents in presenting the product to the consumer. For products with the participation feature, dividends projected for long periods into the future are a significant part of the sales illustration. Generally, the illustrations are based on the current experience of the insurer with respect to its investment returns, mortality experience, expenses, and lapse rates.

Summary: Features of Whole Life

In summary, in whole life we see the following features (see also Table 19.1 "Characteristics of Major Types of Life Insurance Policies"):

• Death benefits: fixed level
• Cash value: guaranteed amounts
• Premiums: fixed level
• Policy loans: allowed
• Partial withdrawals: not allowed
• Surrender charges: none

Separation of Elements

Traditional cash value life insurance products do not clearly show the separate effect of their mortality, investment, and expense components. The distinguishing characteristic of universal life contracts is a clear separation of these three elements. This is called unbundlingFeature of universal life that clearly shows the separate effect of mortality, investment, and expense components.. The separation is reported at least annually, by a disclosure statement. The disclosure statementIn universal life, annually reporting of the gross rate of investment return credited to the account, the charge for death protection, expense charges, and the resulting changes in accumulation value and in cash value. shows the following:

• The gross rate of investment return credited to the accountThe advertised rate of return credited to the account is likely to be higher than the true rate of return being earned on the cash value element of the contract. This issue was discussed at length in Chapter 9 "Fundamental Doctrines Affecting Insurance Contracts" regarding vanishing premiums and market conduct.
• The charge for death protection
• Expense charges
• The resulting changes in accumulation value and in cash value

This transparency permits seeing how the policy operates internally, after the fact.

The insurer maintains separate accounting for each policyowner. The account has three income items:

• New premiums paid
• Guaranteed interest credited
• Excess interest credited

The cash outflow items, from a consumer perspective, consist of the following:

• A mortality charge for death protection
• Administrative and marketing expenses
• Withdrawals or loans

The difference between cash income and outflow in universal life becomes a new contribution to (or deduction from) the accumulation valueThe value of the annuity contract during the accumulation period; consists of premiums plus investment earnings minus expenses. account. Visualize this as the level of liquid in an open container where the three income items flow in at the top and the outflow items are extracted through a spigot at the bottom. Accounting usually occurs on a monthly basis, followed by annual disclosure of the monthly cash flows. The steps in the periodic flow of funds for a universal life policy are shown in Figure 19.5 "Flow of Funds for Universal Life Insurance". The first premium is at least a minimum amount specified by the insurer; subsequent premiums are flexible in amount, even zero if the cash value is large enough to cover the current cost of death protection and any applicable expense charges.

Administrative and marketing expense charges are subtracted each period. Some policies do not make explicit deductions. Instead, they recover their expenses by lowering investment credits or increasing mortality charges (limited by guaranteed maximums). Another periodic deduction is for mortality. The policyowner decides whether withdrawals (that is, partial surrenders of cash values) or policy loans are made. They cannot exceed the current cash value. If the entire cash value is withdrawn, the contract terminates. Withdrawals and loans reduce the death benefit as well as the cash value.

After deductions at the beginning of each accounting period for expenses, mortality, and withdrawals, the accumulation value is increased periodically by the percentage that reflects the insurer’s current investment experience (subject to a guaranteed minimum rate) for the portfolio underlying universal life policies.

The difference between the accumulation value and what can be withdrawn in cash (the cash value) at any point in time is determined by surrender expenses. Surrender expenses and other terms will become clearer as aspects of universal life are discussed in more detail in the next chapter sections.

Death Benefit Options

Figure 19.6 "Two Universal Death Benefit Options" shows two death benefit options that are typically available. Type A keeps a level death benefit by making dollar-for-dollar changes in the amount of protection as the investment (cash value account) increases or decreases. This option is expected to produce a pattern of cash values and protection like that of a traditional, ordinary life contract. When a traditional, straight life contract is issued, the policy stipulates exactly what the pattern of cash values will be and guarantees them. In universal life contracts, there are illustrations of cash values for thirty years or so, assuming the following:

• A specified level of premium payments
• A guaranteed minimum investment return
• Guaranteed maximum mortality rates

Another column of this type of illustration shows values based on current investment and mortality experience. Company illustration practices also usually provide a column of accumulation and cash values based on an intermediate investment return (that is, a return between the guaranteed and current rates).

Figure 19.5 Flow of Funds for Universal Life Insurance

* This accumulation value is zero for a new policy.

