Selecting the best cash-value life insurance policy is a difficult task involving a number of complicated concepts. However, because the amount insurers credit to cash values on UL policies is a critical element of the overall cost of the protection, one primary area of focus should be how the company determines the amount it credits to cash values.
- The amount insurers credit to cash values each year depends on four factors:
- The expenses insurers charge against the policy
- The mortality charges insurers assess against the policy
- The net investment yield earned by the insurers on their portfolio of investments
- The method insurers use to allocate interest to various blocks of policies
- The cash value at the end of any given year is equal to the cash value from the end of the prior year plus premiums (or less withdrawals) paid during the year less expense and mortality charges and plus interest credited. The annual report usually will explicitly show the expense and mortality charges and the interest credits each year.
As described above, two elements usually comprise the expense charge, a fixed annual fee plus a percentage of premiums paid. The company may or may not reveal these fees in its original policy illustration. However, even if it does, the company usually makes no guarantee that they will not change the expense charges. Actual expense charges may increase or decrease in future years.
Every UL contract explicitly states the maximum mortality rates it will charge for all ages and guarantees that mortality rates will not exceed those maximums. Many companies now use the 2001 Commissioner’s Standard Mortality (CSO) table as the basis for their contractually guaranteed maximum rates, but some companies still use the older 1980 CSO mortality table for their new policies. In addition, all policies issued before 2002 used the 1980 CSO mortality table or, possibly, the 1958 CSO mortality table. All three tables are very conservative—that is, they assume mortality rates that are considerably higher than what is actually expected—but the 1980 CSO table and, even more so, the 1958 CSO table are considerably more conservative than the 2001 CSO table. Virtually every company currently charges less than the stated maximums, but those using the more conservative 1980 or 1958 CSO tables have more room to increase mortality charges in future years if their mortality experience is poor.
Although annual statements explicitly show actual mortality charges, many policy illustrations do not. In fact, some illustrations assume very low or no mortality charges, which tend to show projected cash values that are overstated relative to what policyowners can actually expect. Other illustrations include mortality charges based on rates the company is assessing currently, but they also may assume that mortality experience will improve in future years. If the mortality improvements do not materialize as anticipated, actual cash values are unlikely to match the projected cash values.
Net Investment Yield on Investment Portfolio
Over the long run, insurance companies cannot credit more interest to policy cash values than they earn on their general investment portfolios. To assess a company’s long-run interest crediting ability, one should evaluate the insurer’s current portfolio and its investment philosophy.
As a general rule, insurance companies invest their portfolios predominantly in long-term corporate and government bonds and mortgages. However, there are differences in the proportions invested in each type of asset and in the quality, duration, yields, and risk. In the past, overly aggressive investments in high yield and high risk junk bonds and developmental mortgage loans pushed some companies to insolvency. Therefore, one’s objective should be to select companies with investment portfolios and investment philosophies that show a reasonable and acceptable combination of risk and return. What is reasonable and acceptable, of course, depends on the level of risk and the certainty of return desired by the policyowner.
Procedures for evaluating the investment portfolios of insurance companies are discussed in Chapter 3, “How to Determine the Right Company.”
All UL policies, just like all other types of cash value policies, have a guaranteed minimum interest rate. The guaranteed rates, historically, have ranged from 4 to 6 percent. In the recent years of historically low market rates of interest, many insurers have lowered the guaranteed rates to 3 percent, 2.5 percent, or even lower. The rate insurers actually credit to cash values, called the current rate, is (or has historically been) higher than the guaranteed rate. Companies use various methods to determine the current rate they credit to cash values:
- Linked rates – Some companies link their current rates to some specified external, well-known index of yields, such as one-year T-bill rates or an index of intermediate-term, high-quality corporate or government bond yields. For example, the current rate might be set at ½ of 1 percent less than the yield on the specified index.
- Discretionary – Many UL policies provide that the insurance company may use its discretion to determine the current rate. In other words, other than the upper limit set by the investment performance of its general portfolio, the insurance company may credit any rate it wishes. The insurer makes no guaranteed link between the rate earned by the company and the rate credited to policies. However, competitive pressures prevent companies from abusing their discretion and most companies use formulas related to their investment performance to allocate interest to policies.
- Portfolio – The formulas used by companies to determine their current rates on nonindexed UL policies may be based on new-money rates or portfolio rates or, more commonly, some weighted average of new-money and portfolio rates. The new-money rate is the rate of return being earned on the new investments the company acquires with current premium dollars. It is essentially the average current market rate of return on the company’s new investments. The portfolio rate is the rate of return on the company’s general investment portfolio (or the portfolio of investments backing the block of policies). The portfolio rate actually is a blend of the rates earned on new and old money.
