Second to Die Insurance

Survivorship Insurance

by Barry Boscoe, CFP

Survivorship Life commonly known as Second to Die insurance is probably one of the most cost-effective products on the market today for estate planning liquidity.  Due to this fact, insurance companies attempting to enter this market place may design and illustrate products as aggressively as possible, oftentimes projecting premiums and values that cannot be realistically maintained.  The life insurance companies have started to look at other non-guaranteed pricing assumptions as interest rates have fallen over the years.  The fact that they are continuing to look for new ways to illustrate their policies is due to the fact that they are trying to project the lowest possible premiums to attract new sales.  As a result, the mortality and lapse assumptions in many of the products being shown today are designed aggressively and are simply not supportable through life expectancy.

The basic attraction of Second to Die Life Insurance is the comparatively low premium, due to the fact that the death benefit is being paid at the time of the second death.  When two lives are covered, the possibility of paying an early death benefit plummets.  Policyholders are living well past the standard life expectancy due in part to the fact that most policyholders are in the upper income brackets and have better access to health care than many others in their own age group.  These factors combine to allow carriers to assume they will have many years to accrue death benefit proceeds on the Second to Die Life policies.

It is this very advantage that creates the situation in which the greatest care should be taken when reviewing an illustration.  It is not unrealistic to illustrate this product out to age 100.  It is imperative that the assumptions the carrier uses in the projections in the later years be scrutinized, as they will most likely have a significant effect on the policy’s performance.

The result of depending on unrealistic projections is that a policy sold to a 65-year old couple could require large annual payments at age 85 or could fall apart all together with no option to keep the policy in force.

The policy structures available to the survivor life buyer are the same as those available to individuals: Universal Life, Interest Sensitive Whole Life and Participating Whole Life.  The Universal Life design allows the policyholder to pay a premium based on mortality and interest rate assumptions rather than guarantees from the inception of the policy.  The Participating Whole Life design, with its guaranteed premium and death benefit, demands a higher initial premium based on those guarantees, and then declares dividends in later years, which reflect current interest and mortality.  The Interest Sensitive Whole Life premiums include a mortality guarantee but can reflect current interest from the beginning of the policy.  If all three of the product designs were priced for the guarantee, both mortality and interest, the premiums for all three products would be similar.  Furthermore, one could assume that over time the Interest Sensitive Whole Life and Participating Whole Life products would return premiums based on current mortality and interest, which would bring the cumulative cost to that of the Universal Life product.

The inherent problem is that while the lower initial premium of the Universal Life can be appealing, its volatility in later years can cause the contract to crash.  In an effort for the Participating Whole Life carriers to compete with the Universal Life while at the same time maintain the guarantees, it was necessary for them to introduce survivor term riders, which have been available for individual products.  The riders are either paid for entirely by the base policy dividends or have a separate premium charge.  In most cases the term rider is not commissionable, even if a separate premium is charged.  This reduces the sales charges to the contract.  The term riders was originally designed so that the one year term was replaced over time with paid up additions.  Some carriers, however, allow as much as 90 percent term coverage.  Unless the term component is fairly small, there is little chance that the dividend on the base policy will be sufficient to both provide one year term and have enough access to replace the term with the paid up additions.  This becomes most apparent at the older ages when an effort to keep the death benefit in force is most prevalent.  The use of the Paid-Up Additions Rider, also non-commissionable, in the whole life product is essentially pouring all cash into the contract.  The growth on these cash funds provide extra cash to be used for future premiums, thus building in conservatism and allowing premiums to vanish earlier than the policy would normally.

A big concern regarding policy structure is what happens if the product is underfunded in later years, especially where the premium “has vanished.”  On the conservative end of the spectrum is a whole life policy, where the dividends have been used to reduce the premium.  The policy can never “crash” if the dividends are not sufficient to pay the premium.  The policyholder pays the balance of the premium until they are again sufficient.  If a whole life policy with a term rider is underfunded, then when premiums are required they are likely to be the term cost based on ages at the time they are needed.  In most cases, these charges are not guaranteed and so can be increased due to mortality experience.  If the Universal Life Policy has been illustrated to show low premiums, thereby possibly subjecting it to an underfunding, it faces the same scenario as the term riders.  The policyholder will have to deposit enough money to cover the cost of insurance every year with an increasing premium, non-guaranteed, based on current age.

All of the above scenarios can be avoided by reasonable projections.  They do require that one consider the underlying assumptions when illustrating the product.