The type B option is intended to produce an increasing death benefit. The exact amount of increase depends on future nonguaranteed changes in cash value, as described in the discussion of type A policies. The type B alternative is analogous to buying a yearly, renewable level term insurance contract and creating a separate investment account.

With either type, the policyowner may use the contract’s flexibility to change the amount of protection as the needs for insurance change. Like traditional life insurance contracts, additional amounts of protection require evidence of insurability, including good health, to protect the insurer against adverse selection. Decreases in protection are made without evidence of insurability. The insurer simply acknowledges the request for a different death benefit by sending notification of the change. The contract will specify a minimum amount of protection to comply with federal tax guidelines. These guidelines must be met to shelter the contract’s investment earnings (commonly called inside interest buildup) from income taxes.

Figure 19.6 Two Universal Death Benefit Options

* Cash values may decrease and even go to zero, for example, due to low investment returns or inadequate premium payments.

Cost-of-living adjustment (COLA) riders and options to purchase additional insurance are available from most insurers, as you will see at end of this chapter. COLA ridersIncrease the death benefit of universal life annually, consistent with the previous year’s increase in the consumer price index. increase the death benefit annually, consistent with the previous year’s increase in the consumer price index (CPI). Thus, if inflation is 3 percent, a $100,000 type A policy reflects a $103,000 death benefit in the second year. Of course, future mortality charges will reflect the higher amount at risk to the insurer, resulting in higher costs of death protection and lower cash values, unless premiums or investment returns increase concomitantly. Options to purchase additional insurance give the contractual right to purchase stipulated amounts of insurance at specified future ages (generally limited to age forty) and events (e.g., the birth of a child) without evidence of insurability.

Premium Payments

Most universal policies require a minimum premium in the first policy year. In subsequent years, the amount paid is the policyowner’s decision, subject to minimums and maximums set by insurers and influenced by Internal Revenue Service (IRS) rules.

Mortality Charges

Almost all universal life insurance policies specify that mortality charges be levied monthly. The charge for a particular month is determined by multiplying the current mortality rate by the current amount of protection (net amount at risk to the insurer). The current mortality rateIn universal life, can be any amount determined periodically by the insurer as long as the charge does not exceed the guaranteed maximum mortality rate specified in the contract. can be any amount determined periodically by the insurer as long as the charge does not exceed the guaranteed maximum mortality rate specified in the contract. Maximum mortality rates typically are those in the conservative 1980 CSO Mortality Table. Updated mortality tables were adopted in 2006 based on the 2001 CSO Mortality Table, as discussed in “New Mortality Tables” of Chapter 17 "Life Cycle Financial Risks".

The current practice among most insurers is to set current mortality rates below the specified maximums. Mortality charges vary widely among insurers and may change after a policy is issued. Consumers should not, however, choose an insurer solely based on a low mortality charge. Expense charges and investment returns also factor into any determination of a policy’s price. It is also unwise to choose a policy solely on the basis of low expenses or high advertised gross investment returns.

Expense Charges

Insurers levy expense charges to help cover their costs of marketing and administering the policies. The charges can be grouped into front-end expensesIn universal life, expenses applied at the beginning of each month or year consisting of some combination of (1) a percentage of new premiums paid, (2) a small flat dollar amount per month or year, and (3) a larger flat dollar amount in the first policy year. and surrender expensesIn universal life, marketing and administrative expenses applied when policies are terminated. (back-end expenses). Front-end expenses are applied at the beginning of each month or year. They consist of some combination of: (1) a percentage of new premiums paid (e.g., 5 percent, with 2 percent covering premium taxes paid by the insurer to the state); (2) a small flat dollar amount per month or year (e.g., $1.50 per month), and (3) a larger flat dollar amount in the first policy year (e.g., $50). Universal life policies began with high front-end expenses, but the trend has been toward much lower or no front-end expenses due to competition among companies. Those that levy front-end expenses tend to use only a percentage of premium load in both first and renewal policy years. Policies with large front-end loads seldom levy surrender expenses.

