LIFE INSURANCE PRODUCTS

Innovative Planning With `No Lapse Guarantee' Life Insurance

Author: TIMOTHY P. MALARKEY, ASA, MAAA, CLU, ChFC, AND STEPHAN R. LEIMBERG, ATTORNEY, CLU

TIMOTHY P. MALARKEY, ASA, MAAA, CLU, ChFC, is a Principal in the life insurance firm of Lee, Burke & Malarkey, LLP, in Berwyn, Pennsylvania. He is also an Associate of the Society of Actuaries, a member of the American Academy of Actuaries, and a member of the Philadelphia Estate Planning Council. His email address is tim@ lbmllp.com. STEPHAN R. LEIMBERG is CEO of Leimberg Information Services, Inc., co-author with Howard Zaritsky of Tax Planning With Life Insurance, co-author with Robert Doyle of Tools and Techniques of Life Insurance Planning, and CEO of Leimberg and LeClair, an estate and financial planning software creator. His email address is steve@leimbergservices.com. The authors express appreciation to attorney Alan Mittelman, J.D., CLU, of Spector Gadon Rosen, P.C. in Philadelphia, to Charles Ratner of Ernst & Young in Cleveland, and to Larry Rybka of Valmark Securities for their careful review and most thoughtful comments and suggestions. Copyright © 2005, Timothy P. Malarkey and Stephan R. Leimberg.

This article explains the most important characteristics of currently available life insurance products, including `No Lapse Guarantee' policies. The authors then examine an advantageous practical application of No Lapse Guarantee contracts.

Background of product development

Much of this section of the article will involve defining the terms and characteristics of today's state-of-the-art life insurance products. We will touch on the generically-named products found in today's marketplace, and outline a discrete, almost chronological progression—even though in actuality, product evolution has been much more of a fuzzy continuum.

Although we will focus on the products, 1 their characteristics, the catalysts for their development, and relative strengths and weaknesses from an insurance perspective, it should be recognized that changes in tax laws, interest rates, and equities markets as well as many other forces shape product development and suitability for use in a given case. Much of the commentary here will be directly applicable to life insurance contracts that insure one life. A very similar, albeit slightly different, product development history would be necessary to outline second-to-die products.

Term insurance

Term insurance is an appropriate beginning point. The key characteristic of term is that the insurer assumes a death benefit risk only for a finite period of time. Bluntly stated, term runs out. At the end of the stated term, typically, there are no nonforfeiture rights (e.g., cash values) afforded to term policyholders. The insured must die in order for any payments to be made, and no death benefit will be paid unless the insured dies within the specified term. If the insured survives the specified term, absent an exercised renewal provision, the contract expires and provides no payment of any kind.

For many years, term insurance was sold in an “annual renewable term” (“ART” a/k/a “yearly renewable term” or “YRT”) format. ART typically featured a premium that increased each year to track the presumed increase in the likelihood of mortality as (1) the insured aged and (2) time moved farther away from the underwriting process that took place before the policy's inception.

ART was guaranteed to be “renewable” for some number of years (rarely less than four or five and sometimes until age 70 or beyond) as long as the policyowner paid the next premium. The ever-increasing premiums often could or would change annually from a stipulated initial amount, and the ultimate years' premiums were guaranteed only to be below very high levels.

For much of the past 15 years or so, sales of ART contracts have given way to much more cost-effective policies that feature a level (and usually guaranteed) premium for a specified number of years. The duration of these “level term” policies is usually between ten and 20 years, but sometimes longer. Level term policies are usually renewable beyond the “level” period, but the premiums will be unattractive for those individuals who are not able to favorably pass through the underwriting process again.

Over the past 15 years, the inherent price of these policies has continued to fall dramatically, but recently the rate of price decrease has slowed substantially and in some cases increased (because the NAIC clarified the amount of reserves that needed to be set aside for this product). However, even given the slow-down in price decrease, it is still likely that any term insurance more than a few years old for someone who has not experienced an adverse change in health is probably more expensive than what may be available to that client today. So planners with healthy clients should review all term policies more than three or four years old.

An important feature of most high-quality term contracts is the “conversion” feature—the ability of the policyowner to “convert” the policy to a form of cash value insurance (discussed below) without new evidence of insurability. This conversion takes place at the insured's attained age, and can be a very important hedge against the risk that the end of the term coverage will occur at a time when continuance of the coverage is desired but circumstances prohibit the implementation of new coverage. (These circumstances could include an insured's change in insurability or lack of time to implement a new policy before the term policy practically or literally terminates.)

Conversion features are usually available until a certain duration after policy issue and/or until a specified age, and the products to which the policy can be converted are determined by the insurance carrier. Thanks to the design flexibility and wide product array of cash value insurance products, the converting policyowner should be able to structure a cash value policy to closely, if not exactly, achieve the desired objectives of policy conversion.

Term insurance is indicated when the need for life insurance is temporary, when the largest possible amount of coverage is desired for a given amount of annual cash outlay, when the need is intermediate or long-term but the buyer's cash flow is currently insufficient to purchase the needed coverage under a higher premium permanent policy, when the policyowner has better investment opportunities outside the insurance policy than inside it, and as a "rider" when additional death benefits are desired in conjunction with cash value life insurance or "packages" of policies.

Cash value insurance

In essence, all policies that do not fit into the category of term should be in this category, which encompasses any life insurance that could or does have a cash value, some or all of which is available as a nonforfeiture right if the policy is surrendered.

Cash value insurance (“CVI”) is often mistakenly called “whole life” but, in reality, “whole life” is only one form of CVI. CVI is also sometimes thought of as “permanent insurance;” however, while many CVI products can be and/or are designed to be kept “forever” (i.e., until the insured dies), the term “permanent” may be a bit misleading since a number of these policies can (and are designed to) last only a finite number of years.

