Audit your life insurance

A policy should be about transferring risk and providing financial security, not about taking on risk

Your grandparents may have purchased a permanent life policy, put it in a drawer and forgotten about it — and that might have been OK, but today’s life insurance policies are complex financial instruments and should be monitored like any other asset in your portfolio.

The best surprise is no surprise, and a life insurance policy surprise is almost never good. A policy audit can tell you if your policy is in trouble or headed for it, and what corrective action may be possible.

An audit is not just about the policy. What’s changed in your life is also important. What was the original goal of the policy? Is it still valid? If not, what is the new goal? Is the original beneficiary designation still appropriate? Is the policy ownership structure still appropriate? Has the insured’s health improved, thereby creating the opportunity to reduce premiums?

A policy’s long-term guarantees and projected performance are only as good as the financial strength of the insurer. A permanent life insurance policy is literally intended to be in force for a lifetime: yours. An audit evaluates an insurer’s financial health as determined by various rating agencies and provides a review of the company’s financial strength as compared to statutory requirements and other insurers.

Most likely your grandparents’ policy was a whole life contract priced to reflect conservative mortality and company investment return assumptions. Whole life policies have three guaranteed elements: death benefit, cash value accumulation and a level annual premium.

The guarantees increase the certainty that a whole life policy’s long-term promises of delivering the death benefit and cash value will be kept in almost any economic environment, assuming that the issuing company is prudently managed.

Whole life policies are issued by mutual insurance companies, which are owned by policyholders. For reasons too complex to be covered here, whole life policies pay dividends every year; however, dividends are not guaranteed.

Dividends are a function of an insurer’s profitability, which is largely a function of investment returns. Many whole life policies have been purchased with the expectation that policy dividends (current and accumulated) would one day pay premiums. Thanks to a prolonged low-interest rate environment, dividends have been lower than illustrated at the time of purchase. Consequently, most of those policies will now require that premiums be paid out of pocket for more years than planned.

An audit can show how the lower dividend payouts have affected anticipated policy performance. But it is important to remember that a whole life policy’s death benefit is not at risk.

The historic success of the whole life contract notwithstanding, the insurance industry has developed new permanent products designed to provide a greater degree of premium payment flexibility, more transparency and generally lower premium requirements.

The first such product was what we now call traditional universal life. These policies lacked death benefit and premium guarantees, effectively transferring some of the mortality and investment risk to the policy owners. The major risks with these contracts are loss of coverage and greatly increased future premium requirements. Many universal policies issued in the 1980s and ‘90s have suffered those consequences.

There are newer, more complex universal life designs, including secondary death benefit guarantee universal life, variable universal life and indexed universal life. Some introduce stock and bond market risk; others have additional performance characteristics that are subject to change by insurers after issue. Arguably, these policies especially call for regular review.

The low interest rates of the last several years have put pressure on insurance company finances. In response, some have increased the cost of insurance in existing universal life policies, thereby increasing the premiums required to sustain the death benefit. A policy audit can determine if a policy’s coverage is at risk or if premium increases are likely. If caught early enough, corrective action can be taken.

Universal life insurance, in all of its forms, makes up approximately 75 percent of the market. The risks can be managed if the policies are well funded and monitored. Of course, the current financial ratings of the issuing company also should be examined.

Life insurance should be about transferring risk and providing financial security for the policy owner and beneficiaries, and not about taking on risk. But it’s on us as consumers to understand what we own and how it is working out. 

Charles “Chuck” Baldwin, co-founder and principal of The Baldwin & Clarke Companies and president of Baldwin & Clarke Advisory Services, can be reached at chuckbaldwin@baldwinclarke.com.