Solving for the long term life insurance need
What’s in a Name?
By: Peter R. Moison JD
President of Castle Re Insurance Company Ltd
Universal life, index life, variable universal life, whole life, private placement life, guaranteed death benefit life, it is enough to make your head spin. Insurance agents, insurance consultants, insurance brokers, who are you supposed to believe? If you boil all of what you know, or think you know, about life insurance into something very simple it would probably be “I have very little understanding of life insurance. The sales pitch is attractive, the conceptual benefits seem to make sense and be helpful. But I have this gnawing feeling something is not being properly explained about the product of life insurance.”
For most people the need for life insurance is relatively short term. If the need is short term many of the products sold in the U.S. may be fine and profitable as well. But if the need for life insurance is for your entire life then a product approach is most likely going to be a disappointment. We note there are a growing number of insurance consultants who now “specialize” in rescuing policies that are beginning to disappoint. We contend, in far too many cases, there is no economical way to rescue the disappointment. Why? Because life insurance in the U.S. is far too often sold with low up-front costs and high back end costs. Low up-front costs make sense if the need is short term. But high back end costs make no sense if the need is long term. Ask almost any domestic life insurance company if they use lapse supported pricing assumptions with their products and the answer will be yes. Ask the same insurance companies how lapse supported pricing protects them to the detriment of their long-term policy holders and you may find you get an answer that is not very clear. This lack of clarity is one of the major reasons why so many folks who purchase life insurance with the intent of keeping it for their entire life end up disappointed.
What is a constant surprise to us is the lack of understanding regarding life insurance solutions for the high net worth client who has a true need to keep the life insurance in place for his or her entire life. We bet if a survey was taken most high net worth clients and their advisors would be unaware of all the options. One of which is custom designed and implemented life insurance contracts. Thus life insurance does not need to take a product oriented approach. Life insurance is only a product solution because of the failure to think outside of the box. There are a growing number of fee based advisors who are beginning to realize and appreciate the difference between a product approach and a non product custom designed approach.
If you want something done right then you cannot keep going back to the same old well that ends up running dry over and over again. So here are some things to keep in mind: (1) there is no reason why the insurance contract (yes contract and not a policy and not a product of life insurance) cannot be uniquely designed to meet the needs of the high net worth client; (2) there is no reason why the high net worth client’s most trusted fiduciary fee based (legal, tax, investment, and fee based insurance consultants) advisors cannot work together to help in the development of that custom contract of life insurance; (3) there is no reason why the costs of the custom contract of life insurance cannot be kept very low and be guaranteed; (4) there is no reason why the insurance company has to manage the reserve (you know it as cash value) that backs part and eventually all of the claim to be paid; and (5) there is no reason why life insurance for the high net worth client cannot be designed for the client the way other long term planning solutions (wills and trusts for example) are designed for the client. But you have to listen first and then design based on the actual goals and aspirations the client has for his or her family.
If you can get out of the box then let’s start with the nature of the risk insured with life insurance. Specifically life insurance that is intended to stay on the books until the client dies. Unlike any other insurance where the risk insured may or may not occur, the risk insured with life insurance is death. Death is a 100%. Thus, if the insurance contract is to stay on the books until death there is a 100% probability the claim insured will be paid. The logical question is: how can a traditional insurance company make money and survive if the traditional life insurance company has to pay claims on 100% of the insurance policies sitting on its books? The answer is the traditional life insurance company cannot given the lapse supported model that has been traditionally followed. Consider the following:
“…life insurance companies earn large profits on clients who terminate their policies, since policies are often terminated before mortality increases sufficiently above the premium paid. But insurers lose money on those who keep their policies. Therefore, insurers do not earn extra-ordinary profits. Rather, policyholders who lapse cross-subsidize those who keep their coverage.
Making a profit from policies that lapse is a taboo topic in the life insurance industry. It is informally discouraged by regulators and commonly referenced in a negative manner in public by insurance firm executives. As one of their main trade groups recently put it, “the life insurance business vigorously seeks to minimize lapsing of policies (ACLI 2012:64). However, as we show herein, competitive pressure not only forces insurers to compete on this margin; life insurers must endogenously adopt front loads to encourage lapses. That is the opposite of the conventional view that insurers use front loads to reduce lapses.”Source: Lapse-Based Insurance by Daniel Gottlieb and Kent Smetters June 6, 2016.
To be fair this arrangement is potentially beneficial if your need for life insurance is short term. But this traditional model is not very helpful if you want to maintain and grow your insurance for your entire life. This is why there is a whole new crop of insurance folks out there who make their living trying to explain why your life insurance program is running out of steam and what, it anything, can be done about it. We maintain the high net client needs to take a very different approach up front so the client is not having to worry about their life insurance program running out of steam when they need it the most. Therefore, you need to look to an insurance company that gets out of the box and provides a very non-traditional approach. An approach that is life insurance in all aspects but life insurance that is specifically intended to stay on the books and meet the client’s long-term goals and objectives. Not a policy and not a product. Rather a solution that is collaborative and well thought out using the talents of the clients most trusted fiduciary fee-based advisors and a life insurance company that was specifically founded and set up to think out of the box.
