Quick Pay Life Insurance

Vanishing Premium or Vanishing Policy

by Barry Boscoe, CFP

All traditional cash value life insurance policies are built around carrier assumptions as to three key elements:  mortality, expenses and earnings.  The starting point, of course, is recent and current experience; however, emerging trends must also be considered.

In pricing their products, insurance companies work with guaranteed numbers and illustrated numbers. Since life insurance policies may extend many years into the future, the guaranteed numbers are necessarily conservative.

However, because the current experience of most life insurance companies is better than their guarantees, they not only show the guaranteed numbers, but they also illustrate results based on assumptions that are much less conservative than the policy guarantees.  While this makes the products more attractive to the purchaser, it is here that the seed for future problems and disappointments can take root.

The consumer has a choice between purchasing a Whole Life Policy (WL) or a Universal Life Policy (UL).  Even though these policies are constructed out of the same basic “materials” (guarantees and assumptions as to earnings, expenses and mortality costs), and both are considered “permanent” or “cash value” policies rather than pure term insurance, there are significant differences.

For example, WL policies have a fixed premium payable for life, based on the guarantees as to minimum earnings, maximum expenses and mortality charges.  If this fixed premium is in fact paid for life, the policy is guaranteed to endow for its face amount  (i.e., the policy’s cash value will equal the death benefit) at maturity, typically age 100.  Therefore, in a WL policy, if dividends or interest rates should decline, or if expenses or mortality increase, as long as the premium is paid the policy will remain in effect.  Conversely, if current assumptions remain or improve, the policyholder may have the option of either increasing his death benefit, or reducing his premium expenditure, also known as “vanishing premium.”

Unlike WL, a UL policy is “transparent.”  This means that each of its elements – interest earnings, expense charges, and mortality costs – is separately stated, and each functions independently to make up the whole.

Also unlike WL, UL “premiums” are flexible in both amount and duration, although there is always a minimum premium required in the first year to put the policy inforce.  After the first year, as long as the policy’s cash value, including earnings during the year, is sufficient to pay the current policy expenses and the current mortality costs, no additional premium dollars need to be contributed to the policy. However, since the current earnings, expenses and mortality costs are not guaranteed into the future, expected minimum premium payments to keep the policy inforce, are not guaranteed.

This is where the consumer needs to be cautious in purchasing a UL Policy.  Since the policy can be designed to have a minimum premium based on current assumptions, it is highly conceivable and historically true, that at some point a higher premium will be needed in order to keep the policy in place or the policy itself will vanish.

By way of example, consider a man in his mid-40s who purchased a $3,000,000 UL policy in 1990 when interest rates were higher than they are today.  The policy was designed so that he would pay $13,000/yr.  The illustration showed that his payment schedule was adequate to keep the coverage in effect until the policy “matured” at age 95.  Much to the client’s surprise, a current inforce illustration revealed that due to lower interest rates, his policy would expire by age 76 at the current level of premiums.  This is well before his life expectancy.  In order for him to extend his coverage to age 95 as originally illustrated, he had 2 choices:  Either (1) increase his premium payments immediately by 161% – up to $34,000/yr, or (2) continue paying at the current rate until age 76 and then increase his premium payments to over $100,000/yr.!

Conversely, if a WL policy was purchased, the worst that could happen if dividends were to decrease, would be that the policyholder would have to continue paying the same premium for a longer period of time.  However, with a UL policy, the problem tends to compound itself over the years, particularly in the later years when mortality rates are higher.  This happens under the following scenario:  With lower earnings, the policy’s cash value is lower.  With a lower cash value and a fixed total death benefit, the net amount at risk under the policy becomes higher.  With a higher net amount at risk, the mortality charges taken out of the cash value are higher, and with higher mortality charges taken out of the cash value, the cash value is further reduced, thereby further increasing the net amount at risk and causing even higher mortality charges, thereby further reducing the cash value…and round and round it goes until there is nothing left, and the policy itself vanishes.

In an effort to avoid this scenario, one must project conservative assumptions when purchasing a UL Policy.  These conservative assumptions should include the following:

  • A reduced interest rate of at least 100 basis points
  • A projection to allow the policy to endow at the maturity date, either age 95 or 100, depending on the contract
  • An increased premium above the minimum amount projected under the current assumptions.

The difference in premiums between a WL and UL policy are significant due to the fact that the WL guarantees a fixed premium, and as long as the premium is paid, the policy will continue inforce. The risk associated with a UL policy is that the policy itself might vanish unless the consumer is willing to pay a larger premium than illustrated, using current assumptions.  If the consumer is only willing to pay the minimum premium, then the above stated scenario will occur.  Generally, it is too late to rectify the problem, because it would take much too much money to pay the ever increasing mortality costs under the policy necessary to support the death benefit.  In effect, the policy has become a term policy – and, although term insurance may work well when one is relatively young, it becomes prohibitively expensive in the later years when death is most likely to occur.

The solution to this dilemma when utilizing a UL policy is to always pay more than the minimum premium and to make sure that the illustration utilizes conservative assumptions – much more conservative than the current assumptions typically used.