CVI is indicated when the need for life insurance is intermediate, long-term, or indeterminate—for example, when insurance is needed to provide cash for federal and/or state estate, inheritance, or other death taxes, funeral expenses, and administration costs, to provide funding for a business or professional practice "buy-sell" agreement, to indemnify a business for the loss of a key employee, to provide financing for a salary continuation, nonqualified deferred compensation, or death benefit only (survivor's income benefit) plan, to fund personal and charitable bequests, to equalize inheritances, to provide the most efficient and certain method of transferring wealth and assuring financial security to others (especially given the favorable income tax attributes of CVI), to preserve the confidentiality of financial funding (i.e., to provide financial security for an individual in a manner the insured may not want to acknowledge publicly or to provide wealth to someone in an amount the insured does not want to become a matter of public record), and as a tool to help recruit, retain, retire, and reward key employees.

Whole life. Whole life (“WL”) is the oldest form of CVI, and for a number of years it was the only real form of CVI. WL has had many variations over the years (e.g., adjustable WL, participating and nonparticipating WL, current assumption WL, modified and increasing premium WL). The form of WL that is most commonly available today is usually a fairly straightforward version of the product. Compared with other forms of CVI, WL is less common today than it once was, especially in the sophisticated estate planning market.

Although there are fewer sales of this product, WL does have specific advantages that lead to its continued use. WL is most generally available from mutual insurance carriers, and is suitable for those seeking the unique insurance attributes of a mutual company (versus today's more common stockholder-owned structure).

As its name implies, whole life is a contract designed to provide level death benefit coverage over the entire lifetime of the insured. 2 As noted below, level or fixed periodic premiums are computed on the assumption that the contract can be retained—assuming premiums are paid—for as long as the insured lives. The purpose of the level premiums is to make the WL contract affordable for as long as the policyowner wants and is able to pay premiums. 3 Policy cash values are an outgrowth and natural byproduct of the level premium system. WL policies are issued with a table that illustrates the guaranteed fixed cash values the owner of the contract can obtain in any given year, by either borrowing or surrendering the policy.

The most defining characteristics of WL are (1) a fixed premium, (2) the guarantees available with respect to both the cash value and the death benefit, and (3) the allocation of assets underlying the contract. The premise of a WL contract is that if the fixed premium is paid for the “whole life” of the insured, the death claim is guaranteed to be paid. For that fixed premium, there will be cash values and death benefits that are guaranteed, assuming that the premium is paid each year for the insured's “whole life” (hence the product's name). (It is important to note, though, that the guaranteed cash values and death benefits are often a good bit lower than the projected nonguaranteed values [which include both the guaranteed segment and a nonguaranteed supplement], and it is these latter amounts on which clients are usually most focused.)

The dollars that back a WL contract become part of the general account of an insurance carrier, which, under heavy regulation, is typically invested in a portfolio of mid-term bonds, real estate, and mortgage-backed securities. (Depending on the carrier, some small allocations to the equity market place do take place.)

The fixed premium for a whole life contract is calculated by the insurance carriers, so that, if the premium is paid each year (and when enhanced by earnings on those dollars), the guaranteed cash value at some point in the future (often age 100) will equal the guaranteed death benefit. It is this relatively conservative, cash-heavy design that sets WL apart from other products and their guarantees.

However, WL is most typically presented and/or designed to have a premium paid, on a nonguaranteed basis, for a finite number of years (i.e., not each year for the insured's whole life). Rather, the premiums are usually designed to be paid only until the accumulation of cash value within the policy, along with future projected dividends, supports the death benefit “forever” on a nonguaranteed basis. Nevertheless, the best performance of a WL policy can often be achieved when the premium is continued to be paid beyond the point where the policies are projected to be self-supporting.

In most cases, continuing to pay WL premiums results in accumulations of cash value and death benefit that offer very attractive returns due to the accumulation of dividends, especially given the extremely low likelihood that the cash value would ever decrease. (Cash value in a WL contract would be compromised only in the unusually rare event of an insurance company failure.) In short, continuing to pay premiums into a WL contract can offer some of the most attractive after-tax fixed-income returns, given the deferral of the cash value build-up and the tax-free treatment of death benefits, that are available today.

The dividend credited within a WL contract is, simply, the mechanism through which a (most commonly) mutual life insurance carrier credits growth in value in excess of the guaranteed level of growth back to the policy. The dividend is a function of both the carrier's underlying asset performance (in excess of guaranteed performance levels) and the carrier's mortality and expense experience (to the extent these costs are less than the conservatively anticipated levels of those expenses).

Variable life. Variable life insurance (“VL”) is essentially a WL policy 4 that allows the policyowner 5 to select among (and typically switch annually or more often between, or rebalance among) a menu of insurer-determined investments 6 similar in many respects to stock, bond, and money market mutual funds. 7

VL 8 provides a guaranteed minimum face amount (death benefit) and a level premium but differs from classic WL in three important ways: First, premiums (after the insurer charges for expenses and sales costs and mortality costs) are poured into an investment account that is separate and legally distinct from the general investment fund of the insurance company. The general account assets are limited by reserving requirements to be invested primarily in bonds and mortgages. For those policyholders who want any significant exposure to equities, variable life is the choice. The trade-off is that contracts shift investment risk entirely to policyowners. This means the insurer provides no guarantees with respect to policy cash values. Instead, investment risk—and potential growth in both cash values and death benefits—are shifted to the policyowner. Cash values in a VL contract are determined as of a given point in time based on the policyowner's share of the market value of the assets in the separate account. Finally, the death benefit is variable. It may grow or shrink (but not below a stated and guaranteed minimum) according to a formula based on the separate account's investment performance.

