There are a lot of adjustments to be made in our current low interest rate world. It has been a boon to borrowers, especially mortgage borrowers, but a bane to savers and investors who are accustomed to earning a decent rate on low-risk investments. Another financial vehicle that can be significantly affected, and which often comes as quite a surprise, is some types of life insurance.
To be sure, not all life insurance is affected by low interest rates. Term life insurance is “pure life insurance” which does not have any investment component and pays a stated death benefit if the covered person dies within a specified period (the term). Term insurance is best used to cover expenses or lost income that will end at some point, such as the costs of raising children, education, or debt repayment. Whole life insurance, which combines a death benefit and a savings component, has higher premiums for a similar death benefit so that lower interest rates would rarely put the policy in jeopardy.
The primary type of life insurance that could be affected is “universal life”, which is permanent life insurance with a savings component and lower premiums. The savings component accumulates in the early years of the policy and then helps pay for the cost of the insurance, which increases as the insured person ages. This allows the premiums to be “level” for the life of the policy.
When a universal life policy is issued, the premium is based on the earnings rate of the life insurance company’s investment portfolio at that time. There is an “illustration” which usually shows projections based on three rates: the highest rate is the current earnings rate, the lowest rate is the minimum earnings that is guaranteed by the insurance company, and there is often a mid-range rate that is halfway between the other two. In fairness, these illustrations are given in good faith, and the projection based on the current earnings rate has a premium which will keep the policy in effect for the life of the insured, as long as the insurance company earns that rate and the other projected expenses stay constant.
If the insurance company does not earn the rate in the original illustration, or if other policy expenses increase, the policyholder may be in for a nasty surprise. Without much notice, they may be faced with a choice to either pay higher premiums to keep the same amount of insurance or accept a lower insurance benefit and keep the premiums the same.
Consider these two real-life examples:
• A woman whose resources were tied up in a complicated family situation purchased a universal life policy so that her second husband would receive a lump sum if she died first. At the age of 82, and even after making some extra premium payments along the way, she received notice that her premiums would have to double to keep the policy in effect, and would increase even more if she lived into her late 80’s. If she were to live to age 90, the cumulative cost of the higher premiums would have been nearly as much as the insurance benefit. After considering the options, she chose to cash out the policy now (with a value of about 30% of the insurance benefit) and save the amount of the premiums rather than continue the policy.
• A couple in their late 40’s purchased a universal life policy which would pay its benefit when they had both died; they have a child with significant care needs and the policy was an integral part of their estate planning. They chose to make a single premium payment, which based on the projected 6.6% return at the time would pay for an insurance benefit nearly nine times the premium. Ten years later, lower actual earnings forced them to make an additional payment of around 40% of the original payment to keep the policy in effect. This time they made the payment based on the lowest guaranteed rate, which was a good decision because in a few more years the actual earnings went down to that minimum guaranteed rate. But their policy is guaranteed to stay in effect for as long as they live.
Fortunately, there is something a policyholder can do before getting the nasty surprise. They can ask the insurance company for an “in-force” illustration, which is similar to the original projection, but which uses updated figures for the earnings rate and expenses. An in-force illustration will show very clearly how long the policy will last based on the current premiums, as well as show the premiums that would be necessary to keep the policy in effect at the minimum guaranteed earnings rate.
So, if you have had a universal life insurance policy for a few years, it is a good idea to ask for an in-force illustration now. That will give you advanced notice if your policy will be in jeopardy in the future, and you can make decisions now rather than when forced to if the earnings don’t keep pace.