Example/ Surrender Charges

Bill and Mary, both very healthy and ages 40 and 41 respectively, have $300,000 in the bank in Certificates of Deposit, money market accounts, and passbook savings.

Since they want cash accumulation as well as a tax-free death benefit, they decide to purchase a $250,000 indexed life policy on the life of Bill, with Mary as owner. The policy they finally purchase has minimum face amount of $100,000, a fifteen-year surrender penalty, as well as a partial withdrawal provision with a $25 administrative fee.

In year six when the policy has an account value of $15,000 and a cash surrender value of $10,000 Mary decides to cash out the policy for their child’s educational expenses. The insurance company cuts Mary a check for $10,000 and a death benefit is no longer payable.

What can be learned from this example? First, Mary has now permanently depleted both the cash value and death benefit on her husband’s policy. The tax-free death benefit cannot be replaced unless Bill goes through underwriting again. The cash value cannot be replaced, but through additional cash value accumulation and additional deposits within MEC and TEFRA limits. Second, perhaps Mary would have been better off utilizing the loan provision of her policy. This would have enabled her to have temporary access to her policy’s cash value, while accumulating interest against her policy’s cash value. However, the policy’s cash values could be replaced and the death benefits would remain intact (less the loan/interest amounts).

This story is fictional and does not portray any individual(s) or company(ies) nor any anticipated performance of any specific product.

Withdrawals can be made on indexed universal life policies, just as they can on traditional universal life plans. They are usually permitted after the first year, and death benefits and cash values are reduced accordingly. If the policy is not a MEC, an amount in excess of the gain would be taxed on a first-in first-out (FIFO) basis. If the policy is a MEC, withdrawals are taxed on a last-in first-out (LIFO) basis to the extent of a gain. One very important distinction between withdrawals on a traditional universal life and an indexed universal life is the timing of withdrawals. If a withdrawal is made from an indexed strategy prior to indexed interest being credited, no indexed gains will be credited on the amount withdrawn. Therefore, it is important to time withdrawals after bucket anniversaries/policy anniversaries whenever possible.

Most indexed life policies also offer some sort of loan provision after the first policy year. Although fixed rate loans are most prevalent, variable rate loans have become a recent trend in indexed universal life products. Concerning fixed loans, some indexed products allow for preferred loans as early as year five. This can be an attractive feature to policyholders who wish to have access to cash flow at a rate that is equal to that being credited to their policy. More education is needed on the trendy variable loan interest (VLI) rate provisions, however. These have become especially popular because of insurance carriers illustrating favorable illustrated (crediting) rates and even more favorable variable loan interest rates. Some carriers may even advertise the fact that their cash values are not impaired by the loan balance, and continue to participate in indexed gains. All of these factors result in a positive loan arbitrage, or positive net coast loan according to the illustration. However, it is important to remember that with indexed life policies what is actually credited to the policy can differ significantly from what is illustrated. In addition, the VLI rate in effect at the time a loan is initiated (sometimes 20 years into the policy) can differ considerably from that illustrated on a ledger. If an indexed life policy is not properly serviced, and monitored for ongoing changes to rates and premium funding levels, this makes the situation even more precarious. For example, imagine the following scenario:

Indexed universal life policy- illustrated rate of 7.60%

Non-guaranteed account value bonus of 1.00% in years 10+

Total illustrated rate of 7.60% in years 1- 9 and 8.60% in years 10+

Cash flow via variable loans from policy taken in years 20-40

Variable loan interest rate of 5.60% assumed on illustration

In this example, once the cash flow begins in the illustration, an illustrated rate of 8.60% is being assumed. So, the client likens this to their credited interest rate which is a full 3.00% higher than the rate that they are taking cash flow out at. So, despite the fact that the policyholder may be loaning the policy to the hilt, he may actually think he is making 3.00% on his money.

But let’s play devil’s advocate…what if the non-guaranteed account value bonus never gets credited? And, let’s suppose that the variable loan rate at the time the client initiates the loan in year 20 is actually 8.00% based on Moody’s Corporate Bond Yield Average. Now, the client is actually being charged 0.40% more for the loan that what is being illustrated on the policy. A newer development in the area of variable loan provisions includes capping the maximum VLI rate. However, this is an area that deserves much more attention given the block of universal life business that went underfunded after the decline in interest rates in the 1980’s. And although the client is provided with an annual statement each policy anniversary, nothing can replace the value of a diligent servicing agent. Statements only disclose values such as the following:

• Last 12 month’s insurance charges
• Last 12 month’s interest crediting
• Cash values over previous 12 months
• Death benefits over previous 12 months
• Premium payments over the past 12 months
• Name, policy number, and other identifying information

This is a primary example of where agents prove their value in the life insurance transaction. Although the report is sent annually, providing values, an agent may be needed to analyze and translate the policy’s performance to the policyholder. In addition, the client may have forgotten important policy provisions since the last anniversary or policy issue. Annual reviews are an important time to touch base about issues such as liquidity provisions.

Just like traditional life plans, loans reduce both the cash value and death benefit on indexed life policies. Loan interest is payable either in advance or arrears, and it will be added to the loan balance and reduce the values accordingly. Loans are not taxed as current income if the policy is not a MEC. All parties are urged to consult their own tax advisor regarding tax consequences of any distributions on life insurance, as this course should not be relied on for tax or legal advice.

Accelerated death benefit riders allow the policyholder to receive a stated percentage of the death benefit, up to a stated limit, in the event that the insured is diagnosed with a terminal illness. Typically the illness must have a life expectancy of 12 months or less. Riders that provide a waiver of surrender charges upon confinement allow for an annual withdrawal from the account value without incurring a surrender charge if the insured is confined to a hospital or similar facility. Insured must typically be confined for a minimum number of consecutive days before waiver can be utilized. Both of these riders are available on indexed life policies at no cost to the policyholder.

Other life insurance riders may be made available to the policyholder in exchange for increased mortality rates or fees. Most of the riders available on traditional universal life plans are also available on indexed universal life, such as:

• Spouse term rider
• Child term rider
• Other term rider
• Primary insured term rider
• Waiver of premium
• Guaranteed insurability option
• Accidental death benefit