The first VL contracts appeared around 1976. The earliest forms of VL were a variation on WL—that is, the premium was fixed, but rather than the assets backing the contract being bound to an insurance carrier's general account, the policyowner now had a choice to allocate some or all of the assets to a separate account, where there is some choice of investment class.

The appeal of VL was originally, and still is, largely driven by the ability to access the potential upside of the equity markets. Also, there is a unique appeal to VL in that, in the event of an insurance carrier insolvency, the assets allocated to a policy—as part of a separate account—will not be subject to the claims of the insurer's general creditors.

Variable life is indicated where the policyowner (1) is confident he/she/it can select an account that can significantly exceed the return and growth of the insurer's general account, (2) desires long-term coverage, (3) wants a measure of control over the selection of the underlying investments, and (4) needs increasing life insurance protection.

Because policy cash values are not guaranteed and all investment risks (and some death benefit risks) are shifted to the policyowner, VL should be chosen only by those willing to bear these risks in return for the potential upside gains. Some authorities suggest that VL be used primarily as a supplement to a minimum basic level of coverage provided by other types of CVI.

Universal life. Universal life (“UL”) is a "flexible-premium" 9 "current assumption" 10 "adjustable death benefit" 11 type of CVI contract. These contracts are also referred to as flexible premium adjustable life.

UL was developed in the late 1970s and early 1980s, as interest rates soared and the change in dividend rates of WL policies significantly lagged behind the interest rates available in the market.

In comparing UL policies to WL, the key difference is that UL does not have a fixed premium. Rather, a UL contract is flexible and can accept a premium, at any given time, from $0 to a very high level. The incredibly flexible premium of a UL policy allowed policyholders more freedom to adapt their future cash flow commitments to the dynamically changing interest rate world and their own financial situations and constantly varying needs.

Mechanically, as long as there is enough cash inside a UL policy to support that month's charges, the policy will continue to provide full coverage for another month. That said, the actual recommended premium for a UL policy is a function of (1) how long the coverage is desired, (2) the number of years the owner wishes to pay premiums, and (3) the assumed rate of interest backing the policy. As these factors change, premiums can change; further, a policyowner can diverge from a given course at any time. This makes UL a very flexible policy that can be adapted to a client's constantly varying financial circumstances.

When UL was first introduced, it also featured a practical advantage compared to WL in that many of the new UL blocks of business were backed by a portion of a carrier's general account that was, at the time, invested in fixed-income instruments that were newer and, therefore, earning (and returning to those who purchased UL contracts) significantly higher rates of return than WL owners were receiving.

As the years have passed, though, the insurer's assets that back UL and the assets backing WL policy series have, essentially, grown together (driven largely by regulation). So both types of policy can be thought of as having similar asset characteristics—that of a mid-term fixed-income portfolio. Because of this similarity, UL and WL contracts are commonly lumped together to make up the “traditional” forms of CVI.

UL is indicated in long-term coverage needs where maximum flexibility of premium cash flow is desired, and where the insured's financial needs and cash flow are likely to change. This makes UL suitable in the business, retirement planning, and employee benefits fields to finance salary continuation and nonqualified deferred compensation plans, death benefit only plans, key person coverage, buy-sell agreements, and insurance inside qualified retirement plans.

Variable universal life. The next logical entrant in the life insurance arena is variable universal life (“VUL”), which combines the flexible premium design of UL with VL's ability to choose the asset allocation supporting the contract. Sometimes called flexible-premium variable life or universal life II, VUL is an attempt to capture the best features of UL and VL. VUL policyowners can—within limits—determine the timing and amount of premium payments, eliminate one or more premium payments entirely (assuming cash value is great enough to pay current mortality and expense charges), increase or decrease death benefits (within limits and assuming evidence of insurability with respect to increases), make withdrawals of cash without generating a loan against the policy and without interest charges (assuming there is enough cash value to pay current mortality and expense charges), and select between two death benefit options—one level and the other equal to a level pure insurance amount plus the policy's cash value. 12

VUL contracts represent a large portion of the insurance sold today. Whether it is because of the many varied types of funds (especially equity-based funds) that are available within the policies, the aspect of the “separate account” resting outside the insurance carrier, the idea of a flexible premium, or some combination of the above, VUL has been a major force in the CVI market for the past decade.

The ability to optimize these features, along with the unique tax attributes of life insurance (tax-free death benefits, tax-free buildup of cash value, ability to reallocate assets without taxation, and, uniquely, the ability to withdraw after-tax basis and access gain without current taxation), can create a powerful financial instrument that is particularly appealing to high-income, high-net worth individuals and businesses.

VUL is particularly indicated for estate planning and business insurance needs where the potential increase in cash values and death benefits resulting from the successful exposure to underlying assets invested in the equity markets is deemed attractive or necessary. If a policyowner believes that the portfolio he can assemble (from the available choices) underlying the policy will significantly outperform the assets of the (tightly regulated) insurance company's general account, then VUL can make good sense.

Further, VUL offers the best protection of a policy's cash value from future adverse changes at an insurance carrier, or indeed from carrier failure, thanks to the fact that the assets are held in a separate account from the carrier. (Many practitioners speculate that, based on past experience, some carriers may not return to policyholders enough of the “upside” of their general account performance in other types of CVI policies, due to future changes at carriers, carrier consolidations/mergers, etc. The separate account feature of a VUL insulates these contracts from some of these concerns. Even with VUL, however, the nonguaranteed insurance charges within a policy will still be subject to future carrier performance.)

VUL contracts are appropriate for key person coverage, Section 162 (executive bonus) arrangements, financing of salary continuation and nonqualified deferred compensation plans, death benefit only (survivors' income benefit) plans, key person coverage, buy-sell agreements, and insurance inside qualified retirement plans.