As most early issuers of universal policies lowered their front-end charges, they added surrender charges. Whereas front-end expenses reduce values for all insureds, surrender expenses transfer their negative impact to policyowners who terminate their policies. Surrender charges help the insurer recover its heavy front-end underwriting expenses and sales commissions. Questions exist about whether or not they create equity between short-term and persisting policyholders. A few insurers issue universal policies with neither front-end nor surrender charges. These insurers, of course, still incur operating expenses. Some lower operating expenses by distributing their products directly to consumers or through financial planners who charge separate fees to clients. These no-load products still incur marketing expenses for the insurers that must promote (advertise) their products through direct mail, television, and other channels. They plan to recover expenses and make a profit by margins on actual mortality charges (current charges greater than company death claim experience) and margins on investment returns (crediting current interest rates below what the company is earning on its investment portfolio). Thus, even no-load contracts have hidden expense loads. Expense charges of all types, like current mortality rates, vary widely among insurers. Advertised investment returns are likely to vary in a narrower range.

Investment Returns

Insurers reserve the right to change the current rate of return periodically. Some guarantee a new rate for a year; others commit to the new rate only for a month or a quarter.

The indexed investment strategyTies the rate of return on cash values in life insurance to a published index, such as rates on ninety-day U.S. Treasury bills or Moody’s Bond Index. used by some insurers ties the rate of return on cash values to a published index, such as rates on 90-day U.S. Treasury bills or Moody’s Bond Index, rather than leaving it to the insurer’s discretion and its actual investment portfolio returns. This approach also provides a guarantee between 4 and 5 percent.

Some insurers use a new money rate for universal contracts. As explained earlier, the new money rateIn life insurance, credits the cash value account with the return an insurer earns on its latest new investments. approach credits the account with the return an insurer earns on its latest new investments. The practice dictates investment of universal life funds in assets with relatively short maturities in order to match assets with liabilities. When short-term rates are relatively high, such as in the early 1980s, the new money approach produces attractive returns. When short-term returns drop, as they did after the mid-1980s, the approach is not attractive, as noted earlier.

Summary: Features of Universal Life

• In summary, in universal life, we see the following features (see also Table 19.1 "Characteristics of Major Types of Life Insurance Policies"):
• Death benefits: level or increasing
• Cash value: guaranteed minimum cash value plus additional interest when rates are higher than guaranteed
• Premiums: flexible
• Policy loans: yes, but the interest credited to the account is reduced
• Partial withdrawals: allowed
• Surrender charges: yes

How It Works

The Model Variable Life Insurance Regulation, produced by the National Association of Insurance Commissioners, sets guidelines that help establish the form of the product. Certain basic characteristics can be identified.

Variable life is, in essence, a whole life product that provides variable amounts of benefit for the entire life. It requires a level premium; therefore, the out-of-pocket contributions do not change with changes in the cost of living. This limits the extent to which death benefits can increase over time because no new amounts of insurance can be financed by defining the premium in constant dollars. All increases in death benefits must come from favorable investment performance.

Contracts specify a minimum death benefit, called the face amount. In one design, this minimum stays level during the life of the contract. Another design uses increasing term insurance to provide automatic increases of 3 percent per year for fourteen years, at which point the minimum face amount becomes level at 150 percent of its original face value. Assuming continuation of premium payments, the face amount can never go below the guaranteed minimum.

Each separate account is, in essence, a different mutual fund. For example, one contract offers five investment accounts: (1) guaranteed interest, (2) money market, (3) a balance of bonds and stocks, (4) conservative common stock, and (5) aggressive common stock. The policyowner could allocate all net premiums (new premiums minus expense and mortality charges) to one account or divide them among any two or more accounts. Currently, approximately 75 percent of separate account assets are in common stocks. Some policies limit the number of changes among the available accounts. For example, some contracts set a limit of four changes per year. Administrative charges may accompany switches among accounts, especially when one exceeds the limit. Because the changes are made inside a life insurance product where investment gains are not subject to income taxes (unless the contract is surrendered), gains at the time of transfer among accounts are not taxable.

It is assumed that investments in the underlying separate accounts will earn a modest compound return, such as 4 percent. This assumed rate of returnIn variable life insurance, generally is a rate necessary to maintain the level of cash values found in a traditional fixed-dollar straight life contract. is generally a rate necessary to maintain the level of cash values found in a traditional fixed-dollar straight life contract. Then, if actual investment returns exceed the assumed rate, (1) cash values increase more than assumed, and (2) these increases are used partly to purchase additional death benefits.

The additional death benefits are usually in the form of term insurance. The amount of term insurance can change (upward or downward) daily, monthly, or yearly, depending on the provisions of the contract. The total death benefit, at a point in time, becomes the amount of traditional straight life insurance that would be supported by a reserve equal to the policy’s current cash value.

