Thursday, November 8, 2018

No. 294: Universal Life Policies—a Disaster for Life Insurance Companies and Their Policyholders

I have long been concerned that the development of universal life insurance policies might lead to serious problems for life insurance companies and their policyholders. Recent developments have heightened my concerns. Here I provide historical context and offer suggestions that might prevent universal life from damaging the life insurance business.

Historical Background
My first significant exposure to life insurance occurred in the 1950s, when market interest rates were very low. For example, savings accounts often earned interest rates well below 2 percent. By the 1970s market interest rates had risen significantly, and by the 1980s had reached double-digit levels. In the past decade market interest rates declined sharply and have remained at low levels.

Investment-Year Dividends
In April 1975 I wrote to what is now the New York State Department of Financial Services (NYDFS) asking whether it had ever approved the use of an investment-year method in calculating dividends on individual life insurance policies. (The method had been used earlier in the pension business.) In response, a senior department official said no company had made such a request, and that it would be a "monstrous and costly task even with a new generation computer."

In the January 1, 1976 issue of Probe, the late Halsey Josephson's sprightly newsletter, he said a company had just announced the use of an investment-year method, but he did not identify the company. In response to my inquiry, he said it was The Equitable Life Assurance Society of the United States.

The Insurance Forum, my monthly periodical, began its 40-year run with the January 1974 issue. Based on hindsight, one of my most important early articles appeared in the April 1976 issue and was entitled "Great News—Except for Equitable's Old Policyholders." I said the company's use of an investment-year method meant substantial dividend increases for new and recently issued Equitable policies and no dividend increases for old Equitable policies.

Pursuant to the New York State Freedom of Information Law, I asked the department for its approval file. The department denied my request on trade secret grounds. The denial led to a lengthy legal struggle. In that lawsuit I won a partial victory. I reported in detail on the results of the case in an article entitled "The New York Cover-Up Continues To Unravel" in the October 1978 issue of the Forum.

Operation of Universal Life
When the policyholder pays a premium for a universal life policy, that amount is added to the policy's cash value, which is more commonly called the "account value." Also, interest for the preceding year is added to the account value. Then a mortality charge is deducted from the account value. The mortality charge is calculated by multiplying the net amount at risk in thousands of dollars by the cost-of-insurance (COI) rate. The net amount at risk is the death benefit minus the account value. The policy contains a schedule of maximum COI rates that increase with age, although companies typically use COI rates (called "current" COI rates) that are below the maximum COI rates. Certain expenses are also deducted from the account value. The result of the interest added, the mortality charge deducted, and the expenses deducted determines the new account value.

My first extensive writing on universal life was in the November 1981 and December 1981 issues of the Forum. Those articles are in the package offered at the end of this post.

Detailed discussions of the history and operation of universal life may be found in college-level insurance textbooks. See, for example, pages 70-76 in the 15th edition of Life Insurance, by Kenneth Black Jr., Harold D. Skipper, and Kenneth Black III.

The Transparency Feature
For many years prior to the introduction of universal life, I strongly recommended adoption of a system of rigorous disclosure to consumers of the prices of the protection component and the rates of return on the savings component in traditional cash-value life insurance policies. The protection component is the death benefit minus the cash value. When the death benefit is level, the protection component steadily declines as the savings component steadily increases. An important aspect of my proposed disclosure system required that the policy be divided into its protection and savings components.

Life insurance companies strongly objected to dividing the policy into its protection and savings components. Therefore the companies strongly objected to my proposed disclosure system, and they were successful in preventing its adoption.

One feature of universal life is transparency, because such a policy is divided into its protection and savings components. When universal life burst on the scene in the late 1970s, an official of one of the pioneering companies wrote me and said: "Joe, I hope you're satisfied." Unfortunately, transparency did not lead to adequate disclosure of prices and rates of return, but rather introduced a new family of deceptive sales practices into the life insurance market.

The Flexibility Feature
Another feature of universal life is flexibility, because policyholders, within limits, can change premiums and death benefits. Some universal life policies were called "adjustable life" or "flexible-premium life."

I wrote about universal life and expressed concerns. However, I did not foresee the full extent of the problems that would arise from the transparency and flexibility of universal life. Some life insurance companies foresaw the problems and initially held back from offering universal life. Those companies later ended their opposition.