Private placement VUL. A variation on VUL, private placement VUL (“PPVUL”) 13 is available only as a nonregistered product to those who qualify. Generally, the buyer is a high-net-worth individual willing to invest at least $500,000 either initially or over a relatively short period of time. PPVUL is insurance which, as its name implies, is coverage obtained by direct (and often vigorous) negotiation with the insurer to bargain costs and charges to a minimum. These contracts are attractive to high-net-worth individuals and corporations because of the income tax treatment and investment flexibility (including dynamic hedging strategies) that make PPVUL a prime capital accumulation and wealth transfer vehicle. 14

Advantages include impressive internal performance through lower policy charges and institutional pricing, surrender fees, fund asset charges, and reduced (or no) sales loads. Special investment management design as well as a wider array of investment options, insurer responsiveness, privacy, confidentiality, and access to nonregistered investments (e.g., hedge funds) supporting the insurance contract are additional benefits.

These contracts are usually issued either as a modified endowment contract (“MEC”) on a single premium basis or with limited payment periods to produce a non-MEC. 15 These contracts are sold as private placements by both on and offshore insurers, and are provided on a policy-by-policy basis; thus, they avoid SEC registration. 16 Purchasing the policy through an offshore insurer results in a high degree of creditor protection, freedom from state regulation, and a reduction in costs due to the absence of the insurer's obligation to pay either state premium taxes or federal income taxes. (It is important to note, though, that in any given case, the performance of offshore PPVUL may not be as favorable as a contract available domestically due to the policy-specific insurance charges in some offshore vehicles. Moreover, policy ownership structures, or laws applicable to assets within a policy, may also provide attractive asset protection without going offshore.)

To avoid U.S. regulatory and tax jurisdiction, offshore carriers must market and issue such coverage while remaining offshore. Onshore insurers, on the other hand, can market their products directly to U.S. customers—a distinct marketing advantage.

For all flexible-premium insurance contracts (UL, VUL, PPVUL), in most cases the best performance of the policy occurs when the premium is approaching, or at, the upper limits allowable by the various threshold tests called for by government regulation. 17 In addition, prospective illustrated performance is, in almost all cases, heavily dependent on a number of nonguaranteed factors. Exhibit 1 shows a comparison of UL, VL, and VUL.

No Lapse Guarantee universal life

As the last significant entrant into the life insurance arena, No Lapse Guarantee universal life (“NLGUL”) contracts were first introduced a little more than ten years ago. In their early years, they gained only moderate momentum. But due to a number of forces, NLGUL contracts have become common in today's marketplace. This recent surge in NLGUL has been due to (1) absolute improvements—the increasingly innovative and competitive pricing of these policies (largely driven by the shadow account methodology explained below), and (2) gains relative to other products such as UL or VUL, which have been hampered by low interest rates or difficult equity markets.

Background of NLGUL. Before digging into the details of NLGUL, it may be helpful to discuss more of the technical underpinnings of UL versus WL. The economics behind a WL contract involve only “prospective” accounting. That is, the current value of a WL contract is, actuarially speaking, equal to the present value of future liabilities, less the present value of future premiums and earnings. In other words, the dollars that a carrier must have on “reserve” today to meet the promises implicit in a WL policy must equal the difference between (1) what the carrier will someday pay to a beneficiary (assuming premiums are paid and the policy is kept in force), and (2) what the carrier will receive in premiums and investment returns between now and then.

These calculations, resulting in the policy's reserve and then, in turn, the policy's cash value, are done only prospectively. There is no specific accounting as to the dates premiums in the past were actually received.

In order for the mechanics of a UL policy to work, the accounting processes were, in a sense, “flip-flopped.” A UL accounting system, which is used to calculate a policy's reserve and cash value, operates only retrospectively. The premiums that have been paid, the monthly charges that have been deducted, and the interest that has been credited—all these elements are factored into today's cash value.

Product development. A WL policy includes an intrinsic guarantee that if the premium is paid “forever,” (1) cash values will be guaranteed at the promised level and (2) the death benefit will be paid. That premium, however, if required to be paid forever to support the death benefit, represents a fairly expensive and unattractive return in today's marketplace.

Many of today's buyers are focused primarily or solely on guaranteeing the death benefit, and are willing to trade guaranteed cash value in exchange for a lower premium. To meet that objective, following the predominant use of UL through the 1980s, carriers began in the early 1990s to add a “rider” to some UL policies that provided a “secondary” premium-based death benefit guarantee. These earliest riders ensured that, in addition to the fundamental guaranteed maximum charges and minimum interest rates of a UL policy, if the policyowner were also to pay some (relatively low, compared to WL) model extra premium each year, the death benefit would be guaranteed.

These early “secondary guarantee” UL contracts essentially found a crack in the armor of the regulations surrounding UL cash values and reserves. Because all UL rules and regulations revolved around retrospective accounting, a carrier could offer a prospective premium-based “secondary” guarantee without a significant change in reserves and/or cash value. The earliest “secondary guarantee” UL policies were fairly stringent, though. It was not uncommon to see that, if a premium were paid a few days after a grace period, even though the policy itself was in no danger of lapsing, the secondary guarantee could be totally lost. In other words, there was no ability to have any kind of catch-up to re-start the secondary guarantee that the death benefit would be paid no matter how long the insured lived.

Regulations and product development over the last half of the 1990s changed somewhat dramatically (by insurance community standards). Regulations known as XXX and AXXX, and responsive product development, led to the concepts of the “shadow account” and “No Lapse Guarantee” UL policies. In short, these NLGUL policies have the same retrospective accounting as any UL policy (with a cash value resulting from premiums, historical charges, and interest-to-date). The primary guarantees within the policy are that the monthly charges will never go above a certain level and the interest rate will never go below a certain level. These primary guarantees have an ultimate effect on both the death benefit and the cash value of the policy.