If separate account values fall below the assumed rate, (1) the cash value falls, and (2) one-year term elements of death protection are automatically surrendered. The net result is a new death benefit that corresponds to the amount of straight life that could be supported by the new cash value, subject to the minimum death benefit. These variable aspects are what give the contract its name. The nature of variable life insurance, with one-year term additions, is depicted in Figure 19.7 "Hypothetical Values for a Variable Life Insurance Contract".

Policy loans and contract surrenders can be handled by transferring funds out of the separate account. Loans are typically limited to 90 percent of the cash value at the time of the latest loan. Surrenders are equal to the entire cash value minus any applicable surrender charge.

Some variable contracts are issued on a participating basis. Because investment experience is reflected directly in cash values, dividends reflect only unanticipated experience with respect to mortality and operating expenses.

Figure 19.7 Hypothetical Values for a Variable Life Insurance Contract

Note: The relationship depicted between the actual cash value and the total death benefit is approximate. It has not been drawn precisely to scale.

Variable life insurance is technically a security as well as insurance. Therefore, it is regulated by the Securities and Exchange Commission (SEC)—which enforces the Investment Company Act of 1940, the Securities Act of 1933, and the Securities Exchange Act of 1934—as well as by state insurance departments. The SEC requires that an applicant be given a prospectusStatement issued by insurers as required by the SEC explaining the risks of variable life and illustrates how the death benefit and cash values would perform if future investment experience results in returns of 0, 4, 6, 8, 10, and 12 percent. before being asked to sign an application for variable life. The prospectus explains the risks and usually illustrates how the death benefit and cash values would perform if future investment experience results in returns of 0, 4, 6, 8, 10, and 12 percent. Returns also can be illustrated based on historical experience of the Standard and Poor’s 500 Stock Price Index. Because the product is a security, it can be sold only by agents who register with and pass an investments examination given by the National Association of Security Dealers.

A midrange assumption (e.g., 4 percent) produces a contract that performs exactly like traditional straight life insurance. The 0 percent return would produce the minimum face amount; the cash value would be below normal for a period and go to zero at an advanced age. Because cash values cannot be negative, the policy would continue from the time the cash values reach zero until the death without cash values. At death, the minimum face amount would be paid. The 8 and 12 percent returns would produce cash values that grow much faster than those normal for an ordinary life policy; the total death benefit would continue to grow above the minimum face amount. These examples all assume continuous payment of the fixed annual premium.

Summary: Features of Variable Life

The cash value in a variable life policy fluctuates with the market value of one or more separate accounts. Death benefits, subject to a minimum face amount, vary up or down as the cash value changes. Success in achieving the objective of maintaining a death benefit that keeps pace with inflation depends on the validity of the theory that certain investments are good inflation hedges. All investment risks are borne by the policyowner rather than by the insurer. The issuer of a variable life policy assumes only mortality and expense risks.

In summary, in variable life we see the following features (see also Table 19.1 "Characteristics of Major Types of Life Insurance Policies"):

• Death benefits: guaranteed minimum plus increases from investments
• Cash value: minimum not guaranteed; depends on investment performance
• Premiums: fixed level
• Policy loans: yes
• Partial withdrawals: not allowed
• Surrender charges: yes

Summary: Features of Variable Universal Life

In summary, in variable universal life, we see the following features:

• Death benefits: guaranteed minimum plus increases from investments
• Cash value: minimum not guaranteed; depends on investment performance
• Premiums: flexible
• Policy loans: allowed
• Partial withdrawals: allowed
• Surrender charges: yes

Summary: Features of Current Assumption Life

In summary, in current assumption life, we see the following features:

• Death benefits: fixed
• Cash value: guaranteed minimum plus excess interest (like universal life)
• Premiums: vary according to experience, but no higher than a set maximum
• Policy loans: yes
• Partial withdrawals: allowed
• Surrender charges: yes

Policy Ownership

The whole and universal life policies have similar ownership sections. OwnershipIn life insurance, refers to rights policyholders have over their policies such as the right to assign the policy to someone else, to designate the beneficiary, to make a policy loan, or to surrender the policy for its cash value. refers to rights. The owner of a life insurance policy has rights, such as the right to assign the policy to someone else, to designate the beneficiary, to make a policy loan, or to surrender the policy for its cash value. When filling out the initial policy application, the policyowner designates whether the rights should stay with the insured or be assigned to another person, such as a spouse or perhaps to a trust. The ownership provisionA provision filled out by the policyowner stating where the rights of the policy should be assigned (e.g., insured, spouse, or a trust)., sometimes simply labeled rights, shows this designation.

Death Benefits and Death Benefits Options Provisions

This section is unique to universal life policy, as would be expected from the lengthy explanation above regarding the two options of death benefits. In Chapter 27 "Appendix D", you can see the wording of these options, the amounts of coverage, and changes to the amounts.

The changes in basic amount provisionIn life insurance, specifies the conditions under which a policyowner can change the total face amount of the policy. specifies the conditions under which a policyowner can change the total face amount of the policy. Any requested decreases take place on a monthly anniversary date and reduce the most recent additions to coverage (if any) before affecting the initial face amount. Requests for increases in coverage must be made on a supplemental application and are subject to evidence of insurability.

Payment of Benefits Provisions

This section applies to both the sample whole life and the sample universal life policies and to other policies in general. The purpose of the payment of benefits provisionIn life insurance, enables the owner of the policy to designate to whom the proceeds shall be paid when the insured dies. is to enable the owner of the policy to designate to whom the proceeds shall be paid when the insured dies. If no beneficiary is named, the proceeds will go to the owner’s estate. A revocable beneficiaryLife insurance beneficiary that can be changed at will by the policyowner. can be changed at will by the policyowner. Most people prefer the revocable provision. Irrevocable beneficiaryLife insurance beneficiary that cannot be changed only with the consent of the beneficiary. designations, on the other hand, can be changed only with the consent of the beneficiary. For example, a divorced spouse, as part of a property settlement, may be given an irrevocable interest in life insurance on his or her former spouse. The former spouse, as the insured and policyowner, would be required to continue premium payments but could not make a policy loan or other changes that would diminish the rights of the irrevocable beneficiary.

A beneficiary must survive the insured in order to be entitled to the proceeds of the policy. It is customary, therefore, to name one or more beneficiaries who are entitled to the proceeds in the event that the primary (first-named) beneficiary does not survive the insured. These are known as secondary or tertiary contingent beneficiariesIn life insurance, beneficiaries who are entitled to the proceeds in the event that the primary (first-named) beneficiary does not survive the insured.. Such beneficiaries are named and listed in the order of their priority.

If the insured and the primary beneficiary die in the same accident and none of the evidence shows who died first, there is a question as to whether the proceeds shall be paid to the estate of the primary beneficiary or to a contingent beneficiary. In states where the Uniform Simultaneous Death Act has been enacted, the proceeds are distributed as if the insured had survived the beneficiary. Where this act is not in effect, the courts have usually reached the same conclusion. If no contingent beneficiary has been named, the proceeds go to the estate of the policyowner, thus subjecting the proceeds to estate taxes, probate costs, and the claims of creditors. Probate costs are levied by the court that certifies that an estate has been settled properly. Probate costs (but not estate taxes) are avoided when benefits go to a named beneficiary.

A similar problem arises when the primary beneficiary survives the insured by only a short period. In such a case, the proceeds may be depleted by taxes and costs associated with the beneficiary’s estate settlement or because an annuity-type settlement option had been selected. This problem can be solved by adding a common disaster provision (or survivorship clause)Provides that the beneficiary of a life insurance policy must survive the insured by a specified period of time or must be alive at the time of payment to be entitled to the proceeds., which provides that the beneficiary must survive the insured by a specified period of time (e.g., seven to thirty days) or must be alive at the time of payment to be entitled to the proceeds. If neither of these conditions is fulfilled, the proceeds go to a contingent beneficiary or to the estate of the policyowner if a contingent beneficiary has not been named.

Policyowners should designate the beneficiary clearly. No questions should exist about the identity of the beneficiary at the time of the insured’s death. In designating children as beneficiaries, one must keep in mind that a minor is not competent to receive payment. In the event of the death of the insured prior to the maturity of a beneficiary child, a guardian may have to be appointed to receive the proceeds on behalf of the child. As a general rule, policyowners should avoid naming minors as beneficiaries. Where the objective is a substantial estate to benefit a child or children, the preferable approach would be to name a trust as beneficiary. The child or children (the ones already born and those to be born or join the family unit after a divorce and remarriage) could be the beneficiary(ies) of the trust.

