Building a More Secure Life Insurance Contract
By: Peter R. Moison, JD
President of Castle Re Insurance Company, Ltd (Bermuda)
It is refreshing to see more attention being paid to the issues of lapse supported underwriting and why life insurance policies, in far too many cases, are not serving the long term needs of those who purchased them. Recent papers by Bill Boersma and David Barkhausen, and past papers by Glenn S Daily help in the understanding of these issues. With lapse supported pricing the insurance company has priced the policies with the intent that many, many of the policies will either terminate due to actions of the policy owner or otherwise be terminated before the insured dies. This is a brilliant concept if you want life insurance only for a short period of time. But if you need life insurance in place until you die then lapse supported pricing is not for you.
A recent article from the M Group regarding cost of insurance (COI) increases imposed by 6 large life insurance companies discussed possible reasons for the raising of the COI rates. What was noticeably absent from the discussion was the potential impact of lapse supported pricing as a possible reason or one of the reasons for increasing the COI charge. The lack of an analysis of this issue brought to mind a 2014 publication titled Lapsed-Based Insurance written by Daniel Gottlieb and Kent Smetters of the Wharton School. The article made the following observation: “Insurers make money on customers that lapse their policies and lose money on those who keep their coverage.” This could help explain why high net worth clients and their advisors are wary of the life insurance products available for sale in the U.S.
With lapse supported pricing the insurance company knows from the very beginning its model is to escape paying a death claim on a significant number of its policies. Thus a substantial number of those policies must fail to result in a death claim otherwise the insurance company will have gas pains. This may help explain why far too many life insurance policies seem to be forced off the books late in life when the insured and his/her family need the coverage the most.
Who We Work For
We are in business for those who want and need life insurance to stay on the books and result in a death claim. We remain privately owned thus do not work for shareholders. We work for our clients. Therefore, we can take a very different approach. Our business model is for all the life insurance contracts we underwrite to succeed and succeed in a manner that is intended on maximizing the amount paid at death and the amount to help if a family needs cash.
The Nature of Life Insurance Risk
To understand why life insurance can be designed and administered to succeed it will be helpful to have a basic understanding of the nature of life insurance risk. Unlike your typical general risk or property insurance, the risk event insured with life insurance is going to take place. Everyone is going to die but not everyone will have a car accident. Thus when it comes to life insurance, if the life insurance policy or contract continues to stay on the books, the insured will die and the life insurance company will have to pay the death claim. Since the risk of a claim with life insurance is 100% if there is to be no lapse, the life insurance company at some point in time will need the reserve set aside for the claim to equal 100% of the amount to be paid at death. The only question for the insurance company is when death will occur. General risk insurance companies are different since not every general risk policy will result in a claim. Therefore, general risk carriers do not need to have the reserve equal 100% of the potential claims.
Lapse Supported Pricing Does not Make Sense When the Need is Permanent
In fully underwritten life insurance cases it is far more likely the insured will live well into the future and die old. The opposite is also true with respect to an early death where the need for life insurance is temporary. In temporary situations it is very unlikely the insured will die anytime soon. Therefore, since (1) the insurance company knows it is very unlikely it will pay a claim during the temporary time frame, and (2) coverage will terminate within that time frame; it would seem proper to use lapse support to reduce the cost of the temporary life insurance. Unfortunately, life insurance companies also use lapse supported pricing on policies where it is known the insured needs and wants to keep the policy until he or she dies. Such a pricing arrangement is less than brilliant where the need is truly long term and a claim will eventually need to be paid.
As with any insurance contract the more likely a risk event will occur the more the insurance company must set aside in a risk reserve to pay the claim. Since, as noted, it is highly unlikely a fully underwritten insured person will die soon after the life insurance goes into effect, the initial required reserve for a life insurance policy is very low. However, as the insured ages the amount that needs to be set aside in a reserve for that claim increases. Eventually the risk of death is 100%. At such time the required reserve for that claim must equal the claim to be paid. If not, the insurance company will have a liquidity issue.
We believe the liquidity issue is one of the dominant factors that motivates life insurance companies to intentionally design their life insurance products to minimize their claims paying potential. If we are correct that would explain why, in far too many cases, the life insurance policy the insured person wants to keep on the books lapses before the insured dies. In many, many cases written in the domestic life market there is no economical way for the owner of the life insurance policy to prevent the lapse. The owner will most likely end up paying more into the policy than will ever be paid out in death benefit. This is especially true if one considers the time value of money. So what do you do?