- New money – Because insurers invest principally in long-term fixed income types of investments, new-money rates are clearly more responsive to changing market interest rates than portfolio rates. This can work for or against the policyowner. If market rates generally are rising, UL cash values credited with new-money rates will grow faster than those credited with portfolio rates. Conversely, if market rates are falling, UL policies credited with portfolio rates will have faster growing cash values.
- Blending – Most companies use a weighting scheme to produce a current rate that is a blend of new- and old-money rates somewhere between the portfolio rate and the newmoney rate. One method, called the weighted-average portfolio method, computes the current rate by blending new- and old-money rates in a specified proportion. For example, the insurer may set the current rate at 20 percent of the new-money rate and 80 percent of the old-money rate. If the new-money rate is 10 percent and the old-money rate is 8 percent, the insurer would set the current rate at 8.4 percent.
- Modified portfolio – Another method, sometimes called the modified-portfolio method, is the weighted-average percentage rollover method. This method credits a specified proportion (the rollover percentage) of the cash value and current premium payments with the new-money rate each year. The insurer continues to credit the rest of the cash value with the old new-money rates that applied in previous years. That is, the insurer rolls over the specified percent of previously invested money plus interest on the cash value over each and every year into a new-money rate. Example. Ignoring mortality and expense charges, assume the rollover percentage is 20 percent and the annual premium is $1,000.
Year 1: New-money rate = 9 percent. The first-year premium is credited with 9 percent. End of year value, $1,090.
Year 2: New-money rate = 8 percent. The insurer credits the second-year premium, $1,000, plus 20 percent of the first-year premium and interest, $218 (0.2 × $1,090), with 8 percent. The insurer credits the remaining portion of the first-year premium plus interest, $872, with 9 percent. Total end of second-year value is $2,265.92 [($1,218 × 1.08) + ($872 × 1.09)]. End of year second-year money is $1,315.44. End of year remaining first-year money is $950.48.
Year 3: New money rate = 10 percent. The insurer credits the third-year premium, $1,000, plus 20 percent of remaining first year’s money plus interest, $190.10 (0.2 × $950.48), plus 20 percent of second year’s money plus interest, $263.09 (0.2 × $1,315.44), which totals $1,453.19, with 10% interest. The remaining first-year money plus interest, $760.38 (0.8 × $950.48), continues to get 9 percent. The insurer credits the remaining second-year money plus interest, $1,052.35 (0.8 × $1,315.44), with 8 percent. Total end of third-year value is $3,563.86 [($1,453.19 × 1.10) + ($1,052.35 × 1.08) + ($760.38 × 1.09)]. End of year third-year money is $1,598.51. End of year remaining second-year money is $1,136.54. End of year remaining first-year money is $828.81.
The process continues each year. After a number of years, each year’s remaining money will be entirely absorbed or rolled over into later year’s new money classes.
The amount of interest that the insurer actually credits to any policy depends on the timing and size of premium payments. If policyowners make large premium payments in years when the new-money rate is high and no premium payments in years when new-money rates are low, cash values will grow more rapidly (relative to total premium contributions). However, even if policyowners make no premium payments in years when new-money rates are low, the amount the insurer credits to cash values will reflect the low new-money rates because the specified percentage of each prior year’s money is always rolled over to the new-money rate of the current year.
With either the weighted-average portfolio method or the modified portfolio method, the rate insurers credit to cash values will be more responsive to changes in new-money rates if the new-money percentage or the rollover percentage is higher. If market rates currently are low by historical standards and one expects market rates to increase, one should look for companies with high new-market or rollover percentages. Conversely, if market rates currently are high by historical standards and one expects them to fall, one should look for companies that use lower new-money or rollover percentages.
- Direct recognition – Some companies use the direct-recognition method to determine the rate they credit to the portion of the cash value that is secured by policy loans. Companies that use this method typically credit interest on the portion of the cash value that secures policy loans at the minimum guaranteed rate or 2 percentage points lower than the policy loan rate, whichever is higher.
- Persistency bonus – Some companies also pay periodic bonuses for persistency, that is, to reward long-term policyowners. Companies may pay these bonuses either as retrospective increases in the general interest rate or as lump-sum additions to the policy cash value. However, one should view projected persistency bonuses that are not guaranteed with caution. Bonuses that are not guaranteed may, in some cases, merely be a way for insurers to make illustrated values appear higher, without any requirement that the company actually pay the bonuses as illustrated.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM