For example, an illustration showing a policy’s performance based on a 6 percent earning rate will provide numbers that relate to premiums paid, and accumulation of cash value that are only accurate if the insurance company achieve a 6 percent earning rate for that period (i.e. if the insurance company meets the projections that assumed in the illustration). Therefore, the policy illustrations are used more as a sales tactic because performance is never guaranteed. This is something to keep in mind when reviewing different types of policies, and even different insurance companies.

Thus, it is important to ask insurance agents to show various illustrations based on different projections (especially as it pertains to guaranteed maximum premiums and guaranteed minimum earning projections).

NOTE: Hiring someone with experience in assessing different types of policies from different insurance carriers so that they can present them to you objectively is ideal (although not always practical).

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Thus, the owner of variable life insurance can invest the policy’s cash value investments similar to a mutual fund, stocks, bonds, government securities, and more, and the cash value has more protection as it is not subject to claims by the insurer’s creditors.

The trade-off is (1) the policy owner carriers the investment risk, (2) there is no guaranteed minimum earning percentage (or minimum return) by the insurance company (since they are not investing the cash value in their own), and (3) the insurer still collects administrative fees, which makes this type of policy more expensive. This being said, costs of variable life insurance policies are typically offset by higher investment yields.

NOTE: Although a TOLI avoids this issue since the settlor can select a viable trustee, Variable Life Insurance is not appropriate if the owner cannot monitor investments, has a low-risk tolerance, and does not intend to hold the policy for at least 10 years.

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On the other hand, if this policy’s cash value falls below a termination threshold, the future payments needed to keep the policy in force can become impracticable to maintain. Moreover, there is no renewal under this policy so, if it terminates and the insured still wants insurance, the insured faces the risk of whether they are still insurable or will have to pay higher premiums because the insured is older. Thus, it is important to pay premiums and meet cash value requirements when purchasing Universal Life Insurance.

Some cool features of this type of policy (as a tradeoff for the increased risk) is that cash values can increase at a higher rate, and the insured can also withdraw money from the policy’s cash value as opposed to just taking a loan against it.  

NOTE: Secondary Guaranteed variation of Universal Life shifts the investment risk of universal life insurance to the insurance company by guaranteeing the death benefit and fixing premium costs. Thus, the policy owner is protected from the carrier’s investment risk and increased charges.

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With a first-to-die policy, the proceeds are paid at the death of the first spouse to die, whereas second-to-die policies pay proceeds after both spouses die. Premiums with joint life are very flexible in that premiums can be payable up until first death, second death (or life), or the premiums can be set up to vanish.

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This type of policy combines Term and Whole Life Insurance, and the dividends earned are used to buy additional paid-up whole life insurance that ultimately replaces the term insurance.

This product is substantially more sensitive to how well the insurance company operates financially because the insured takes the risk that, if the company has poor mortality or investment experience (after the guaranty maximum premium expires), (1) there might be insufficient funds to buy paid-up additions, and/or (2) the company will substantially increase the term premium. As a result, the premium in a blended product does not feature the guaranteed level premium found in other whole-life policies.

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Current Assumption Whole Life Insurance is also known as Interest-Sensitive Whole Life, and offers a level premium that remains fixed for a period of time. At the end of the period, the premium amount (and possibly death benefit) will be reevaluated based on the policy’s cash value, which directly correlates with the insurer’s profitability (whether it collectively beat investment projections, and accurately assessed policy lapse rates and mortality rates).

Thus, if the insurance company exceeded expectations, premiums will likely decrease, whereas if the insurance did not meet expectations, premiums will increase. Under each scenario, the policy owner will have some decisions to make.

If premiums increase, the insured can (1) pay premiums at the same amount and lower the death benefit, (2) pay a higher premium to keep the same death benefit, or (3) sacrifice cash value (if available) and pay the same amount of premium.

On the other hand, if the insurance company performed better than expected, the insured could (1) (if still insurable) pay the same premium amount and increase the death benefit, (2) pay the same premium amount with the same death benefit, and increase the policy’s cash value, or (3) pay a lower premium.

