The historic vote this week on a non-binding referendum to determine whether the United Kingdom should leave or remain in the European Union has made headlines. The 52–48% vote, with a participation rate of almost 72% of the electorate, was in favor of exit by a 4% margin.
In the past few years, we have posted many entries dealing with the cost of insurance (COI) increases we have seen in Current Assumption Universal life (CAUL) policies. Almost three years ago, we were among the first to begin ringing the bell on this issue (see: If The Cost Of Insurance Goes This High, You Are Guaranteed To Have Some Angry Clients.) We have been asked by many of our trustee clients to explain the possible reasons for these increases.
If you have attended any of our webinars explaining life insurance (see: https://www.itm21st.com/Education), you know that Universal Life is a transparent policy, meaning you can actually see all of the costs in the policy. The beauty of the product is not only its transparency, but its simplicity. I like to explain it as a bucket with a spigot on the side. The premium placed in the bucket grows tax deferred, and each month, the carrier deducts the various charges in the policy from the cash value, with the COI typically being the largest charge.
There are four different factors that impact pricing or costs in a CAUL policy:
Overhead or expenses
We will leave mortality until the end and begin with investment earnings. Part of the profit earned on a CAUL policy comes from what is called the interest rate spread, the difference between what a carrier earns on its investment and the amount credited to the policy. The bulk of the investment in a CAUL policy is in fixed vehicles. These policies were born in the early ‘80s, an era of sky-high interest rates. Today’s historically low interest rate environment has put tremendous pressure on the carriers. In fact, we pointed out in September of last year (see: Transamerica Cost Increase Causes Premium to Maturity to More Than Double: A Case Study for Trustees) that Transamerica’s investment returns appeared to be lower than what it was contractually obligated to pay on a policy we reviewed. That fact was also noted in the lawsuit filed last month against Transamerica (see: Consumer Group Files Suit against Transamerica for Cost of Insurance Increases) that alleged that Transamerica’s real reason for the COI increase was “to subsidize its cost of meeting its interest guarantee, to recoup past losses on the policies and on its investment portfolio, and to make the policies more profitable by inducing policy terminations by those policyholders who could not afford the increase.”
It is interesting that the lawsuit referenced above mentions inducing policy terminations. Persistency is one of the factors in policy pricing that the consumer does not see in an accounting of the policy, but plays a role in policy profitability.
Carriers expect a certain percentage of people to drop their policies in the early years and often build that into their pricing model. According to studies, you can expect 9% of policies purchased to be dropped in the first year alone, and by the end of 10 years, approximately 49% have been surrendered or lapsed (1). In the early years, the policyholder pays much more in premium than the actual cost of coverage. If you surrender a policy in those years, you recover little (because of surrender charges), and you will have overpaid for your coverage. Although the carrier has acquisition costs in those years, they are still well ahead, helped greatly by those early surrenders. If fewer people than the company estimated leave early, their pricing model can suffer. It appears that in some situations this may have happened.
Overhead expenses are another factor in pricing. Servicing in-force business has become a drag on profits, so much so that at least one carrier (one of the carriers who raised COI) will only accept one illustration request per year free of charge (up to 3 illustrations per request), then charges a fee for each additional request.
Increasing reserve requirements are also playing a possible role in the pricing strains that carriers have felt. Most of the carriers raising COIs are European-based companies subject to Solvency II, a European Union regulatory overhaul of the insurance industry that could be affecting policy pricing because of a tightening of capital requirements. It is interesting to note that executives of six American-based life insurance carriers reportedly said they would not be raising COIs, though they did say that if interest rates remain low, they would not rule out an increase in the coming years (2).
Which brings us to mortality, the pure insurance component of the policy. Carriers begin with mortality tables to provide a basic estimate of the risk of death at each age. But carriers also underwrite their risks differently, and while the underwriting differences are not great, they may play a role in differences from one carrier to another.
Marketing and business decisions can play a role in actual costs. For example, in years past, there were “shave programs” at some carriers that allowed the underwriting to be artificially improved to generate lower premiums for the consumer and new business for the carrier. And I can remember back in my brokerage days a number of carriers who loosened underwriting requirements in December to hit their year-end numbers. Those cases may be coming back to haunt some carriers.
One carrier raising COI cited issues with conversion policies, those term policies that can be converted to new permanent policies without undergoing underwriting. The carrier in question was a big player (and still is) in the term market, and some of those that converted their term policies to CAUL policies with the carrier did so because they had a health issue that would not allow a fully underwritten policy to be obtained at better rates with another carrier. In other words, this term carrier was subject to adverse selection…those who could, got better rates elsewhere. Those who could not settled for converting their existing term policy.
Some pundits believe that the carriers actually have no issues with their mortality calculations and that the insured in these policies are not dying earlier than expected. According to actuaries, we are as a group living longer (3). And there has been a recent report that the wealthiest among us (who tend to buy more and larger policies) have a longer lifespan (4). These reports suggest what the attorneys in the Transamerica lawsuit referenced when they asserted, “Transamerica raised its COI not because of mortality issues, but because of other factors, chief among them the low interest rate environment.”
Should the Transamerica lawsuit referenced here and another lawsuit we cited in a past blog (see: John Hancock Hit With Class Action Lawsuit Over Cost of Insurance In Some Universal Life Policies) go to court, we may find out whether the carriers’ expectations regarding mortality assumptions were correct, but until then, there is no way to know.
Whatever the outcome, it is not much solace to the grantors we are dealing with that have been told to double the gifts to their trust just to keep their policies in force. As I have mentioned in the past, managing life insurance policies has gotten much harder.
Lapse-Based Insurance, Daniel Gottlieb and Kent Smetters, April 15, 2014
The Life Settlement Report – November 5, 2016
The Rich Live Longer Everywhere. For the Poor, Geography Matters, New York Times April 11, 2016
Our firm manages life insurance for TOLI trustees and institutional investors, and I have heard a concern from both parties about the recent Current Assumption Universal Life (CAUL) cost increases. People are worried about the direction of in force policy pricing. Are the increases an aberration or will they spread? I am not a soothsayer, nor am I on the boards of any of the carriers that have increased costs or are contemplating a raise, but I do have some insight into the matter because of our role in the policy management industry.
Have you ever fantasized about having a crystal ball to guide your investment picks?
In my last blog, Turning the Battleship Around…Has it Started?, I wrote about Whole Life dividend trends and stated perhaps the dividend slide might be “leveling off and slowly trending upward.” I based that thinking on the fact that of the “Big 4” Whole Life carriers—Northwestern Mutual, Mass Mutual, Guardian Life, and New York Life, three had “either maintained or increased their dividend rate,” which I believed was a “positive trend.”
Life insurance carriers have traditionally been a conservative lot when it comes to investing, with the vast majority of their investable assets in highly-rated bonds and a lower proportion in gold standard mortgages.