Insurance is Risk Transfer; But What are the Risks?
Insurance is risk transfer. In its purest form, Term insurance transfers the financial risk of an untimely death (i.e., mortality) to the insurance company. The premium and death benefit for the policyholder is known and guaranteed. If mortality results are better than expected, the insurance company makes an additional profit beyond the original assumptions. If mortality results fall short of expectations, the insurance company’s profit declines. Policyholders have little uncertainty (other than the future claims paying ability of the insurance company), but also no upside if results are better than expected (e.g., reduced premiums), and no flexibility to access value prior to death should their needs change.
In the past 50 years, the industry has developed new forms of insurance in which the policyholder shares some of the downside risk and upside potential with the insurance company. For example, in participating Whole Life (WL) contracts, policyholders share in favorable mortality, interest, and expense results through policy dividends, which can be used to suspend premiums or increase the face amount. Policyholders also assume some downside risk since dividends are not guaranteed. If experience is worse than expected, dividends may be reduced, potentially requiring additional premiums. However, there is a guaranteed floor to downside performance via the base contract.
Whole Life then gave way to Universal Life (UL). With UL, the same risks and opportunities are shared with the policyholder, but they are “unbundled” and more transparent than the “black box” dividend calculations inherent in Whole Life. UL also includes a guaranteed floor for downside performance.
Considerations for Financial Flexibility (Cash Value)
In addition to the amount of required premium, an important consideration is the flexibility of the chosen product—that is, the ability to access value in the contract prior to death (i.e., cash value) should the policyholder’s needs change over time. Although insurance is a long-term investment, having access to cash values can provide emergency cash or income if needed. Additionally, cash values can be used to fund a policy exchange into a product with better potential performance. Withdrawals will decrease the death benefit and cash value and may be subject to policy limitations and income tax.
Different product types, and even different products within a product type, can have significantly different levels of cash values. Some products have surrender charges, which can significantly reduce cash values in the early policy years; other products contain cash value enhancement riders, usually available for an additional fee, which typically increase cash values in the early policy years and slightly reduce cash values in the later policy years. Of the different product types, NLG typically offers the lowest cash values, often producing zero cash values in the early policy years and zero cash values in the later policy years. There are some NLG products that provide enhanced cash values, but the offset is increased guarantee death benefit premiums.
Product Planning and Risk Mitigation
The current economic environment makes it even more critical for policyholders to understand product type risks and opportunities, and plan and review accordingly. At the time of purchase, it is important to understand risks and guarantees, which may be quantified by illustrating downside scenarios (including guarantees). Understanding the impact of funding policies at different levels, including more conservative premiums that will provide a cushion in the policy to withstand a downturn, is also beneficial.
For insurance that has already been purchased, inforce illustrations can provide an early warning as to whether adjustments in funding or death benefit, or even a policy replacement (i.e., 1035 exchange), may be necessary. In-force reviews may need to be more frequent for aggressively funded policies or for products that contain more risk. Note that in-force reviews may show actual policy performance that is ahead of schedule, providing opportunities for reduced future premiums or for taking cash distributions.
Life Insurance Company Due Care
Company financial strength is always an important consideration, but it is even more critical in today’s environment. Reviewing and understanding insurance company financial strength ratings help policyholders and their advisors become comfortable with the claims paying ability of the company. Consider the value of diversifying insurance across multiple insurance companies to spread the claims paying risk. Some advisors may even provide ongoing reviews of insurance company financial strength, a valuable service in the current economic cycle.