Payment Methods

Life insurance is designed to create a sum of money that can be used when the insured dies or the owner surrenders a cash value policy. In the early days of life insurance, the only form in which the death proceeds or cash value of a policy were paid was in a lump sum. Because a lump-sum payment is not desirable in all circumstances, several additional settlement options (or settlement plansAllows the policyholder or beneficiary of a life insurance contract to stipulate, from a variety of options, how the death benefit will be provided.; also called payment plans) have been developed and are now included in most policies. The owner may select an option in advance or leave the choice to the beneficiary. The owner may also change the option from time to time if the beneficiary designation is revocable. The payment plans have the following methods for death proceeds:

• Interest method—the beneficiary leaves the proceeds with the insurer and collects only the interest
• Fixed years method—even distribution of the proceeds over a certain number of years
• Life income method—even distribution of the proceeds over the life of the beneficiary
• Fixed amount method—even distribution of the proceeds until depleted
• Joint life income method—even distribution of the proceeds over the life of the beneficiary, with continued distribution to his or her beneficiary at the same or reduced level
• One-sum method—a lump-sum distribution
• Other method, as agreed upon

Premium Provisions

This section also applies to both the whole and the universal life policies. Premiums are payable on the due date on a monthly, quarterly, semiannual, or annual basis. The first premium must be paid in advance, while the insured is in good health and otherwise insurable. Subsequent premiums are due in advance of the period to which they apply. Insurance companies send a notice to the policyowner indicating when the premium is due. The time horizon over which premiums are payable depends on the type of policy (e.g., through age ninety-nine for a straight life policy), and it is stated on the cover page. Note in the sample universal life policy of Chapter 27 "Appendix D" that the premium limitations section allows the insurer to refund any overpayment of premiums. As you know, such possibility may occur because of the flexible premium allowed for universal life policies.

Dividend Options

Participating policies of mutual insurers, such as State Farm, share in the profits the insurer earns because of lower-than-anticipated expenses, lower-than-expected mortality, and greater-than-expected investment earnings. The amounts returned to policyowners are called dividends. Dividends also involve the return of any premium overpayment. Dividends are payable annually on the policy anniversary. They are not guaranteed, but they are a highly significant element in many policies.

When purchasing a participating life insurance policy, the policyowner can choose how the dividend money should be spent from one or more of the following dividend optionsWhen purchasing a participating life insurance policy, the policyowner can choose how the dividend money will be distributed from among several choices. (see Chapter 26 "Appendix C"):

• Applied toward the next premium
• Used to buy paid-up additional insurance
• Left with the insurer to accumulate interest
• Paid to the policyholder

The majority of companies offer these four options. The selection of the appropriate dividend option is an important decision.

Guaranteed Values Provisions

This section illustrates the major differences between the whole life and universal life policies. A whole life policy guarantees that a policyholder who decides to cancel the policy can either take cash for the surrender (cash) value or continue the policy in force as extended term insurance and paid-up insurance. These provisions are also called nonforfeiture optionsIn whole life insurance, guarantees that a policyholder who decides to cancel the policy can either take cash for the surrender (cash) value or continue the policy in force as extended term insurance and paid-up insurance. in other policies. The sample whole life policy lists these amounts in the Schedule of Insurance and Values in Chapter 26 "Appendix C".

As pointed out earlier, the cash value life plan results in the accumulation of a savings (or cash value element, from the insured’s perspective) that usually increases as each year passes. If the contract is terminated, the policyholder can receive the cash value, or the policy can be converted to extended term insuranceNonforfeiture option where the death benefit of a whole life policy continues at its previous level for as long as the cash value supports this amount of term insurance. or paid-up insuranceNonforfeiture option where death benefits are paid up completely without expiration date, as if a new policy providing a lower death benefit was in place.. Under the extended term insurance option, the death benefit continues at its previous level for as long as the cash value supports this amount of term insurance (like a single premium life). Under the paid-up insurance option, it is as if there is a new policy providing a lower lifetime death benefit than the old one did. The death benefits are paid up completely without an expiration date. Both extended term and paid-up options are nonforfeiture options.