For a No Lapse Guarantee (“NLG”) policy, the accounting of premiums, interest, and charges results in the regular cash value, and the primary guarantees govern the worst-case performance for the death benefit and cash value. At the same time, the death benefit (and the death benefit only) is also subject to a secondary “no lapse” guarantee. This new form of secondary guarantee is a result of the retrospective accounting done “on the side,” in a “shadow account,” and it factors in actual premiums paid to date, a level of charges better than the worst-case guaranteed charges, and a level of interest at or higher than the worst-case guaranteed interest rate.

The result of the shadow account calculation is that, if the shadow account is sufficient to keep the policy in force, the death benefit will not lapse. In this manner, most carriers are addressing the danger that the guarantee might be lost because of the client's failure to pay premiums on time. So, while the UL policy may have what appears at first to be typical current interest rate performance, its death benefit (but not cash value) is also protected by the shadow account. Thus, the shadow account offers a built-in premium catch-up mechanism to prevent a loss of the death benefit guarantee.

The end result. The “bottom line” of today's NLGUL policies is a type of CVI that perhaps should be thought of in its own insurance asset class. WL and UL offer interest-rate-based performance while VUL is generally used by those seeking equity-based performance. In all three of those cases, policy attractiveness is measured by both the cost-effectiveness of the death benefit as well as the performance of the cash value.

In the opinion of many, the NLGUL asset class is unique. It features (relatively inexpensive) permanent death benefit guarantees at the expense of cash value performance. Analytically, NLGUL policies typically offer very attractive guaranteed death benefit internal rates of return (“IRR”) up to, and a bit past, life expectancy. (It is not uncommon to see these death benefit IRRs approach, and exceed, an after-tax rate of 7% even beyond life expectancy.) WL and UL death benefit returns may be (or may not be, depending on the case) projected to be as favorable, but the illustrated WL and UL death benefit returns will assuredly carry the assumption of performance risk by the policyowner.

Some argue that it is prudent to think of NLGUL policies as largely illiquid. The reason is that it is unlikely that these contracts will have a cash value that is attractive for any other possible uses in the future—due to the projected underperformance of the cash value. The lack of a significant cash value is clearly a disadvantage if a cash value that can be rolled over to another new product innovation is desired in the future. Nevertheless, most who use NLGUL are not uncomfortable with the illiquidity, given the relatively certain shifting of permanent death benefit risk to the insurance carrier. Further, proponents argue that, in many cases of trust-owned insurance, the existence of a notable cash value is, at best, a secondary bonus to a family, given that the cash is likely to have been tied up in trust anyway.

On the other hand, the lack (or non-existence) of cash value within an NLG contact creates a “last stop on the train” phenomenon—that is, the policyowner's options to perhaps make a change in the future will be very much limited, if not precluded. The policyowner needs to be permanently comfortable with those death benefit returns of the NLG policy—because once the policyowner gets on this train, the reality is that he can't (economically) get off.

NLGUL also bears the solvency risk of the carrier issuing it, especially because the low cash value and attractive guarantee of the death benefit create a situation where the policy's risk is less likely to be transferred elsewhere in the future. Those advisors who are comfortable with this point out that this risk does—to at least some degree—exist with any insurance, and there are some protection mechanisms to mitigate the risk. Some authorities, however, argue that these policies increase the solvency risk of carriers that issue them, particularly those insurers that have underpriced their NLG products. 18 The greatest risk to policyholders is the possibility that in an insolvency, the rehabilitator would "reform the contract." Most state guarantee funds only provide that limited death benefits and cash value will be paid. This risk is more than theoretical; contracts were reformed in the several large insurance company failures.

Finally, the last potential disadvantage of NLGUL is that, while the death benefit is likely to have relatively little downside, NLGUL is also less likely than alternative contracts to have a notable performance upside in the event of rising interest rates, or bull equity markets (which could positively drive the WL/UL and VUL markets, respectively). Those who favor NLGUL would counter that the lack of upside is a fair trade-off for the very attractive “locked-in” IRR at death. Obviously, an NLGUL contract is most appealing and appropriate for clients seeking to assure the financial security of future generations through the most cost- and tax-effective and economically certain wealth transfer mechanism possible.

Aside from the issue of proper reserves (which in itself is a complex, difficult to determine, highly controversial, and very important issue), planners should give special attention to (1) suitability (e.g., is the client better served by a product that is flexible enough to meet life's inevitably changing circumstances than by the features of a policy that guarantee the sufficiency of the premium?) and (2) fitting this type of contract to a buyer's circumstances. It is essential that clients be informed—in writing—of how those products really work, what's required to maintain the guarantee, and what happens to the product if the client fails to meet those requirements.

It is also essential that the products being considered for purchase are compared with a current assumption product and tested for relative premium flexibility, cash values, and potential to benefit from higher interest rates. In other words, would some other type of product be more suitable for the client's particular facts and circumstances? It's essential that the client be presented with an array of choices that allow an informed decision.

At the “end of the day,” the tried-and-true principle of diversification—not one but two or three different life insurance contracts, across more than one carrier—may provide the best answer to the question of product selection. For some clients, the assurance of a death benefit at a certain level with no future volatility—especially in the face of an otherwise well-diversified financial picture—could make a heavy concentration of NLG desirable. But because of NLG's illiquidity and consequent lack of flexibility, in most cases clients will be best served by using NLG as a relatively modest portion of an insurance portfolio that is carefully diversified across carriers, products, and cash value/death benefit performance projections.

