Today, many existing life insurance policies, including those issued by some very well known companies, are no longer the good policies they once were. As a result of overall market conditions during the past several years, many of these so called “good policies” have in fact become bad policies.

While the costs of these bad policies have or will increase substantially, most policy owners and their advisors have no idea that anything has changed or that their policy has become and will remain economically unviable. What the owner of a bad policy can do about it has to be evaluated on a case by case basis.

What Does this Mean to You?
You as an attorney may be able to help avert most of these excessive future costs if you own or if you have clients who own or are a trustee for a trust that owns a bad life insurance policy. If you are the trustee for a trust that owns a bad life insurance policy, as a fiduciary you may have a liability issue.

Pricing - How Variable Insurance Policy Premiums are Determined
All companies establish the amount of premiums they will charge for every variable insurance contract offered before it is made available for sale to the public. This process, called “pricing,” involves actuarially determining the total future cost to the company for insuring its risk. The amount of insurance risk for each policy depends on its cash value. The company pays the death claim and keeps the cash value.

Costs of mortality, expenses and policy lapses are three of the most important elements of pricing. Mortality costs over the long run are relatively easy to estimate. Long term expenses and policy lapse rates are much more difficult to predict.

The two potentially largest policy costs to an insurance company are: (1) the monies paid into the policy will not be sufficient to cover the actual claim paid when an insured person does not live as long as expected and (2) the chance that actual operating expenses will be greater that originally projected.

To cover these M&E (Mortality and Expense) risks, additional charges are included as a percentage of the cash value for the life of the policy. Any insurance costs charged and/or M&E risk charges that exceed actual costs are kept by the company as profit.

Another important pricing issue is what happens to a policy should the insured live to age 100. Many policies today provide that the insurance benefits will continue past age 100, usually at no cost to the policyowner. However, many existing policies provide that at age 100 the policy is terminated, its cash value is paid to the policyowner and any gain will be taxed as ordinary income. Should the gain be large, the taxes paid will be significant.

Many companies with policies that terminate at maturity have said they will change these contracts to extend past age 100 before the issue becomes a problem. The real problem is that the cost of extending a policy will have to be paid by either the company or the policyowner, as it was never included in the pricing.

How Does a Policy Become Bad?
One reason many good policies become bad is that over time the pricing assumptions may become impossible to achieve. Today, this is the case with many policies because of recent unexpected market conditions. As the result of huge investment losses, lower than expected premiums paid, and higher than expected policy lapses and withdrawals, current cash values are substantially lower than projected. In fact, cash values are so much lower today that insurance risk costs for many companies have become intolerable.

These companies have had more payouts than they can afford. Substantially lower cash values mean substantially less income from M&E risk charges and other policy fees and charges. These result in substantially increased costs of the insurance coverage in force and substantially decreased profit margins or in some cases significant operating losses. The results can be disastrous for any company, especially for a stock-owned company paying dividends.

In most cases, an insurance company will offset these increased costs by raising any fees and charges that are not currently limited in the contract and/or to increase the cost of insurance (COI) paid by the policy owner. Typically, a variable policy cannot support a COI increase without an increase in the amount of premiums paid and/or the number of years that additional premiums will need to be paid to keep the policy in force. For the policyowner, these increases can often become staggering, especially when COI is raised near or up to the contract maximum.

Surprisingly, a company needs no justification to increase COI, which can occur even when actual mortality costs are falling. Also, policyowners may not even be notified of a COI increase. When the total required premiums exceed a certain amount, what had been a good policy becomes economically unviable. That is, the price that will ultimately be paid for the policy makes no economic sense and the same benefits can be or could have been purchased at a much lower price. By the time a policyowner realizes this, it may be too late to do anything about it.

How Else Can a Policy Become Bad?
Another reason a company’s insurance risk costs may become intolerable is because of decreased earning assets. While operating and investment losses can increase insurance costs, most damaging are two asset accounts that from a layman’s prospective are not assets at all. These accounts are Deferred Acquisition Costs (DAC) and Goodwill. Both can be characterized as merely accounting entries to reflect dollars that have already been spent, but cannot be deducted from current and/or previous years’ revenues due to accrued accounting rules.

Acquisition Costs are all expenses that are directly attributable to a new policy or contract. Examples include sales commissions, marketing costs, support costs and even some General Account investment losses. Instead of deducting these expenses in the year the policy is issued, the IRS requires that these expenses be spread over the expected life of a policy.

For example, when a company pays $100 million in acquisition costs, if the IRS allows $10 million to be deducted, the remaining $90 million is added to DAC. The company’s $100 million is gone. So are the taxes paid on $90 million. The initial addition, if any, to earning assets from these new contracts, will most likely be minimal.

Goodwill is essentially the price paid in excess of the accounting value to acquire another company or assets from another company. Any acquisition costs attributable to future years included in the purchase would be added to DAC.

The earning assets of a company equals its total assets less DAC, Goodwill and any other non-earning assets. If earning assets decrease, maintaining the current income from these assets becomes increasing difficult. While each year a relatively small percentage of DAC and Goodwill can be deducted from current revenue, for a significant number of companies total DAC and Goodwill is in fact presently increasing each year. In many cases, to offset a decrease in earning assets, companies will raise COI to increase policyowner premiums.

What About Whole and Universal Life Insurance?
While some of same issues affecting variable policies affect all policyowners, the primary difference in whole and universal life policies is that the insurance company also bares all of the investment risk. For these policies, the biggest problem currently is that General Account earnings for many companies are decreasing to the point where overall yields are falling below the guaranteed minimum rate. This is the result of fixed income yields being substantially lower today then they were a number of years ago.

What does a company do when a policy guarantees a return that is higher than the yield from its General Account? For a company that elects not to absorb the costs, one option is to raise all of the policy costs that it can. The result for many policyowners is that premiums will increase, benefits will decrease, or there will be a combination of both.

How Can You Tell If a Policy is Bad?
First and foremost in evaluating a policy is to get an in-force policy illustration from the company. You will actually want to see several run at different net rates of return and make sure whether or not M&E charges are deducted from the gross rate. You will also want to see the cost detail showing mortality costs, fees, charges and credits for each year.

You may be able to assess if the policy is still economically viable just from in-force illustrations. You may want to compare the in-force to the original sales illustration, if you have it. If the original illustration uses a high rate of return and/or credits and/or reductions in COI and other fees or charges that are not guaranteed, the cost of the policy may be much higher than shown.

If you are inclined, you may wish to review the company’s financial statements over the past few years for changes in DAC and Goodwill. If not, have your accountant or a qualified professional review them. In some cases, however, DAC may not be reflected by financial statements.

Other signs of a possible trend in increasing costs are when a company lays off a large number employees, makes changes in senior management, sells off assets or divisions, has a high turnover of sales agents, increases COI, has a decline in the quality of service and support, or acquires another company.

If you determine that a policy is not a good one, the insured’s current health may dictate what can be done about it. Significant changes in net worth or planning objectives may also affect the owner’s current insurance needs. You may want your financial advisor to show you sales illustrations and information for new policy alternatives from a number of companies. If your advisor cannot provide these to you, find an advisor who can.

Complicated? You bet it is. But the more you know about how insurance policies work, the better off you may be and the better you will be able to serve your clients.