With universal, current assumption, and variable universal life policies, the policyowner may discontinue premium payments at any time without lapsing the policy, as long as the surrender value is sufficient to cover the next deduction for the cost of insurance and expenses. In the universal life policy, there is a description of the account value at the end of the first month. It is 95 percent of the initial premium less the monthly deduction. Thereafter, adjustments take the interest rate into account. The following sections are covered in the sample universal life in Chapter 27 "Appendix D":

• Account value
• Monthly deduction
• Cost of insurance
• Monthly cost of insurance rates
• Interest (guaranteed at 4 percent in the sample policy)
• Cash surrender value
• Withdrawals
• Surrender charges
• Basis of computation, which includes the table of surrender charges

Policy Loan Provisions

Policy loan provisionsApply to whole life and the universal life policies and allow the owner to borrow an amount up to the cash value from the insurer at a rate of interest specified in the policy and up to the account value in universal life. apply to both the whole life and the universal life policies. The owner can borrow an amount up to the cash value from the insurer at a rate of interest specified in the policy, and up to the account value in universal life. In the sample universal life policy in Chapter 27 "Appendix D", the interest rate is set at 8 percent. In the whole life policy, the majority of insurers use a fixed rate of interest or a variable rate, as indicated in the sample whole life policy in Chapter 26 "Appendix C".

General Provisions

Both the whole life and the universal life sample policies conclude with general-provision sections that include the following:

• The contract
• Annual report (universal life only)
• Projection of benefits and values (universal life only)
• Annual dividend (universal life only)
• Dividend options (universal life only as part of this section; see dividends for whole life above as a separate section)
• Assignment
• Error in age or sex
• Incontestability
• Limited death benefits (suicide clause)

Waiver of Premium

The waiver of premium riderIn life insurance, provides that premiums due after commencement of an insured’s total disability shall be waived for a period of time. is offered by all life insurance companies and is included in about half of the policies sold. Some companies automatically provide it without charging an explicit amount of additional premium. The rider provides that premiums due after commencement of the insured’s total disability shall be waived for a period of time. A waiting period of six months must be satisfied first. In flexible premium contracts such as universal and variable universal life, the waiver of premium provision specifies that the target premium to keep the policy in force will be credited to the insured’s account during disability.An alternative to the waiver of premium rider for flexible premium contracts waives only the amount required to cover mortality cost and expense deductions. If a premium was paid after disability began and before the expiration of a waiting period, the premium is refunded. When disability begins before a certain age, usually age sixty, premiums are waived as long as the insured remains totally disabled.

Disability Income

The disability income riderIn life insurance, provides a typical income benefit of $10 per month per $1,000 of initial face amount of life insurance for as long as an insured’s total disability continues and after the first six months of such disability, provided it commences before age fifty-five or sixty. provides a typical income benefit of $10 per month per $1,000 of initial face amount of life insurance for as long as total disability continues and after the first six months of such disability, provided it commences before age fifty-five or 60. Disability payments are usually made for the balance of the insured’s life as long as total disability continues. Under some contracts, payments stop at age sixty-five and the policy matures as an endowment, but this is less favorable than continuation of income benefits.

The definitions of disability for these riders are like those for waiver of premium provisions. Most disability income insurance is now sold either through a group plan (e.g., see Chapter 22 "Employment and Individual Health Risk Management" and Case 2 of Chapter 23 "Cases in Holistic Risk Management") or as separate individual policies. Most life insurers do not offer this rider.

Accidental Death Benefit

The accidental death benefit (or double indemnity) riderIn life insurance, usually provides that double the face amount of the policy will be paid if the insured’s death is caused by accident, and, sometimes, triple the face amount if death occurs while the insured is riding as a paying passenger in a public conveyance. is sometimes called double indemnity. It usually provides that double the face amount of the policy will be paid if the insured’s death is caused by accident, and sometimes triple the face amount if death occurs while the insured is riding as a paying passenger in a public conveyance.Policies with flexible face amounts usually issue the accidental death rider for a fixed amount equal to the basic policy’s initial face amount. Figure 19.8 "Accidental Death Benefits Rider" illustrates the accidental death benefit rider.

A typical definition of accidental death is, “Death resulting from bodily injury independently and exclusively of all other causes and within ninety days after such injury.” Certain causes of death are typically excluded: suicide, violations of the law, gas or poison, war, and certain aviation activities other than as a passenger on a scheduled airline. This rider is usually in effect until the insured is age seventy.