The Interest Rate Problem
As mentioned, universal life was introduced when market interest rates were rising. It became common for companies and agents to refer to a high interest rate in their marketing of universal life. A classic example, which I wrote about in an article entitled "How Not to Advertise Universal Life," appeared in the May 1984 issue of the Forum. I reproduced in the article a newspaper advertisement headlined "Life Insurance Paying 12% Interest? Unbelievable!" The company was crediting a 12 percent new-money interest rate on universal life. The problem was that, when market interest rates declined, which they inevitably did, the company had to lower the credited interest rates, leaving policyholders feeling they were victims of a "bait and switch" scheme.

The Inadequate Premium Problem
When a person buys a universal life policy, he or she, usually in consultation with an insurance agent, selects the amount of the death benefit and the "initial planned annual premium." The problem with the planned annual premium is that it may be inadequate to keep the policy in force for the desired length of time, whether that is the insured's lifetime or some shorter period. This situation can occur when the selected premium is too low from the outset to sustain the policy for the desired duration. It also can occur when credited interest rates decline, when COI rates increase, or when the policyholder elects to reduce or skip entirely the payment of the planned annual premium.

The Annual Report Problem
Each year the company sends an annual report to the policyholder to keep him or her informed of the status of the policy. Some of the annual reports I have seen are complex, and the policyholder may not examine it. Even if he or she looks at it closely, he or she may not understand it. The agent, who normally receives a copy of the report, may or may not look closely at it, and may or may not review it with the policyholder.

The Problem of Increasing Premiums
Over the years, two major problems have afflicted universal life. First, as credited interest rates declined, it became necessary for policyholders to pay larger and larger premiums to maintain their policies. By "maintain," I refer not only to keeping the life insurance in effect, but also assuring the policy will remain in effect for the desired period.

To compound the problem, universal life policies normally include a guaranteed minimum interest rate that will be credited to the account value. If market interest rates decline below the guaranteed minimum, the company may elect to increase COI rates to maintain the policy, and that would force the policyholder to pay larger and larger premiums to maintain the policy for the desired period.

Universal life policies invariably allow companies to increase their COI rates (up to the maximum COI rates) and many companies have been increasing COI rates to compensate for the interest shortfall. In recent years there have been many lawsuits prompted by large increases in COI rates. The lawsuits usually involve disputes over whether the COI rate increases are allowed under the precise language of the policies.

To my knowledge, no such lawsuit has ever been fully adjudicated. In other words, I believe that no such lawsuit has ever been decided by a judge or jury, and therefore that no such lawsuit has had a chance to survive an appeal. I believe that all such cases have been dropped or settled, that the terms of the settlements in class action lawsuits have been made public, and that the terms of the settlements in individual lawsuits have been kept confidential.

The Administrative Problem
The introduction of universal life made it necessary for companies to develop elaborate systems for administering the policies, especially in light of the flexible premium characteristic of the policies. To compound the problem, companies engaged in a race to develop new versions of universal life in an effort to help their agents in the marketplace. Each new version required the development of a new administrative system. I believe that some companies invested so many resources in development of new policy forms that they failed to develop adequate systems for administering those new policies. Inadequate administrative systems, in turn, led to the companies being unable to service the policies adequately. For example, companies sometimes were not able to respond adequately to policyholder and agent requests for policy information, and companies sometimes were not able to provide meaningful annual reports to policyholders and agents.

Three Suggestions
The first suggestion is that state insurance regulators significantly expand the requirements they impose prior to approval of universal life policies. As examples, companies should be required to submit for approval not only the policy forms but also the annual reports the companies will provide to policyholders and agents explaining the policies, illustrating the policies, and describing the current status of the policies. An important reason for such requirements is to force the companies to show they have developed the systems necessary to administer the policies.

The second suggestion is that state insurance regulators require prior approval of COI increases, just as they require prior approval of increases in the premiums for long-term care insurance policies. I recognize that this suggestion may necessitate formal rule making or even legislation, but I think such a requirement is essential.

The third suggestion, a corollary of the second suggestion, is that state insurance regulators require companies to notify the regulators prior to imposing COI increases. Some states already have adopted such a requirement. See, for example, Regulation 210, which NYDFS adopted on September 5, 2017, and which took effect on March 19, 2018.

Available Material
I am offering a complimentary 25-page PDF consisting of the five Forum articles mentioned in this post (15 pages) and NYDFS Regulation 210 (10 pages). Email and ask for the November 2018 package about universal life.