Distinguishing between the Concept and the Product of Life Insurance
First of all there needs to be a belief that the concept of life insurance is a good one. It is important to realize we are talking only about the concept of insurance as opposed to the product of life insurance. We know what the product is and why many, many folks are turned off by the product. Even those who agree the concept is sound either stay away from the product of life insurance entirely or only buy a fraction of what they could really use. If you are frustrated by the product and agree the concept is a good one then you have to look for an alternative to solve this dilemma. We sincerely believe the concept of life insurance is an extremely beneficial concept. A concept that can provide more long term planning benefits than any other single estate planning concept. The challenge is to put that concept to good use and into a life insurance contract that is designed to stay on the books and truly benefit the client and his or her family. This means two things: (1) the contract must be designed correctly and without lapse supported pricing, and (2) it must also be represented and described correctly. Life insurance is insurance and it should not represented as a security, or a tax wrapper. If you believe the concept is beneficial then you should require that the contract be designed to fit your unique needs with all costs designed to be both low and guaranteed.
The value of the concept of life insurance is that it provides a tax free lump sum cash payment upon the death of the insured and a lifetime safety net of funds that can be used to help out when cash is needed or an opportunity arises. If the concept is developed and administered properly the payment at death and the size of the lifetime safety net should both be maximized. This includes proper investment of the reserve with the upside benefiting the insurance contract and not the insurance company. There is no rule that says the upside or spread of the invested reserve has to go to the insurance company. Imagine, if instead of the upside going to the insurance company, that upside went to the benefit the life insurance contract. We believe it should.
Let’s continue with a Q&A in an effort to help explain why we can help your professional team design the correct life insurance contract for your situation. And a contract that is intended to stay on the books until death. No lapse supported pricing used.
Q. What are the elements of life insurance?
A: Life insurance is actually very simple. There are three elements: (1) the cost of insurance; (2) overhead and profit; and (3) the reserve or what is marketed as cash value.
Q. Can any of the elements be guaranteed?
A.Yes both the cost of insurance and the overhead and profit of each insurance contract can be guaranteed and guaranteed in a manner where such costs are extremely low. In the U.S. life insurance policies sold as universal life; variable universal life; and private placement variable universal life generally have contractual provisions that allow the insurance company to unilaterally increase such costs. We do not believe that is proper.
Q. What about the reserve, can that be guaranteed?
A. No insurance company can completely guarantee the value of the reserve. The reserve is generally invested in various holdings that fluctuate in value.
Q. How do most domestic life insurance companies reserve for their claims?
A. Whole life and universal life insurance companies use a general account to reserve for their claims.
Q. Is there is another way to reserve?
A. Yes. We are a true segregated account life insurance company. As such we are required to place the premium we receive for each insurance contract into its own separate and protected account. Such an account is known as a segregated account (SA). The SA holds and invests the premium for the life insurance contract for which the SA was created. Think of it as a mini general account set up exclusively for the respective life insurance contract.
Q. Can the SA be used by the insurance company for all insurance contracts?
A.No. The SA can only be used, under Bermuda law, for the life insurance contract for which it was created.
Q. Is the SA subject to general claims against the insurance company or by other insureds?
A.No. The SA cannot be claimed against by general creditors of the life insurance company; by other insurance contract owners; by other insureds; or by other beneficiaries.
Q. Is that also true of a general account?
A.Generally speaking no.
Q. So if the general account experiences a problem or is placed in some kind of awkward situation all life insurance policies sharing in that general account may be affected?
A.Yes. A good example is the recent cost of insurance increases imposed by several domestic carriers. One of the reasons provided by these insurance companies for the increase is the low yield they are experiencing on their general account.
Q. Is this also true of products such as variable universal life and private placement variable universal life can increase their costs?
A.While neither of these products are general account products, the domestic life insurance companies have decided to use lapse supported pricing with these products. Thus they have the same ability to increase the cost of insurance and overhead/profit costs. Anyone who purchases these products to provide lifetime protection should be concerned about the long term viability of their policy.
Q. So what is the difference between a general account product and a life insurance contract that has its own dedicated SA?
