The importance of life insurance policy design
By Ken Godfrey
Life Insurance Financial Evaluations, LLC
Owning permanent life insurance products is a long-term commitment. If you are an individual or company that owns or is looking to purchase new permanent life insurance, there are a number of topics you should consider.
Permanent life insurance products currently receive favorable tax and accounting treatments. However, these favorable tax treatments are only realized if the policy is held until the death of the insured. Therefore, permanent life insurance products are generally designed to provide life insurance coverage well past life expectancy. If you are an individual or company that owns or is looking to purchase new permanent life insurance, there are a number of topics you should consider.
Owning permanent life insurance products is a long-term commitment. Policy illustrations are based on a set of assumptions and actual non-guaranteed results will differ from the policy illustration as sold. It is important to commit to paying the scheduled premiums on time and as illustrated. It is also important to continuously monitor the policy performance and make necessary adjustments, such as modifying premium or death benefit levels. In the event policy performance is less than originally projected, additional or higher premiums may be required in the future to carry a policy beyond mortality age.
During the planning and policy design stage, it is important to consider whether or not the insured is contemplating accessing policy values at some point in the future. In many cases, life insurance premium levels are targeted to be the lowest estimated payment to carry the policy to maturity based on a set of assumptions at policy inception. If accessing policy values is not considered in this calculation, taking policy loans, surrenders and/or withdrawals at a later date, the policy may risk lapsing. A policy lapse can have severe, unwanted tax consequences if policy loans are outstanding.
As a result, if surrenders or withdrawals are taken, the cash values that receive the crediting of interest and dividends are lower and therefore, the benefits of compound interest are diminished. Policy loans may also negatively impact policy performance. Depending on the policy net loan rate (interest/dividend crediting rate less loan rate charged), the effect of taking policy loans can be negative, neutral (wash loans), or positive on cash values. The result may result in positive arbitrage if the interest/dividend rate received is higher than the loan rate charged on loaned amounts.
However, even if the net result of taking a policy loan is positive, the interest/crediting rate received on the loaned amount will most likely be less than what would have been received if the policy loans were not taken. The policy may have been originally designed to perform to policy maturity based on receiving the full amount of the interest/dividend crediting rate. The policy performance may be less than expected if the impact of policy loans and its drag on interest/dividend earnings was not considered in the original policy design.
The higher the loans, surrenders and withdrawals taken out of the policy, the less the cash values receive the crediting of interest and dividends and the benefits of compound interest are diminished. If the foregone compounding of interest or dividends is significant and a cushion was not built into the policy at issue, then the policy may not perform as originally projected and could lapse prior to mortality.
Contemplating access to policy values is vital during the policy design stage. If the policy owner anticipates accessing policy values, then the policy should be designed to be over-funded. Over-funding a life insurance policy should provide additional safeguards against a policy lapsing. If managed properly, the policy should provide the intended financial results. Understanding these policy dynamics and committing to managing the policy is crucial to a successful permanent life insurance plan.