Future. Natural evolution is likely to lead to more carriers entering the NLGUL market, and those that are already in it may further enhance their contracts. Opposing forces, however, are likely to be the pressures caused by the regulatory bodies that may further tighten carriers' ability to offer these policies, as well as the hardening reinsurance marketplace that most carriers use to enhance product competitiveness.

We have begun to see notable product development of NLG Variable UL, and the development of this hybrid will assuredly continue in the near term.

NLGUL and fixed annuities—Guaranteeing a transfer of wealth

Fixed annuities. Although a description of the general annuity marketplace is beyond the scope of this article, 19 a bit of background may be useful. The annuity universe can be divided in half from two different perspectives. First, there are “fixed” and “variable” annuities. The former rely on a declared interest rate and are backed by an insurance company (similar to UL and WL). On the other hand, “variable” annuities allow the contract owner to choose the assets that back the policy from among a number of different funds or asset allocations (similar to VL and VUL).

Second, annuities can also be divided between “immediate” and “deferred” contracts. The former call for payments to the annuitant to begin now and continue for some period of time (tied to the annuitant's life, a guaranteed period, or some combination thereof). Alternatively, “deferred” annuities are simply vehicles where dollars rest while (hopefully) growing until the point of “annuitization” (i.e., when payments to the annuitant begin).

In all cases, annuities enjoy one of the tax-favored aspects that characterize CVI—the ability for dollars to grow (assuming cooperation from the underlying assets) without current taxation. Unlike life insurance, however, when money comes out of the annuity contract, any gain in excess of after-tax premium deposits will always be taxed as ordinary income.

The rest of this article will focus on the use of “fixed immediate” annuities (“FIA”). These are contracts under which an amount of money (i.e., premium) is transferred to an insurance company in exchange for the insurer's promise to immediately start to pay to the annuitant a stream of dollars consisting of principal and interest. Embedded within the calculation of the stream of annuity payments is an assumed internal rate of return declared by the insurance company (as opposed to market-based performance that the annuitant controls). The level of this internal rate of return will drive the competitive differences between different annuity products.

As has been the case in the life insurance marketplace, FIAs have improved over the years due to declining expense levels and market competition. On the other hand, at this time, FIAs face one of the same great challenges confronting any interest rate-sensitive product—the low yields in the current interest rate environment.

Annuity pricing. Despite the low interest rates in the FIA market place, annuities can still provide an attractive return on an initial premium in absolute terms (and a very attractive return in relative terms) if the annuity stream is tied to a life that extends beyond life expectancy.

The periodic (usually monthly or quarterly) payments from an FIA will be at a maximum level if the payment is tied to a single life, with no guarantee feature. Simply put, the annuity will continue as long as the annuitant is alive. These FIAs are called “life only” payouts. Such “life only” payments provide the maximum annuity payouts because the risk to the annuitant is greatest, and, correspondingly, the least risk is passed to the insurance carrier. At the extreme, with a “life only” annuity, if an annuitant were to die soon after paying the initial premium and after receiving only a few (or potentially no) periodic payments, the insurance carrier will have significantly “won” and the annuitant will have experienced a complete loss of principal.

Depending on the client's age and the product/pricing structure for a given carrier, other FIA payment options could be selected instead of “life only.” These are typically (1) “life with refund” (resulting in payments that continue for life, but if the total aggregate payments at death don't exceed the initial premium, a refund of the balance is made), or (2) “life with x-year certain” (payments for the greater of life or × years). Payments can also be tied to more than one life (i.e., “joint-and-survivor annuities”).

Because all these FIA variations pass more risk from the annuitant(s) to the insurance carrier, the level of each periodic annuity payout will decrease, for a given single premium, versus the individual “life only” option. And, because the periodic payments will be lower, the rate of return delivered to an annuitant will be less than it would have been, given the same life expectancy, under the “life only” option.

Transferring wealth with an annuity tied to an NLG life insurance contract. Clearly, an FIA will deliver an optimal return under a “life only” option if the annuitant lives beyond life expectancy. But in reality, while an annuitant can clearly choose the “life only” option, it is not so easy to simply elect an extended life expectancy.

We can mitigate, and in essence hedge, the economic risk of the annuitant's premature death, if we synchronize a life insurance contract with an FIA. This concept is not new; it has been a part of pension-based planning for many years. (In advising someone about a pension payout choice, the discussion is quite similar to choosing, or not choosing, the “life only” annuity option in an FIA discussion.)

A “new” twist on this planning technique arises from the recent product development and popularity of NLG life insurance contracts. In the traditional setting, if a person chose a “life only” annuity (or pension) option, and wanted to hedge that risk by purchasing a life insurance policy, there still may be some noteworthy risk that will be borne by the annuitant/insured. That is, if the interest rate (for WL and UL buyers) or equity (for VL and VUL buyers) markets don't perform well, the “life only” annuitant will have traded the risk of a premature death for the risk of a poorly performing life insurance policy.

With the option of using the relatively inexpensive death benefit guarantee offered by an NLG contract, in conjunction with an FIA, an annuitant/insured has the opportunity to “lock in” a guaranteed return. For a given single premium, an annuitant will get a fixed “life only” annuity payment for as long as he or she lives, and the economic risk of premature death is then hedged by using part or all of the annuity payments received to purchase and maintain an NLG life insurance contract that has a guaranteed death benefit for a given annual premium. Further, because the timing of payments from an FIA is predictable and fixed, they will dovetail well with, and will address, the premium-timing sensitivity that can exist with an NLG contract.

On the other hand, although the return is “locked in” and guaranteed, the policyowner and all advisors must be comfortable that the return is, in absolute terms, attractive. Again, the NLG contract is best thought of as a last stop on a train from which the client can't easily or inexpensively get off, and there is assuredly a risk that the NLG/fixed annuity locked-in return could be lower—perhaps significantly lower—than the returns available in the marketplace in the future. So, this strategy is appealing for those who think the locked-in return is an attractive number, but will be unappealing for those who think they might be able to find a higher return in the future.