In order to qualify for most life insurance policies, you must show you are in good health and a good moral risk. The same is true for a custom designed life insurance contract. It must be insurance. Thus, you submit to a physical exam, take some tests; agree to have your medical and driving records reviewed, etc. In short you must be fully underwritten before the life insurance company agrees to take you on as a risk. Given this it is a pretty sure bet if you qualify for the life insurance contract the risk of you dying any time soon is extremely low. Another way to look at it is the probability you will live to a ripe old age is very high. One should consider taking advantage of that fact in the design of the life insurance contract. Given the same, the traditional model of buying heaps of high up-front death benefit when you are least likely to die seems to be oxymoronic. Instead you should look at a way to deliver the largest amount of death benefit when you need it the most, late in life. Believe it or not this is the most cost-efficient way to structure long-term life insurance. Why? An understanding of reserve, sound actuarial principals, and the tax law will help.
As pointed out the risk of death is 100%. What is uncertain is when death will occur. As you age the risk of death increases and it increases to the point where actuarially the risk is 100% even though you are still alive. Seems odd we know. But this fact is true in the tax code as well. As the risk of death increases the amount that must be set aside in a reserve account to help cover the eventual death benefit payout also increases. When the risk of death is 100% the amount in the reserve account must be equal to 100% of the claim to be paid. Sounds simple enough until you think about how you can precisely make the reserve equal the claim to be paid at the precise time the risk is 100%. Given the reserve is invested and investments do not produce a constant rate of return how can the insurance company make sure the reserve will equal 100% of the claim at the moment in time it needs to? At first blush this would seem to be a real head scratcher. But the solution is far simpler that one would think.
In order to maximize the death benefit when it is needed the most, late in life when statistically you will die, actuarial sense would dictate the death benefit should be a function of the reserve set aside. As the person ages the proportion of death benefit to the reserve should decrease. In other words when you are 65 the death benefit may be 120% of the reserve, when you are 75 the death benefit may be 105% of the reserve and when you are 95 the death benefit may be 100% of the reserve. By making the death benefit a function of the reserve you not only make your life insurance program extremely cost efficient you also create a situation where there is no need for the insurance company to hope that you will lapse your insurance. Best of all it creates a situation where the insurance company should be able to guarantee your costs. As the life insurance contract reserve grows so does the long-term death benefit. While we would all hope the reserve is well invested so it grows over time what happens if it does not? If the reserve is not well invested the impact is simply less death benefit. The good news is there is a way to help assure sound investment.
Believe it or not the Internal Revenue Code (Code) is the best friend of the high net worth client who wants his or her life insurance program to stay on the books and be maximized over time. The Code allows the client to design his or her insurance in a very customized manner. At a minimum the Code (1) allows the premium the client pays for his or her life insurance to be segregated into its own reserve account with such account entirely dedicated to his or her life insurance contract; (2) allows the premium to be invested by a independent discretionary investment manager who is not part of the insurance company; (3) allows the death benefit to be a function of the investment value of the segregated account; and (4) allows the insurance contract to be designed to include either tax efficient, tax inefficient, or no access to the cash in the segregated reserve account.
This is not rocket science but the client should make sure he or she works with the proper fee based advisors so the final custom contract of life insurance is consistent with the client’s long-term planning objectives; is tax compliant; has a reliable, honest and knowledgeable independent investment manager; and is administered properly. This is taking life insurance to where it should be for the high net worth client. It is both out of the box and not pigeon holed in the same old product box. It is not a staid product solution but rather the result of a collaborative effort of the client’s most trusted advisors working closely with the life insurance company to come up with the right contract design for the client.
Unfortunately, the true custom design approach is not possible in the U.S. The reason is life insurance is regulated by each state. Insurance companies can only sell products of insurance that are approved by the state regulator. Products must be sold by licensed insurance agents and brokers using the pre-approved policy form. At this time true custom contracts of life insurance can only be completed outside the U.S. This is not a bad thing at all as those contracts can be reinsured with the same reinsurers used by U.S. companies, the segregated account assets can be invested by a U.S. based independent investment advisor with the investments held by a U.S. based custodian such as Fidelity; be U.S tax compliant; be designed by the client’s U.S. based fiduciary advisors; and the list goes on. There are private letter rulings that support the use of jurisdictions outside the U.S. The key is to work with insurance companies whose owners have extensive knowledge of life insurance, have been set up to help design and administer custom designed life insurance contracts, understand the Code and other tax rules, and who do not engage in stupid stuff. It is also important the segregated account set up to hold the reserve for the client’s insurance contract is protected by the jurisdiction’s law so it cannot be used for any purpose other than the client’s insurance contract. In short protected. Castle Re (the “Re” stands for reinventing) is unique in this regard. Castle Re was created by a tax attorney who grew up in the life insurance business, practiced tax, business and estate planning for 26 years, advised clients on the issues associated with the product of life insurance, taught life insurance, and has one of the most thorough and best understandings of life insurance.