Whole Life Vs. Universal Life: UL Evolves into Legacy-Protector and Robust Wealth Generator

September 10, 2013 by Guy Baker

When I first came into the insurance profession in the early ’70s, the staple product was whole life. I loved whole life. What was there not to love? Whole life offered guaranteed premiums, guaranteed cash value and a long history of dividend payments that eventually could make the premiums disappear (based on dividend performance). Whole life had a guaranteed loan rate. NonPar whole life was a form of the word. It catered to the buy-term-and-invest-the-difference discussion. It was a way to have the guarantees, but at a lower premium.

Historical Perspective

Inflation raged and interest rates shot up significantly. Interest rates spiked, the policy loan rate was set at 5 percent and certificates of deposit rates rose to 18 percent. All this caused panic in the halls of many insurance companies. Called “disintermediation,” the company response was to instill variable rates and thus, risk was introduced into the hallowed institution of whole life.

E.F. Hutton, a little-known life carrier, introduced a revolutionary new product called universal life (UL), which was designed to provide the ultimate in flexibility. UL allowed the insured to design their own premium and cash values. Dial it up and dial it down. Many of the old-line agents who mainly had sold whole life for their entire careers found they were competing with the low-cost UL products. The pressure to provide a competitive product increased. Some companies decided to convert their policyholders to UL. Most of the old-line companies stayed the course, but developed a more flexible form of whole life.

Early on, I was fortunate to build a friendship with Lynn Miller, one of the key actuaries who designed the Hutton UL. He has long since retired. We sat down and had a very detailed discussion about the reality of UL. I walked away from that discussion convinced that the only difference between UL and WL was the assumptions. Whole life bases the premiums on the guaranteed interest in the product. UL bases the premium on the assumed interest rate in the product. Otherwise, the mortality costs were the same and the expense loads were, in some cases, less.

So in the final analysis, and I think this is true today, the difference was never in the math. The difference is in the guarantees. With whole life, the insurance company accepts most, if not all, of the risk. It is heavy in guarantees. The policyowner’s only obligation is to pay the premium each year. Any improvement in mortality is reflected in the non-guaranteed dividends. This is also true of expenses. Improvements are reflected in the dividends. So while the initial, guaranteed premium is based on guaranteed mortality and guaranteed expenses, the dividend performance is fundamental to policy performance over time. Even though whole life is a bundled product (the policy expenses, interest earnings and mortality costs are not readily transparent to the agent or the client), it has been the historical dividend scale that provided the competitive edge.

Shifting Risk

With UL, however, virtually all of the risk is shifted to the policyholder. There are underlying guarantees: the mortality costs, expense loads and minimum interest rate. But the illustration is based on current assumptions for these three factors. Everything is unbundled and transparent. The “black box” of whole life was opened for all to see. With a high interest rate assumption, a UL illustration shows significantly lower premiums for the same face amount compared to WL. (With a low interest rate, not so much.) The premium differential between WL and UL could be 50 percent or more. With these types of “savings,” consumers were only too willing to trade in their “high cost” WL for a “low cost” UL with twice the coverage or more. When interest rates hit 18 percent, I saw several illustrations for 40 years based on this as the annual rate. Who wouldn’t buy that?

Impact of UL on the Marketplace

To protect the carrier’s book of business, some companies developed variable whole life. This combined the math of WL with the opportunity to participate in a more aggressive portfolio than the general account of the carrier. The ability to illustrate a “historic” 12 percent return gave WL agents a product to counter the aggressive illustrations used for UL.

In some respects, this became a Pandora’s box. Existing WL policies became prey to the aggressive UL illustrations. The unintended consequence was 20, 30 and 40 years of WL renewals that were lost overnight as policyholders flocked to UL to reduce their insurance costs. To the unsuspecting and uninformed, this shift of risk was neither understood nor appreciated. It was not until interest rates dropped below 5 percent that the reality of UL became apparent. There really was no economic difference between WL and UL, except for the assumptions.

An unintended consequence occurred from this. In order to add more return to the policies, these same creative agents and actuaries combined to engineer variable universal life (VUL). So both sides of the aisle had the same ability to offer eye-popping performance. And again, the net result was that agents further cannibalized the book of whole life policies that had offered proven stability for decades. Agents traded the future value of their renewals for the present value of a large first-year commission. The income security that was such an incentive for many agents virtually disappeared in a flurry of replacement activity.

Indexed Universal Life

Enter IUL – indexed universal life. Variable universal life had its heyday during the go-go ’90s, but when the tech bubble and credit bubble clobbered the market, variable life suffered significant losses. Indexed annuities and IUL became the logical middle ground between a general account product struggling with low interest rates and a variable product with wide swings. Having the ability to offer guarantees on the downside with unlimited upside potential (even if it was capped) became an acceptable risk for agents and insurance buyers still trying to recover from the market aftershocks.

So is IUL the panacea the insurance industry is desperately seeking? It is hard for me to argue against market performance over the past 85 years. The U.S. stock market’s total return for more than eight decades is 9.8 percent. That includes the six “black swan” events. We had two of them in the 2000-2010 decade. But set those returns to 0 percent, using call options purchased with the interest on the underlying general account portfolio in the policy, and the returns jump significantly.

The Future of Life Insurance

No one has a crystal ball that can foresee the future, but we all have heard the past is prologue. Is it true of the stock market and its impact on IUL? Are there systemic factors caused by programmed trading, exchange traded funds, credit derivatives and an unsettled world that will circumvent the creative minds trying to drive higher returns? Can IUL answer the call 20 years from now?

The real downside for any insurance policy is the yin and the yang. The positive with IUL is its flexibility. WL is not flexible. If you don’t pay the premium on a WL policy, the premium will be paid from the existing cash values. As long as there are cash values, the WL policy will continue with a death benefit adjusted by the outstanding loan balance. Cancel the policy and the owner may have a tax surprise. The same could be true of an IUL, but it is less likely to happen.

The flexibility is the yin and the yang. The yin is the ability of the policyowner to stop and start premiums without incurring loans or interest charges. But the yang is the impact this flexibility has on the policy’s long-term viability. The real power of life insurance is the long-term compound interest effect on the cash value. Underfund the policy and you have a really expensive term policy that will fall apart when the insurance is needed most.

The word of caution is to make sure the policyowner understands the lack of guarantees and the impact this will have when they reach 65 or older. I remember an elderly client and his penetrating gaze when he asked me, “Will this policy be here when I die?” He bought the insurance to benefit his family. He wanted to be certain that it would pay the death claim.

Policyowners buy insurance for a variety of reasons. IUL is a very cost-efficient way to fund life insurance premiums until death, even if the policyholder lives longer than the actuaries predict they will. But if the policyowner does not pay the scheduled premium and expects the policy to deliver on the promised illustrated value, there is going to be a major disconnect. As agents, it is our responsibility to educate the policyowner as to the merits of the policy and its potential downsides.

Originally Posted at InsuranceNewsNet Magazine on September 2013 by Guy Baker.