A. It may be helpful to use an analogy here. Do you remember the playground game called “Crack the Whip?” We used to play it at recess in grade school. A long line of kids holding hands would be created. The leader would run at full tilt and make sharp turns until finally the whiplash was sufficient to cause the line to fall down. We would all laugh then. However, it is no laughing matter when the general account cracks the whip. When that happens the life insurance policies supported by that general account will have some issues. The same cannot be said when reserve for each insurance contract is supported by a segregated account. The failure of one segregated account has no impact on any other insurance contract. It only impacts the one insurance contract associated with that SA. Thus no crack the whip whiplash with segregated accounts. But this not true when the insurance company has the ability to increase the costs of the policy they sold you.
Q. Is a SA similar to a general account?
A. The funds in the SA are the reserve set aside by us for the particular life insurance contract for which the SA was created. Each life insurance contract has its own SA, thus its own unique reserve. So in that respect it is similar. A general account is the reserve set up for many, many life insurance policies, however. The funds held by the general account are invested by the insurance company in a diversified portfolio of assets. Similarly, the funds held in a SA are also invested in a diversified portfolio of assets. Both are considered to be the reserve set aside to back the risk. But there are two substantial differences. In a typical general account setting the whip can crack and when it does all the policies sharing in that general account will be impacted. There is no crack the whip syndrome where the reserve for each life insurance contract is held in a truly dedicated SA as long as the insurance company cannot increase your policy costs. The other substantial difference is who gets the spread on the investments.
Q. Who takes the upside spread in a general account?
A.The insurance company.
Q. Who shares in the upside spread with a SA?
A. With us all investment gain or spread stays exclusively with the SA associated with the insurance contract. No spread goes to us. And, unlike other insurance companies, we cannot erode the spread by increasing the costs of the contract as we guarantee such costs. A well invested SA and a well-designed and invested custom life insurance contract will do two things: (1) maximize the death benefit when it is needed the most and (2) maximize the lifetime safety net benefits. This may not be entirely true, however, where the life insurance company uses lapse supported pricing and has the ability to increase the risk cost as well as the other expenses of the policy. We do not use lapse supported pricing and guarantee all costs. Thus we have no ability to pull the carpet out from underneath the contract owner.
Q. Since the reserve is invested in a diversified manner with both general account policies and SAs then why in the U.S. are general account products not considered securities but variable products are?
A. The quick answer is variable products in the U.S. are intentionally designed and marketed by domestic insurance companies to be securities. With variable products the premium is held by a separate account. U.S. companies allow the owners of variable life insurance policies to select how the reserve is invested among a limited list of investment choices provided by the insurance company. This is supposed to make the owner somehow feel they are directing the investment of the reserve. General account products have not been considered to be securities. One reason for this is the owner of the insurance policy has no choice but to have the premium paid for the life insurance go into the general account. The owner also has no say so in how the general account is invested.
Q. Did we set ourselves up as a segregated account life insurance company to promote life insurance as a security?
A.No. We do not believe life insurance should be marketed as a security. Life insurance contracts are insurance thus we believe insurance is insurance and should not be marketed as a security or as a “tax wrapper” the primary purpose of which is to avoid income taxes. We also believe in practicing in such a way to both help protect the integrity of each insurance contract and to maximize the long term benefits life insurance is intended to provide. The reality is the SA essentially operates as a mini general account for the respective life insurance or annuity contract. Why? Because it is legally the reserve set aside to help meet the eventual claim either at death for life insurance or to meet the future payout from the annuity. Our business model, however, is each life insurance contract is a customized solution uniquely designed for each client. Because of this each SA is managed by an independent outside investment manager. No investment choice is provided to the owner of the segregated account life insurance contract. Similar to the description in the above Q&A the premium has to go into the SA associated with the respective life insurance contract. Also, similar to a general account, the owner has no control over how the SA is invested. It is also important to note Castle receives no compensation or fees of any kind from the independent investment manager. The loyalty of the investment manager is to the SA and not to Castle. Also, as noted above Castle takes no spread. The entire ups and downs of the investment belongs, as it should be, exclusively to the respective SA.
Q. Must life insurance always come in the form of a pre-approved and unalterable regulated policy?
A.In the U.S. the answer is yes. Thus it is not possible to create a true customized contract of life insurance in the domestic marketplace. We do not practice that way. Each life insurance contract is uniquely designed to meet the needs of the respective client. No cookie cutter, one size fits all approach with us.