Quantitatively, it is not uncommon today for an annuitant, who would qualify for a favorable life insurance classification, to be able to buy a single premium FIA and then use the after-tax periodic FIA payments to purchase a life insurance contract to “fully guarantee” a net return of 7%, or more, at—or a bit beyond—life expectancy. (The term “fully guarantee” is realistically threatened only by the ability of the insurance carrier[s] to deliver on its promises. While this risk is hopefully negligible, it should not be overlooked.)

For an example with real numbers, a $400,000 single premium from a healthy 65-year-old individual could fund an FIA stream which, after paying tax on a portion of the annuity payments, could purchase a guaranteed death benefit of more than $1.4 million. If the annuitant died at age 83, the return on the initial premium is more than 7.2%. With a death at age 83, the 7.2% return was truly guaranteed 18 years earlier because the annuity will pay all the premiums over the intervening 18 years, and because the NLG contract guarantees that the death benefit premium will not change during that time.

As with any insurance-based solution, if a premature death occurs, the return will be even higher. On the other hand, if death occurs well beyond life expectancy, the net return may still be in the 4%-5% range. These returns, compared with others in today's interest rate market, are attractive, especially considering that they are after-tax returns (the ultimate payment of the life insurance death benefit, if structured properly, will be income tax-free).

This technique can be made even more powerful if some relatively simple estate planning techniques are used. If (1) the initial would-be lump sum annuity premium were in the client's otherwise taxable estate, (2) the ultimate NLG contract were owned by, and payable to, a device outside the estate (such as an irrevocable trust), and (3) the periodic annuity payments were transferred out of the estate by way of tax-free transfers, then the leverage created by using an asset (which would otherwise be significantly taxed in the estate) to “lock in” a 4% to 7% return, or more, on an after-tax basis, is significant. In comparing this method of wealth transfer to other strategies, consider that here there is no probate or administrative cost or other "slippage" that can reduce the value passing to the named beneficiary.

Similarly, suppose that a healthy person already holds an appreciated deferred annuity in his estate. If that deferred annuity will be unused and therefore will be subject to both income and estate tax at his death, purchasing the most competitive FIA (via a tax-free Section 1035 exchange) and an NLG life insurance contract will assure a much more favorable result than will the previous taxable strategy.

Finally, if an annuitant has a history of health problems that could shorten his life expectancy, there is a chance that even greater leverage may be created thanks to underwriting “arbitrage” available in the marketplace today. If an annuitant can legitimately demonstrate to some insurance carriers that his life expectancy is likely to be materially shortened (i.e., if the insurer can be convinced that the annuitant is not a "standard" risk), the client may be able to purchase a “rated” FIA, which will increase the payout of a “life only” option.

On the other hand, despite the person's medical history, it may still be possible for him to obtain a favorable NLG contract because of another life insurance carrier's current aggressive underwriting practice (some of these are called “table shaving” programs). With this confluence of facts, the effective “guaranteed” return of the FIA/NLG combination can be even greater (especially considering the possibility of a sooner-than-normal life insurance payout).

Caution. Anyone marketing any UL, VUL, or NLGUL policies—especially in conjunction with an FIA—should consider the tax consequences if the insured lives beyond the policy maturity date (e.g., age 100). Different contracts and different states may have entirely different rules concerning the cash value and the death benefit of the policy after the maturity date. Obviously, this is a greater concern in the case of very elderly insureds. Certain contract provisions may cause uncertain tax results for the policyowner and should be reviewed by tax counsel.

Conclusion

At no time in recent years have practitioners had as many cost-efficient options to (1) help clients "match the product to the problem," (2) better address clients' changing circumstances, and (3) accomplish estate planning objectives. This unprecedented opportunity is accompanied by a responsibility and professional obligation to work with competent insurance specialists to learn more about the pros and cons of currently available life insurance products and how they can be used to meet clients' needs and goals.

Exhibit 1.Comparison of UL, VL, and VUL

Feature                     UL            VL              VUL
-------                     --            --              ---
Death Benefit               Yes           Yes             Yes
Guaranteed While
Policy in Force?
Premium Amounts             Yes            No              Yes
Flexible?
Policyowner                  No            Yes             Yes
Chooses How
Premiums Invested?
Policyowner Can             Yes            No              Yes
Vary Frequency or
Amount of
Premiums Paid?
Policyowner Can              Yes           No              Yes
Increase or
Decrease Death
Benefits?
Death Benefit                Yes           No               Yes
Options A and B
Available?
Cash Values                   No *         Yes              Yes
Fluctuate
Depending on
Performance of
Underlying Asset?
Interest Rate on              Yes           No               No
Cash Values
Guaranteed?
Partial Withdrawals           Yes           No               Yes
Allowed From
Cash Values?
Cash Value Grows              Yes           Yes              Yes
Tax-Deferred
Annual Statements             Yes            No              Yes
Detail Monthly
Deductions for
Costs and C.V.
Growth?
Considered a                   No            Yes              Yes
Security?
   
* The current interest credited to cash values of UL contracts fluctuates with
the performance of the insurer's general portfolio, but cash values, once
accumulated, do not fluctuate in value with fluctuations in the market value
of the assets in the general portfolio. Table courtesy of Tools and Techniques
of Life Insurance Planning (800-543-0874).

