Why So Complicated
Why So Complicated?
By: Peter R. Moison, JD
President Castle Re Insurance Company, Ltd
If you really think about it life insurance should be one of the least complicated forms of insurance around. Unlike most other forms of insurance there are no repeat claims as you die only once thus the insurance company does not have to worry about paying multiple claims under the same policy of uncertain amounts. So why so complex? Some of the reasons may be the way the death benefit is traditionally designed and the need for traditional life insurance companies to minimize their claims paying potential. While there are most likely other reasons, such reasons are likely subsets of the two reasons noted. In the high net worth marketplace, where the need for life insurance continues until death, neither of these reasons, or their subsets, are valid.
We firmly believe in the high net worth marketplace, where the client is generally healthy, the traditional death benefit design is flawed and one that benefits the insurance company and not the insured or his or her family. The traditional death benefit design is a high up front and level death benefit. Why such a high level of initial death benefit? Probably because of the sale tactic “you could die tomorrow thus you need that twenty million dollars of coverage today.” While it is true you could die tomorrow the reality is the chances of the same are extraordinarily slim. If the life insurance company accepts you as a risk after making you take a battery of medical tests and looking into both your health history and life style, they know the chances are overwhelming you will live to be old. If that is the case then it would make more sense to design the insurance to provide the maximum payout when you are most likely to die and not when it is least likely. A lot of money is wasted paying the risk cost of insurance with high up front death and level death benefit cover.
But if you feel you need high up front level death benefit coverage then it may be good to look at and think about some issues. We have covered lapse supported pricing in other articles. Lapse supported design is a different issue. It has to do with human nature and the uncertainty of the future. Remember the old adage “the best laid plans of mice and men…” How many times have each of you changed your plans; updated an estate plan or a business plan; had to shift gears to accommodate the unexpected, and so on? It is just the way it is. Insurance companies are aware of this. Unfortunately the product of life insurance is not always as flexible as you are when things change. Let’s take a look.
For purposes of this example let’s strip away all costs of a $20,000,000.00 domestic universal (also applies to domestic universal variable) life insurance policy other than the risk cost. This means no revenue for the insurance company, no commissions and no mark up on the risk cost. Let’s also assume a male age 65 with a standard non-smoker rating and the cash reserve set aside for the policy grows at a non-guaranteed annual rate of return of 4%. To keep this policy on the books until age 101 you would have to pay $625,000 a year each and every year. At age 101 the policy will lapse with no value. Keep in mind the $625,000 is the risk expense only. If you pay the $625,000 each year like clockwork, never miss a payment, and the interest rate does not go down, you die before your 102nd birthday, and the insurance company will sell you a product with nothing in it for them, you win. The odds of the insurance company doing this for free are about the same as nothing changing in your life over the next 36 years. So let’s now look at this from two different directions. First you miss paying one or more annual premiums and the credited interest rate goes down. But let’s do it one at a time.
Let’s assume you miss paying the 10th premium but the assumed rate stays at 4%. Believe it or not your coverage period decreased from age 101 to age 96. Let’s assume you miss 3 premiums and the actual rate of return is 3% per annum. Your coverage now expires at age 91. You paid 92% of the premiums, the interest rate went down by 25 % but your coverage period went down by 28%. If you die after age 91 all is lost. The sum total of the premiums paid is as follows: never miss a premium payment total paid is $23,125,000; you miss 3 premiums total paid is $21,250,000. You paid more than you will get out of the policy if you live past 91 and the crediting rate is 3%. Just imagine how this will look once the domestic insurance company figures in commissions, premium tax, what they call DAC tax (not a tax at all), and overhead and profit.
Is there another way to look at this? Yes. Let’s assume the same facts but instead of paying $625,000 a year each and every year you pay $2,734,375 a year for 4 years for a total of $10,937,500. Let’s further assume you agree you do not need the entire $20,000,000 of death benefit now. Instead you want to maximize your back end death benefit because that is more in line when you are supposed to die. Finally let’s use the same assumptions, male age 65 with a standard non-smoker rating and, the only cost is the risk cost, and the crediting rate is 4%. Instead of insurance cover terminating at age 101 coverage not only continues until death it grows well beyond $20,000,000 as follows:
Age 84: $20,694,059
Age 90: $25,388,099
Age 100: $34,822,285
Age 105: $42,366,634
What happens if the crediting rate is 3%? Coverage does not terminate it is simply less:
Age 84: $17,395,536
Age 90: $20,139,358
Age 100: $25,079,077
Age 105: $29,073,524
What if the crediting rate is 1%? Coverage still does not lapse it is simply less again:
Age 84: $12,207,016
Age 90: $12,563,834
Age 100: $12,859,665
Age 105: $13,515,637
What you have effectively done, by causing the life insurance contract to be designed differently, is you have taken into account the uncertainty of the future. Instead of a lapse the coverage is simply adjusted. If things are so bad the crediting rate has dropped to 1% per year it is likely the need for insurance has also decreased. If things are better the converse may also be true: the need for an increasing death benefit. Either way the death benefit is more than the amount paid in, unlike the level death benefit and annual premium arrangement shown in the first example.
This can all be accomplished with no commissions, no premium tax, no DAC tax (as noted not a tax at all), and with a reasonable negotiated and transparent fee for the insurance company. But it cannot be done efficiently in the U.S. due to state regulation. It can, however, be done by in a manner that complies with the U.S. tax law and by a life insurance company that is treated as a U.S. life insurance company for income tax purposes but not for regulatory purposes. And in a manner where the costs are known, understood and guaranteed. We are in Bermuda because we are allowed the dignity of helping to design a U.S tax compliant life insurance contract that meets your needs and not one dictated by the insurance company and the regulators. There are reasons why Bermuda is one of the top 3 insurance jurisdictions in the world. This is one of them. Would we like to be in the U.S? Yes, but the regulatory environment prevents us from doing what is in the best interest of the high net worth client who wants and needs life insurance for life.
We specialize in listening and helping you and your advisory team to design the right contract for your long term planning. All it takes is some thoughtful insight into your long term objectives and how a proper design can both accomplish your objectives and prevent the insurance company from using the uncertainty of the future to derail your insurance coverage. It does not and should not be complicated to achieve the same. It simply means getting out of the traditional box, asking the right questions, and not engaging in the typical sale oriented questions.