Almost all products today are proposed and illustrated based on mortality assumptions rather than guarantees.  Most carriers track mortality experience on an annual basis.  When an improvement has been consistent for several years, they then will include that improvement in their current pricing structure.  In a Participating Contract it would mean an increased dividend.  In a Universal Life Contract it would mean a reduction in current mortality rates.  The risk of reducing current mortality rates gives a false sense of security to the policyholder.  Several carriers are projecting improvements in mortality out into the future.  By way of example, if the carrier’s overall mortality experience is improving at a rate of 3 percent per year, the carrier would assume a 3 percent improvement in mortality into the future.  This scenario would reduce mortality charges significantly over the life of the contract.  An assumed mortality improvement of 3 percent per year, compounded annually, will allow mortality rates over 25 years to drop in half.  If a carrier has assumed a 50 percent improvement, they will be faced with the cost of those inaccurate assumptions just when the death benefits become due.

It is obviously unrealistic to assume mortality will continue to improve indefinitely.  There is some argument that mortality will even begin to decline in the near future due to the impact of increased environmental illnesses and stress related diseases.  Therefore, the prudent product design projects mortality for survivor life products at current rates and is considered to be overly aggressive to project mortality improvements.

The second method that carriers use to keep projections competitive is to assume a lapse rate based on their entire portfolio.  It has been shown that survivor life products have a much higher persistency than individual products.  However, since lapses in later years save money for the carrier, because they save on paying the death benefit, many carriers now have this type of lapse rate pricing structure.  A typical individual life lapse assumption might have the carrier paying out 50 percent of the initial death benefits, whereas the experience with survivor life is that over 75 percent of the death benefits are eventually paid out.

The real problem with second to die products is lapse assumptions.  How deep will the carriers go into their own pockets for money when they have more death benefits to pay than they had initially projected?  One of the ways to determine whether a product has a lapse assumption is to do “reverse engineering” on the product.  The second way is to ask the carrier; however, this has proven to be an exercise in futility since the carriers guard their assumptions as they would guard Ft. Knox.  If, in the end, the carrier has used a higher lapse rate which does not occur, there will not be adequate funds to meet the benefit commitments when they come due.

The use of aggressive assumptions in an effort to bring the projected costs down makes the buyer’s job more difficult.  Illustrating a reduced interest rate of 100 to 200 basis points below current interest assumptions does not take into effect mortality or lapse assumptions that the carrier may have built into their projections.

The first step in finding over-aggressive mortality and lapse assumptions is in product comparisons.  Carriers which illustrate better than the bulk of the competition should have the “smell test” applied to them.  When the effect of a drop in interest rate is much less than the comparison, it is likely that the product is being supported by a projection of mortality improvement or a high lapse assumption.

Some carriers will even go as far as to claim a “mortality dividend” in later years, while others will include an increase in credited interest in the later years.  The buyer should ask the basis for these assumptions and are they guaranteed to happen?

In reviewing illustrations, the difference in how products look is due to the vanish method or period used.  It only makes sense that a one pay plan would show a lower cumulative premium than the longer pay plans, which is simply based on the time value of money.  One caution is the one-pay plans tend to be more interest sensitive than the longer pay plans.  This is due to the fact that they rely on using the extra money paid in the early years to accumulate at interest, adequate funds to meet future premiums.  If the interest rate reduces or any of the other assumptions are off, it will have a greater effect due to the dependence on these factors in the later years.

Most carriers will illustrate a higher premium from year one when asked to decrease the interest rate assumption.  This is not entirely realistic unless the client funds for the lowered interest rate from the beginning.  The carriers that illustrate an extended premium at the reduced rate are probably more realistic, but are bound to a larger disparity in cumulative premiums based on the reduced rate.  This is due to the fact that when the premium is increased initially there is more premium in early years to accrue at interest than if the premium is kept low and paid longer.

Most carriers will show the policy endowing at age 100.  However, the policy can be designed to show one dollar at age 100.  While it is not prudent to “zero” out the cash at 100 it is also not entirely necessary to have the policy endow.  Purchasers are, as a general rule, not interested in the cash value but more in the death benefit.  The reason for maintaining cash to age 100 is to validate that the policy will still be healthy at that point in time.  A very low cash value might indicate jeopardy if expense or mortality charges increase.

Unfortunately, there is no way or reason to state that one type of product design is better than another.  As long as the policy is structured responsibly and conservatively, any of the forms of contracts will perform well.

One should be cautioned in purchasing the one pay or vanish premium method.  In most cases the client’s ability to pay premiums increases as time goes on, because the money means less to them. The client’s estate grows and their needs for more insurance increases.  The “vanishing” premium methodology is inconsistent with the client’s needs.  The vanishing or one pay premium method short circuits the need for death benefit.  Smart planning calls for full pay arrangements allowing the death benefit to increase.  A product which looks good for the first 20 years is not adequate for the survivor life buyer. You must look beyond the illustration and into the assumptions scrutinizing the product, which looks too good to be true.

The most important factor to remember when purchasing survivor life, is that you are buying it for your lifetime.  Therefore, looking 20 to 30 years downstream is not unrealistic.