by Peter C. Katt, CFP®, LIC
Peter C. Katt, CFP®, LIC, is a fee-only life insurance adviser and sole proprietor of Katt & Company in Kalamazoo, Michigan. (www.PeterKatt.com)
This column is a potpourri of interesting and important insurance issues that recently have been in the news or observed in my client work. I hope this information is useful in your practice.
Long-Term Care Insurance Premium Increases
My long-term care insurance (LTC) positions expressed in late 1997 columns for the Journal were: (1) There was (is) a very limited market for LTC. The middle class can’t afford it, the wealthy can self-insure leaving the upper middle class as the only reasonable buyers; (2) There was no real experience with pricing LTC, so companies would price it to sell and premiums would soar; and (3) Stick with the most ethical companies (for example, Northwestern Mutual, Guardian, and MassMutual).
Rather soon after LTC policies were sold, many companies began raising premiums on existing policies. The increases likely caused sticker shock to all buyers, with an especially harsh impact on the middle class who thought they could afford the buy-in premiums. The premium increases continue.
A Wall Street Journal article from July 2, 2013, goes into great detail about continuing LTC premium increases on existing policies. To understand if the companies I readily recommend had the same practice of increasing premiums on existing policies, I contacted Northwestern Mutual, Guardian, and MassMutual. They informed me that they have never increased premiums on existing policies. Northwestern Mutual and MassMutual have increased premiums on new policy series, and Guardian stopped selling LTC as stand-alone insurance.
For the upper middle class, LTC may be an appropriate risk management asset. The motivation for buying LTC is so a family’s nest egg isn’t depleted due to elder-care costs. But this also can be handled with buying additional life insurance that could, upon death, replace assets used for possible elder-care expenses. An advantage of life insurance is that unlike LTC that may never pay a benefit, we know the life insurance will.
Deferred Variable Annuities
This commentary isn’t about whether variable annuities (VAs) should be purchased, but about existing VAs with lifetime income and yield guarantees. Another recent Wall Street Journal headline from June 25, 2013, informs us that “Misjudged Annuity Guarantees May Cost Life Insurers Billions.” In light of losing billions, some insurers are changing the terms of these guarantees. The greatest concern for such policyholders is if negative financial events similar or worse than those that occurred in 2008 were to happen, there may be more adjustments with the guarantees (with the most dire outcome being insolvency of one or more companies that have sold the guaranteed VAs). Each VA owner with these guarantees needs to decide whether to continue with that company or make a switch to a company not losing billions. Relevant factors in making a decision is whether there are surrender charges and the extent of the guarantees. It may be worth it to take additional risk for the extra benefits.
I had a dust-up with a few VA sellers following my November 2006 Journal column, “The Good, Bad, and Ugly of Annuities.” My major problem with the apparent risk to hyper-guaranteed VAs was that some sellers were promoting the complete safety of them, having clients go all in with their investment portfolios. I still caution advisers about financial products that appear to be too good to be true.
Don’t Buy on Fear or Greed
Many insurance sales begin with a client being solicited by an agent who highlights the fears and/or greed of a client that some insurance product will solve. Usually, the agent knows exactly what product he or she wants to sell before actually meeting the prospect. In fact, the use of insurance assets should only be based on using a planning process that elevates the client’s situation, needs, and goals so the insurance asset(s) are best suited to the situation and aren’t the focus of a sales pitch. When the sales approach is used and the purchase is not necessarily a good match to the client’s goals, the resulting insurance asset(s) can later leave clients and advisers with unease about why it was acquired in the first place and vulnerable to constant questioning about how it fits into the client’s financial needs. This comes up nearly every month in my work, as clients don’t have a clear reason for buying some of their insurance assets and have little motivation to continue paying premiums.
Immediate Annuity Purchases May Be Reasonable
I admit to confusion regarding the pricing of immediate (income) annuities. First, some background. Income annuities exchange a single sum for lifetime income. Income can be guaranteed for a specified period, usually 10 years, or income stops upon death. There is a cost for having a guaranteed period of payments. For a 65-year-old male, it is around 3.5 percent.
When non-qualified funds are used, a portion of income is taxable. For a 65-year-old male, 35 to 40 percent of the income is taxable, and 60 to 65 percent is considered a recovery principal from the single-sum paid into the annuity. However, after recovering all of the cost basis, income payments become fully taxable. Typically this will take around 20 years for a 65-year-old male.
Three cases in the past six months have given me conflicting information. In one case, I obtained quotes for an immediate (income) annuity for a client and calculated the embedded lifetime yield to be in the 5.3 percent range. This is very good considering the level of interest rates. Two others indicated that the yields were in the 1.5 percent range.
My conclusion isn’t to assume but to analyze each case to determine the embedded lifetime interest rate.
Index Universal Life: Great Deal or Mirage?
Current assumption universal life (CAUL) insurance refers to cash value policies whose future performance depends on future interest crediting rates. If crediting rates decrease, policy owners should raise their target premiums. If crediting rates increase, premiums could be decreased. When making a purchase decision, generally the higher the crediting rate the better the proposal appears. But consumers and advisers need to be wary of illustration tricks that may make some proposals look better than they are.
During the late 1980s and 1990s, many companies used illustration gimmicks to make their policies appear to have fewer premiums or create higher values than their current pricing could provide. Among the common techniques used were bonus interest in five or 10 years, lapse-supported pricing, and return of mortality costs after 10 or 20 years. I never saw one of the gimmicks produce better medium- or long-term values versus companies that didn’t resort to such illustration gimmicks. In fact, it is my sense that the companies that don’t use such gimmicks produce far superior value for policies.
The illustration wars of the 1980s and 1990s were such a problem that the life insurance industry promulgated model regulations for life insurance illustrations in 2001. Under the regulations, interest rates embedded in the illustrations are not supposed to be greater than the earned interest rate underlying the disciplined current scale. The disciplined current scale requires insurers to use non-guaranteed elements that are reasonably based on actual recent historical experience.
The word “index” in index universal life (IUL) refers to interest crediting rates that are determined by reference to various stock indexes. I have seen IUL illustrated rates as high as 8.2 percent that also included a 0.5 percent bonus rate starting in the 11th policy year for illustration purposes. The problem is that IUL premiums collected are not being invested in stocks. The sellers of IUL apparently use hedging techniques to cover returns that are illustrated as much larger than what their investment portfolios could produce. I question how IULs exorbitant illustrated crediting rates are in compliance with illustration regulations.
It is possible that IUL will turn out to be just a marketing gimmick to justify illustrating much higher interest crediting rates than a company’s investments can cover. Sales pitches using 8 percent and 9 percent crediting are backed up by such contract language as, “… the annual index growth that will be recognized in the calculation of the index earnings for an equity indexed segment on a segment anniversary. We will determine in advance the participation rate applicable to each equity indexed segment for each 12-month period and will communicate it to you in an annual report or in notices to you.” Huh? This suggests to me that IUL companies can credit whatever they want. I see no logical reason why IUL will provide better actual performance versus conventional CAUL and whole life.
I don’t believe that IUL is any better or worse than CAUL; each are creating different expectations. The problem with IUL is that it may be creating greater adviser and consumer expectations than realistically can be realized by using crediting rates in the 8 percent range. This will result in underfunded policies.