|Universal Life Insurance
Which type is best for your client?
May 19, 2011
The estate tax is back, with an exemption equivalent of $5 million and marginal rate of 45 percent. Large estates with difficult to market assets face a potential estate tax liquidity problem. Life insurance is ideal for this situation because the proceeds are triggered by the same thing that causes the estate tax to be due — death of the client. There are two excellent liquidity life insurance options. Each option has potential advantages and disadvantages. These differences are not benign. The differences are potentially huge, depending on future events, especially fixed-income rates. Helping clients and advisors understand the differences is important so an informed choice can be made. In my experience many insurance agents only recommend the guaranteed no-lapse universal life choice. This is a mistake. The following case study explains the two options and differences.
The client, 57 and single, has a $17 million estate represented by a fractional interest in income-producing real estate. Currently her advisors don’t believe its value will increase much in the future. Debra’s estate tax is currently approximately $5 million. This is the life insurance amount covered in this case study. Debra is in excellent health and she qualified for a preferred rating.
Due to the estate tax liquidity need and likelihood that Debra will continue owning her share of the building for life, the most logical life insurance approach is to purchase level death benefit universal life insurance (UL), with premiums paid every year in order to keep the annual premiums as low as possible. That is, a premium design of paying larger premiums for a shorter period, say, 10 years, is not necessarily the most appropriate route. There are three UL options:
- Static-priced UL,
- Market-priced UL
- Equity index UL.
Equity index UL purports to pay interest based on stock market indexes with minimal guarantees. While equity index UL typically illustrates crediting rates of 8.5 percent to nine percent, I don’t believe it will actually credit these levels and think the high illustrated crediting rates could mislead advisors and clients about future policy performance. I consider equity indexed UL to be no better or worse than conventional market-priced UL and therefore don’t present it to my clients.
A few years ago many life insurance companies developed and began selling UL policies with no lapse secondary guarantees based on paying specified premiums. I refer to these no lapse policies as static-priced. The premiums and death benefits are guaranteed — what-you-buy-is-what-you-get. We can think of this as term-insurance-for-life.
Static-pricing is in stark contrast to market-priced UL. A market-priced policy’s performance (target premiums) will depend on future fixed-income yields and mortality experience. Target premiums are determined by factoring in the current crediting and cost-of-insurance rates to fund a policy for the lifetime of the insured.
Static-priced policies have low to zero cash values whereas market-priced policies have robust cash values. Another major difference is that market-priced policies will likely have more premium flexibility. This comes into play when close attention is paid to an insured’s health over the years. For example, if Debra at 80 has terminal cancer and it is determined that she won’t live more than five years, a market-priced UL’s premiums could be halted because there would be enough cash value to carry it for at least another five years. Usually, static-priced ULs don’t have this flexibility. When policies are well managed this can be a big savings in favor of a
Static-Priced UL — Acme Life
My review of static-priced policies for Debra indicated that Acme Life has excellent pricing. A $5 million policy has guaranteed annual premiums of $52,827 paid every year. Like term insurance this is a simple deal — pay the $52,827 and $5 million death benefits are guaranteed lifetime. The cash values are low to zero and there is less or no premium flexibility compared with the market-priced alternative.
Table 1 shows Acme Life’s financial strength ratings.
Market-Priced UL — Premier Life
The best option for market-priced UL was a low-expense Premier Life policy. The target premium for $5 million coverage from Premier Life will change as the crediting rate changes. Based on the current 5.6 percent rate-the-target premiums are $65,359, compared with $52,827 guaranteed for Acme Life static-priced UL.
It is important for Debra to understand how the possible target premiums can be affected by changing crediting rates. I estimated this in Table 2.
You will note that if Premier Life’s crediting rate averages less than about 7.1 percent the target premium will exceed the Acme Life’s static-priced guaranteed premium of $52,827.
Table 3 shows Premier Life’s financial strength ratings.
Cash Value Difference
As noted, static-priced policies have little to zero cash values. In contrast market-priced policies have robust cash values. Table 4 shows the cash value difference. The premiums for Acme Life are $52,827 and $65,359 for Premier Life.
This report demonstrates two reasonable options for this situation. Each option has potential advantages and disadvantages. Some clients have a significant preference for one approach and would make their entire purchase in that manner. Others have split preferences and would mix the purchase among them.
If your client believes that fixed-income yields will remain low for an extended period of time and that cash-value liquidity and premium flexibility aren’t important, Acme Life is the better choice.
If a client believes that fixed-income yields will go up on a sustained basis and that cash-value liquidity and/or premium flexibility are important, Premier Life is the better choice.
Debra and her advisors seriously considered both the Acme Life and Premier Life options. After assessing the situation Debra decided to purchase the market-priced Premier Life UL, primarily because its robust cash values gave her a greater sense of security for the trust. I would have been satisfied regardless of the decision because I believe Debra and her advisors understood the important differences and made a decision they believed in the trust’s best interest.
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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.
* Forefield Advisor, a PFP Section and PFS Credential benefit, has additional resources on the use of life insurance. The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter, apply to become a PFS Credential holder.