1

  See Leimberg and Doyle, Tools and Techniques of Life Insurance Planning (800-543-0874), and Zaritsky and Leimberg, Tax Planning With Life Insurance (800-950-1216), for more specific guidance as to life insurance products and their taxation and use. See also Baldwin, New Life Insurance Investment Advisor (McGraw-Hill Trade, 2001); Graves, McGill's Life Insurance (5th ed., The American College, 2004); and Schwartz and Turner, Life Insurance Due Care (ABA Section of Real Property, Probate and Trust Law, 312-988-5522).


2

  There are many types of whole life contracts. The oldest and most common is ordinary level-premium whole life, more commonly known as ordinary or straight or traditional or continuous premium whole life.


3

  During the early years of the contract, premiums charged are greater than necessary to provide a pure insurance death benefit equal to the “face amount,” the amount promised by the insurer in the event of the insured's death. This excess amount, together with earnings on policy values, is held in a reserve and gradually “used up” during the years when the insured's probability of death is more likely and therefore the cost of providing the agreed-upon amount of insurance is higher than the money received from the policyowner, and the level premiums are no longer sufficient. In essence, there is an “overcharge” in the early years of the policy to compensate for an “undercharge” in later years.


4

  Most of the key legal benefits of a WL contract are also contained in VL. These include guaranteed maximum mortality charges, nonforfeiture values, a policy loan provision, a reinstatement period, and settlement options.


5

  See the Estate Planning Newsletter Archives in Leimberg Information Services, Inc. (http://www.leimbergservices.com) for the latest information on Section 817 , which covers the taxation in this area.


6

  Because variable life contracts are considered securities, a prospectus must be provided to prospective buyers. This prospectus sets forth information on the insurer, including certain financial data, the way the insurer will use the policyowner's premiums, the investment characteristics of the policy, and most importantly, extensive information about the contract's expenses, fees, loads, and rights of the policyowner.


7

  Some insurers offer a wide choice that might include foreign stock funds, bond funds, GNMA funds, real estate funds, zero-coupon bond funds, and even funds that specialize in specific areas (such as small capitalization stock funds), market index funds, or funds that focus on sectors of the economy (such as utilities, high tech, or communications).


8

  Rybka, "A Case for Variable Life," J. Am. Soc'y of CLU & ChFC (May 1997), and Black and Skipper, Life Insurance (13th ed., Prentice-Hall, 1999).


9

  Under a flexible premium contract, the policyowner can, within limits, decide how much he, she, or it wants to pay and even skip a payment entirely—as long as there is sufficient cash value in the policy to cover current policy charges.


10

  Additions to policy cash values are determined by current interest rates, current mortality costs, and current expense charges.


11

  A policyowner of an adjustable death benefit contract is allowed to lower policy death benefits or, assuming he or she is able to prove insurability, increase the policy's death benefit.


12

  These two death benefit options are typically called Option A (or I) and Option B (or II). The death benefit stays level under A just as it would in a classic WL contract.


13

  See Harris, "Due Diligence Tips for Private Placement VUL,” Nat'l Underwriter (Cincinnati; 5/29/00); Ratner, "Private Placement Life Products: Domestic, Offshore or Atoll? The Reality Check Please," 140 Tr. & Est. 48 (July 2001); Theodore, "Introduction to Private Placement VUL," Product Matters, Soc'y of Actuaries (Nov. 2002, Issue 54); Zaluda and Wolven, "The Use of Private Placement Life Insurance in Tax and Estate Planning,” 43 BNA Tax Mgmt. Memo. 187 (5/20/02); Colvin, "Planning for International Private Placement Insurance: The U.S. Perspective," 96 J. Tax'n 94 (Feb. 2002) ; Gassman, Holub, and Gad, "Offshore Life Insurance: A Potent Wrapper for Ordinary Income Investments, " LISI Estate Planning Newsletter at http://www.leimbergservices.com; Solomon and Saret, "Reaping the Benefits of Offshore Private Placement Life Insurance," 29 ETPL 435 (Sept. 2002).


14

  One cost of the underlying investment options is a much reduced liquidity, which results in unique problems and challenges for both the policyowner and the insurer. For example, policy values are not determinable on a daily basis. Moreover, limited liquidity complicates the processing of recurring monthly charges—a problem often solved by a requirement that some level of liquidity be maintained to cover those charges.


15

  The trade-off here is that the internal rate of return (“IRR”) on surrender is greater with a MEC than with a non-MEC because a MEC provides less life insurance and therefore lower costs while a non-MEC provides a higher net amount at risk—i.e., more insurance and greater liquidity but greater consequent insurance charges and lower cash values. Therefore, many individuals try to obtain the minimum face amount that will still satisfy the Guideline Premium test.


16

  Theodore, "Introduction to Private Placement VUL," Product Matters, p. 22 (Nov. 2002).


17

  Regardless of whether the policy is issued on or offshore, if the policyowner is a U.S. taxpayer, the contract must comply with the definition of life insurance under Section 7702 . In essence, the policy must be considered life insurance under state or local law and it must also meet the so-called cash value accumulation test or the test under which most VUL contracts comply, the "Guideline Premium/Cash Value Corridor" test—as well as minimum asset diversification and investor control tests.


18

  See Rybka and Jones, "Guesses, Projections, Promises & Guarantees," 59 J. Soc'y Financial Service Professionals No. 4 (July 2005). Mr. Rybka notes, "While secondary guarantees constitute an unequaled marketing success, they have triggered growing concerns among the industry's leading pricing actuaries and rating agencies. They caution that some companies having large blocks of secondary guarantee products may, in some circumstances, cause long-term financial impairment to their reserves and create risk for those very policyholders who were seeking the safety of guarantees."


19

  For more information on annuities, see Tax Planning With Life Insurance (800-950-1216), and Tools and Techniques of Life Insurance Planning (800-543-0874). See also Leimberg and Gibbons, “Annuities and Estate Planning,” 29 ETPL 360 (July 2002).

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