Q. Why are we located in Bermuda?
A.We would love to be located in the U.S. Unfortunately the regulatory environment in the U.S. does not allow for true custom designed life insurance or annuity contracts. All life insurance and annuity policies sold in the U.S. must be sold using product and policy forms pre-approved by the state where the policy is sold. Those forms cannot be altered. That means no ability to truly design a specific insurance contract to meet the unique needs of each client. Our business model is life insurance for the high net worth client needs to be the result of a collaborative effort with the client’s trusted professional advisors. You simply cannot provide a customized solution unique to the client if your only choice is to buy a policy that must use an unalterable form pre-approved by the regulators. We do not have that constraint in Bermuda.
Q. Does the Bermuda location mean the assets in the SA must also be invested and managed in Bermuda?
A. Not at all. Such assets are generally managed and invested in the U.S. with such assets held in quality independent U. S. based custody accounts.
Q. What about commissions?
A.We are not in the business of selling life insurance products. Period. Therefore, we do not use any life insurance agents or brokers thus we pay no commissions. All professional advisors work for the client and negotiate their fees with the client. Thus the loyalty is to the client. If we paid commissions for business then the loyalty shifts away from the client to the party who is compensating the agent or broker. It is the job of the client’s professional team to fully understand the long term planning objectives of their client. That is what their client is paying them to do. We work with those fee based professionals to help them design and implement a unique and custom designed life insurance contract for their client.
Q. Are the costs of the custom designed contract of life insurance guaranteed?
A. Yes. We do not believe the insurance company should have the ability to raise the agreed upon cost structure.
Castle’s business model is to work with the client’s professional team to help design a custom life insurance solution that meets the unique needs of each client. The final contract is to be U.S. tax compliant, entered into for the traditional purposes of cash value life insurance, transparent, and very low cost with such costs guaranteed. We do not believe anyone who is looking for a lifetime life insurance solution should enter into a life insurance arrangement based on a non-guaranteed current projections of all costs and an arrangement that uses lapse supported pricing assumptions. Such elements are an invitation for the insurance company to pull the rug out from underneath the client.
Let’s look at the cost of insurance language that appears in a recently state approved PPVUL domestic policy: “…The Cost of Insurance Charges are…the Cost of Insurance rates, as determined by Us….” “Current Cost of Insurance rates, which may change from time to time….” Now let’s look at the language associated with the other policy costs for the same policy: “Current charges and rates, which may change from time to time during the life of this Policy as determined by Us.” “Us” in this excerpt is the domestic insurance company. Emphasis in bold was added. Similar provisions appear in most, if not all, universal life, variable life, and private placement policies issued in the U.S. Hard to understand why anyone would want to knowingly give the insurance company such a right. We do not ask nor do we expect anyone to allow us to do this.
We wonder how many insureds understand how much latitude the ability to increase costs gives to the insurance company. The insurance company wants the latitude as a way to protect itself. One has to wonder if the regulator who approved the policy form that contains such provisions thinks it more important to protect the insurance company than to protect the policy owner.
We also wonder if most consumers have heard of, or understand, lapse supported pricing. Lapse supported practices not only protect the insurance company from paying too many death claims they also erode the long term safety net value. With such a model it is very likely the insured will be in for a rude surprise late in life when he or she needs the death benefit to be paid.
What is perhaps of greater interest is we have not seen a domestic policy whose current scale of either insurance or any other cost are lower in the long run than our guaranteed insurance and other costs. Why is that? One reason is we do not mark up the risk cost and we do not use lapse supported pricing assumptions. Unlike in the U.S. the insurance risk cost is not a revenue source for Castle. In addition our overhead/profit expense is negotiated up front with the owner of the contract. After costs are agreed with the life insurance contract owner such costs become part of the customized insurance contract and we cannot change them. Lapse supported pricing is simply not, and never has been, part of our business model. Keeping all costs low means the investment of the reserve (cash value) does not need to be stressed thus has a much better opportunity to be soundly invested so both the long term death benefit and the lifetime safety net can grow and grow well.
We want the life insurance contract to grow in value, be consistent with the long term planning objectives of the client and with the good advice rendered to the client by his or her independent professional advisors, and we want the customized contract to stay on the books and provide the long term benefit life insurance is supposed to provide. It is why we were formed and why we stay in business.