Figure 19.8 Accidental Death Benefits Rider

Guaranteed Insurability Option

Many insurers will add a guaranteed insurability option (GIO)In life insurance, gives the policyowner the right to buy additional amounts of insurance, usually at three-year intervals up to a specified age, without new proof of insurability. to policies for an additional premium. This gives the policyowner the right to buy additional amounts of insurance, usually at three-year intervals up to a specified age, without new proof of insurability. The usual age of the last option is forty; a small number of insurers allow it up to age sixty-five. The amount of each additional purchase is usually equal to or less than the face amount of the original policy. If a $50,000 straight or interest-sensitive life policy with the GIO rider is purchased at age twenty-one, the policyowner can buy an additional $50,000 every three years thereafter to age forty, whether or not the insured is still insurable. By age forty, the total death benefit would equal $350,000. The new insurance is issued at standard rates on the basis of the insured’s attained age when the option is exercised. The GIO rider ensures one’s insurability. It becomes valuable if the insured becomes uninsurable or develops a condition that would prevent the purchase of new life insurance at standard rates.

Accelerated Death Benefits

Some medical conditions regularly result in high medical expenses for the insured and his or her family or other caregivers. The need for funds may significantly exceed benefits provided by medical and disability insurance because of deductibles, coinsurance, caps on benefits, and exclusions, and (perhaps primarily) because of having purchased inadequate coverage. Accelerated death benefitsTriggered by either the occurrence of a catastrophic (dread) illness or the diagnosis of a terminal illness, resulting in payment of a portion of a life insurance policy’s face amount prior to death. are triggered by either the occurrence of a catastrophic (dread) illness or the diagnosis of a terminal illness, resulting in payment of a portion of a life insurance policy’s face amount prior to death.

The accelerated benefits are also called living benefits, or terminal illness rider. Usually, the terminally ill insured can receive up to 50 percent of the death benefits to improve quality of life before death. Often, the coverage is provided without an additional premium. The benefit can usually be claimed when two doctors agree that the insured has six months or less to live. When the insured desires greater amounts, he or she may use a viatical settlement company to transfer the ownership of the policy to a third party in return for a higher percentage of the death benefits, perhaps 80 percent. A more detailed discussion of viaticals is provided in the box “Do Viatical and Life Settlements Have a Place in Today’s Market?”

Catastrophic Illness Coverage

When a catastrophic illness riderIn life insurance, provides that a portion (usually 25 to 50 percent) of the face amount of the policy is payable upon diagnosis of specified illnesses. is added to a life insurance policy (usually requiring an additional premium), a portion (usually 25 to 50 percent) of the face amount is payable upon diagnosis of specified illnesses. The named illnesses differ among insurers but typically include organ transplantation.

As benefits are paid under either a catastrophic or terminal illness rider, the face amount of the basic policy is reduced an equal amount, and an interest charge applies in some policies. Cash values are reduced either in proportion to the death benefit reduction or on a dollar-for-dollar basis.

Buy More Life Insurance

As long as you are insurable, you can buy more life insurance as your needs increase. What if you become uninsurable? You can protect yourself against that possibility by buying a policy with a guaranteed insurability option; however, this has drawbacks. First, the option is limited to a specified age, such as forty, and you may need more insurance after that age. Second, you must buy the same kind of insurance as the policy you have. Third, the premium will be higher due to your age.

Buy a Cost-of-Living Rider or Policy

Another alternative is the inflation rider (or cost-of-living)Automatically increases the amount of life insurance as the consumer price index rises., which automatically increases the amount of insurance as the consumer price index (CPI) rises. It provides term insurance in addition to the face amount of your permanent or term policy up to a point, such as age fifty-five for the insured. If, for example, you have a $100,000 whole life policy and the CPI goes up 5 percent this year, $5,000 of one-year term insurance is automatically written for next year at the premium rate for your age. You are billed for it along with the premium notice for your basic policy. Because your premium increases with each increase in coverage, you may conclude that you bear the risk of keeping your coverage up with inflation. Keep in mind that no evidence of insurability is required. You do not have to accept (and pay for) the additional insurance if you don’t want it. If you refuse to exercise the option, however, it is no longer available. In other words, you can’t say, “I’m short of funds this year, but I will exercise the option next year.” Table 19.4 "Inflation Rider Option (at 5 Percent Annual Inflation)" illustrates how the inflation rider option would affect your total amount of insurance if you had bought a $100,000 whole life policy in 1995 and the inflation rate was 5 percent every year.

Buy a Variable or Variable Universal Life Policy

The face amount of variable life and variable universal life (except for the level face amount type) policies fluctuates with the performance of one or more separate accounts. You have the option of directing most of your premiums into common stock accounts where long-run returns are expected to offset CPI increases.

If you buy a variable life policy, you assume the risk that the equity markets may be going down at the same time that the CPI is going up. Should you buy a variable life policy? The answer depends on you. How much investment risk are you willing to take in coping with inflation?