Universal Life Insurance Chapter 17 Tools Techniques

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Characteristics § Flexible premium § Policyowner is permitted to select whatever premium he or she wishes to pay (within limits) § Policyowner can adjust, change and skip premiums § As long as cash values are sufficient to cover policy charges § Current assumption § Current interest rates, mortality and expense loads determine what additions are made to the cash value § Adjustable death benefit § Policyowner's are permitted to raise or lower their policy death benefits § Increases may be subject to evidence of insurability 1

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § When is the use of this tool indicated (cont'd) § When policy flexibility is desired § For young families § Flexibility to adjust to changing needs in the future § In the business market § Split dollar plans § Key employee coverage § Funding Buy-sell agreements § Nonqualified deferred compensation agreements 2

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Advantages § Premium flexibility § Death benefit flexibility § Note – decrease are permitted, but reductions in the first seven years could create adverse tax consequences § Policy is transparent § Unbundling of policy allows policyowner to track policy values, loads, expenses and death benefits via policy statements § Death Benefit Options § Option A – Level death benefit § Option B – Increasing death benefit (base face amount plus account value) 3

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Advantages § Cost of living rider § Increases death benefit by increase in the consumer price index without evidence of insurability § Back-end loads § Greater percentage of initial premiums go into cash values § Policyowner directly participates in the favorable investment, mortality and expense experience of the company § Cash value increases accumulate income tax deferred 4

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Advantages (cont'd) § UL policies have typically paid a higher effective rate of interest on cash values than have tax-free municipal bonds § Cash values are not subject to fluctuations in market values characteristic of longer term municipal bonds and other longer term fixed income investments when market rates change § Policies values can be borrowed at a low net cost § Policyowner's can withdraw a portion of their policy values without surrendering the entire policy 5

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Disadvantages § Policyowner can easily allow their policy to lapse due to the flexibility of premium feature combined within inadequate premiums being paid § Policyowner bears risk of of adverse trends in mortality or expense loads § Direct recognition method § Borrowed cash values are credited with a lower interest rate than are borrowed cash values § Considerable surrender charges in the first 5 to 10 years § Policy flexibility may create a modified endowment policy inadvertently 6

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Tax implications § General tax rules § Cash values grow tax deferred § Death benefits are paid income tax free § Policyowner can withdraw up to their basis and take policy loans income tax free § For Non-modified endowment policies § Exceptions to the cost recovery rule § Withdrawals coupled with reductions in death benefits § Years 1 -5 § Any withdrawal may be taxable if there is a gain in the policy § Years 6 -15 § Taxation of withdrawal based on mathematical test § Cash value corridor test 7

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Tax implications (cont'd) § Modified Endowment Contract (MEC) Rules § Penalty for classification as a MEC relates to distribution § Distributions are taxed under the interest first rule rather than the cost recovery rule § In addition, these distributions are subject to a 10% penalty tax if they occur before the policyowner reaches age 59 ½, dies or become disabled § Distributions include withdrawals and loans 8

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Tax implications (cont'd) § Modified Endowment Contract (MEC) Rules (cont'd) § Ways to run afoul of the MEC rules § Increase in premium payments during the first 7 contract years may push cumulative premiums above the amount permitted under the “seven Pay Test” § A reduction in death benefit during the first seven contract years triggers a recomputation of the seven pay test § A material change in the death benefit at any time triggers a new seven pay test which is applied prospectively § UL illustrations will indicate the maximum amount (the seven pay premium) that may be paid over the first seven years, without classifying the policy as a MEC § If the policyowner inadvertently violates the test, they have 60 days (typically) to reverse the transaction that created the MEC 9

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Tax implications (cont'd) § Modified Endowment Contract (MEC) ) § Alternatives § Current assumption whole life (CAWL) § Also called interest sensitive whole life § Universal life without the adjustable features § Adjustable Life (AL) § Combines elements of fixed premium ordinary life and the ability to alter, within limits to alter the policy plan, premium payments and face amounts § Variable life (VL) and variable Universal life (VUL) 10

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Fees and Acquisition Costs § Surrender charges § Spread over 5 to 10 years § Decline yearly § Explicitly shown on the Illustration § Difference between the account value and the net cash surrender value § Commissions § Based on a percentage of the “Target Premium” § Target premium is generally the level annual premium payable if the policy was configured as a level premium whole life policy § Initial commission generally between 20% and 90% of the target premium § Renewal commissions generally between 2% and 5% of the target premium 11

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Fees and acquisition costs (cont'd) § Policy issue and administrative expenses § Flat dollar amount, or § Percentage of premium, or § Fee per $1, 000 of face amount § Typically around $25 - $50 per year plus 5%+ of premium § Selecting the best policy § Complex determination due to the many components of UL policies § One critical element is the amount credited to cash surrender values 12

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Selecting the best policy (cont'd) § Factors involved in crediting amounts to cash values § Expense charges § Fixed fee plus a percentage of premium § Not explicitly stated in illustration § It is defined in the policy contract § There is a current (expected) charge and a guaranteed maximum charge § Mortality charge § Based on a mortality table the carrier selects for this policy § 2001 CSO Mortality Table § 1990 CSO Mortality Table § 1980 CSO Mortality Table § 1958 CSO Mortality Table § Which table they select is up to the actuaries 13

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Selecting the best policy (cont'd) § Factors involved in crediting amounts to cash values (cont'd) § Mortality charges (cont'd) § Current mortality charges § Guaranteed maximum mortality charges § Optional illustration column will show these charges § Formula that created these charges is proprietary to carrier § Net Investment Yield § Insurance companies cannot credit more interest to policies cash values than they earn on their general investment portfolio § Generally, the portfolios are predominately invested in long term corporate and government bonds and mortgages 14

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Selecting the best policy (cont'd) § Factors involved in crediting amounts to cash values (cont'd) § Net Investment Yield (cont'd) § There are differences between insurance companies assets with regard to: § Proportions invested in in each type of asset § Quality § Duration § Yield § Level of Risk § With regard to investment portfolios and investment philosophies § Reasonable and acceptable combination of “Risk and Return” 15

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Interest crediting methods § Linked rates § External well known index of yields § One year T-Bill rates § Intermediate term high quality corporate or government yields § Discretionary § As declared by the insurance company § Portfolio § Rate of return on the companies general investment portfolio § A blend of rates earned on new and old money 16

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Interest crediting methods (cont'd) § Linked rates (cont'd) § New Money § Rate of return being earned on new investments the company acquires with current premium dollars § Average current market return on the company’s new investments § More responsive to changing market interests rates than portfolio rates § New money crediting rates will rise faster and fall quicker than portfolio crediting rates § Blending § Weighted blend of new money and portfolio crediting methods 17

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Interest crediting methods (cont'd) § Linked rates (cont'd) § Modified portfolio § Credits a specific percentage of of cash value and current premium with new money rates § The rest of the cash value gets the “old” new money rates that applied in previous years § Direct recognition § The crediting rates applied to cash values is split § A crediting rate (current) against un-borrowed cash value § A crediting rate against borrowed cash values (typically lower than the policy loan rate. (Some carrier will credit the loan rate against the loaned cash values creating a “wash loan” effect) 18

Universal Life Insurance Chapter 17 Tools & Techniques of Life Insurance Planning § Interest crediting methods (cont'd) § What the illustrations do NOT tell you § What investment strategy underlies the crediting method § How the current mortality charges relate to the guaranteed mortality charges § As a percentage § What margin exists for the company to increase mortality charges § The rate of return on death benefit and cash surrender value § Some companies have this as an optional column that you must request to get illustrated 19