|Life Settlements, Insurance and Benefits
How financial planners can help their clients with these added services.
March 17, 2011
Rather than focus on one topic in this article I am providing a synopsis of five topics that frequently pop up in my practice. While life settlements and managing policy maturities affect elderly clients, better understanding variable universal life insurance is for all clients. On the other hand, taxation of disability income benefits and family protection affect 30- and 40-something professional clients.
A life settlement is the sale of a life insurance policy to a third-party. The policyowner typically receives cash for the sale in an amount greater than the surrender value (or there would not be any reason to go through the life settlement process). The buyer (investor) assumes ownership and pays premiums it deems necessary to keep the policy solvent. In addition, the buyer receives the death benefit upon the death of the insured. The original idea was to purchase policies when insureds health had deteriorated more than just due to aging. This created mortality arbitrage. However things have gone down hill in the life settlement business as they have gotten away from the original intent.
The life-settlement business has earned a murky reputation from both the policy selling and investing sides. Because of the huge sums made by those involved in transacting life settlements, some wealthy clients have been hustled into buying policies for the sole purpose of selling them in two years for profits. Too often a profitable sale doesn’t materialize and the client is out the premiums paid for unneeded policies. In addition premium financing also gets entangled with this scheme with even worse results.
The sale of a policy is a messy transaction. Lots of failed promises seem to turn up during the process. A seller cannot be sure where the policy will end up and it is common for a purchased policy to change investor hands often. All the while the insured must provide health information to the investors. Selling a policy should be a last resort.
On the investing side, there have been many instances of individual investors getting scammed buying policies from life settlement firms. The most likely problem is a phony life expectancy that exaggerates the expected rate of return.
Managing Life Insurance Policy Maturities
A policy’s maturity profile is a little noticed pricing factor. Correctly interpreting and applying a policy’s maturity is very important in properly managing life insurance. A policy matures either at the death of the insured or as specified in the contract. Universal life (UL) purchased in 1980s and early 1990s often have maturities of age 95. Subsequent to this time maturities went to 100. Now they are often 120. UL generally matures for its cash value at the specified age. This is a problem for older policies with age 95 maturities and insureds living past life expectancy. Policyowners don’t realize that while the policy may be funded to 95, its value will become the cash value that may be very low relative to the death benefit. The policy-management goal, as long as an insured remains in good health, is to set and reset UL target premiums so the cash values will equal the death benefits at policy maturity. The same principles apply to variable universal life (VUL). A few recent UL and VUL policies have a lifetime extension rider that means if the policy is in force (even with $1 of cash value) at 100, it will continue to 115. Whole life has always been more consistent with respect to policy maturities. The contract premiums are set for the policies cash values and death benefits to be the same at maturity (100 and more recently 120). Juggling premiums isn’t necessary with whole life. Policy maturity is almost always overlooked when they are reviewed.
Variable Universal Life
Variable universal life or VUL allows policyholders to control how their policies’ premiums are invested by selecting from various sub-accounts (mutual funds) available. Most VUL buyers select equity funds. In contrast to VUL, whole life and UL policy premiums are mostly invested by the insurance company in investment grade bonds held for yield. Therefore, investment results for whole life and UL will change relatively slowly and are backed by a minimum guarantee, which means the cash values can never take a loss. In contrast, VUL policies invested in equities will have investment results that are volatile and unpredictable with occasional dramatic cash value losses. This plays havoc with trying to select a premium schedule to follow and leaves policies vulnerable to lapsing.
VULs with level death benefits are toxic life insurance assets because of this investment volatility when using equity sub-accounts. References to long term stock market returns use an arithmetic average that is misleading. For example a $100,000 investment that has an 80 percent gain the first year and 50 percent loss the second is worth $90,000, but has an arithmetic average for the two years of a plus 15 percent. With market volatility there is no way to know how much premiums should be. Such a policy will always be overfunded or underfunded as gains and losses are booked. If large cash value losses are incurred when insureds are elderly this can essentially destroy a policy because cash values drop and the net amount at risk increases, causing insurance costs to go up. For these reasons I do not recommend VULs with level death benefits that are invested in equity sub-accounts to my clients.
VULs with minimal initial death benefits relative to intended premiums where death benefits go up when market gains occur and can be adjusted downward in the presence of losses is the only way that VUL should be used and only with the active assistance of an advisor that knows how to manage such a designed VUL.
Disability Income Insurance
Many professionals have a combination of personal disability income (DI) policies and employer provided long term disability (LTD). Disability benefits are income-tax free when the premiums have not been deducted. Clients are in better financial shape when not disabled, so not deducting DI and LTD premiums makes sense. Most premiums for personal policies are not deducted but many LTD premiums paid by employers are. I recommend that clients in this situation work with their human resources department to obtain a 1099 in the amount of the LTD premiums and pay tax on this amount so the benefits are tax free. Good record keeping is essential when this is done.
Most married clients raising children are underinsured. Ideally clients should have life insurance and invested assets to provide a surviving spouse with enough income to live comfortably from investment earnings. This is true even if both parents are professionals and working. Quite likely a surviving spouse would either adjust their working condition or need substantial assistance with raising children. Recent clients, both physicians with three young children, were underinsured. Terri had $1.76 million. I recommend she have $3 million for total increased premiums of some $900. Ryan had $900,000. I recommend he have $3.5 million for a total increase in premiums of $2,400. Considering the low cost of level term, having sufficient life insurance isn’t a financial burden but just not thought through very well. When I recommend child-raising clients to substantially increase their life insurance, I have never had an objection. They always do it.
I believe these snippets will provide you with greater insight as you interact with your clients financial issues. I will probably get to full presentations of these topics in the near future.
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Peter Katt, CFP, LIC, is a fee-only life insurance advisor since 1983, he has written insurance columns for AAII Journal and Journal of Financial Planning since 1991.
* DISCLOSURE: Readers should assume that all investment advice mentioned in this column are the author’s and/or his firm’s unless otherwise noted and does not necessarily reflect the views of the AICPA or the AICPA Wealth Management Insider.