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Limited-Pay Whole Life insurance requires a premium payable for the life of the insured or until the policy endows, however, the premiums are designed to fully pay off the policy prior to death of the insured. Because the insurer must collect enough money to pay off the policy in a shorter period of time, premiums for this type of policy are more expensive than level-term insurance providing the same protection.

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Annual Renewable

An annual renewable term contract provides fixed coverage for the present year and guarantees the right to renew for the following year at a specified rate. Please note that it is usually inappropriate for a life insurance trust to own annual renewable term insurance.

Level Term

With level-term insurance, the policy is written for a fixed period of years and total premiums for the entire period of coverage are divided into equal installments. Some popular feature offered as an option with level-term insurance is allowing you to convert your insurance to a whole life policy, and/or offering renewable term.

Decreasing Term

In decreasing term insurance, premiums remain constant over the period of coverage, but the death benefit amount decreases annually. These policies are usually used to ensure payment for declining assets such as a mortgage balance or to provide a fixed income for a duration of time.

Modified Term Modified term insurance is initially just term insurance for roughly 10 years and then automatically converts to whole life or permanent insurance.

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Term Insurance

Term insurance is temporary insurance that provides coverage for a limited period of time without any buildup of cash value. It is also the least expensive type of insurance when young, but increases in cost as you grow older upon renewals

Term insurance is typically the most sensitive type of insurance in relation to an insurance company’s economic well-being. An insurance company could increase premiums on a yearly basis to reflect changes in its operational success (e.g. issuing policies that have a low lapse rate, exceed investment expectations, and accurately estimate mortality rates). If insurance companies do not meet financial expectations, premiums will likely be raised to the maximum guaranteed premium, which is usually much higher than what an insurance agent illustrates to you when selling a policy.

Whole Life Insurance

Whole life insurance has fixed premiums rather than ones that rise with age. As a general rule, you will either pay premiums for the insured’s life or until the policy “endows” (meaning the policy is designed to pay a certain amount after death or at the end of the contract period).

The non-fluctuating premium system results in insurance companies collecting more than it needs to pay off claims in the early years, and less than it needs to pay out claims in later years caused by increased mortality. This system works because excess premiums earned in early years (which are invested) cover the shortfall of earnings in the later years.

Whole life premium payments provide two benefits: insurance protection (or a death benefit) and an investment account. The risk portion is essentially term insurance, and the investment portion acts as a savings account inside the policy (commonly known as cash value). Cash value is a liquid asset that builds up over time, and is available to the policy owner who can borrow against the policy. The cash value is usually free from current income taxes while the policy is in force, however, when the policy is surrendered for its cash value, income taxes will be due.

In standard whole life insurance, premiums will not increase (or adjust) to reflect actual mortality experience. However, the illustrated premium structure usually assumes that the policy will offset future premiums with interest or dividends earned from the policy’s cash value (cash value gets re-invested into the policy), thereby reducing the number of years that you have to pay the premium. This concept is typically referred to as a “vanishing” premium.

However, the vanish date shown in the illustrations is not guaranteed, and will take longer if the insurance company was unable to achieve its risk projections are off. This highlights why it is critical to purchase a policy from a highly rated insurance carrier.

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To ensure you purchase a policy from a credible carrier, there are several service providers that rate life insurance companies, such as Moody’s, Standard & Poor’s, and A.M. Best. These companies analyze more information than what these carriers present in their annual statements. Strong ratings are Aaa, Aa1, Aa2, or Aa3 from Moody’s, AAA, AA+, or AA from Standard & Poor’s, and A from A.M. Best.

This being said, there are three main risks affecting a carrier’s profitability, which therefore impacts a carrier’s ability to meet the expectations they illustrate to you through their insurance agents. These factors are experienced Mortality/Claims, Investment experience, and Lapse Rates.

Mortality/Claims

Mortality or Claims experience refers to incidents of death, which is critical in estimating what an insurance company will have to pay out on its issued policies. Although you cannot predict individual mortality, group morality can and with great accuracy. For example, it is 10 percent likely that a healthy 40-year-old non-smoking male will die within 20 years, whereas the likelihood of a healthy, 60-year-old non-smoking male will die within 20 years is 50/50.

Thus, it is important to determine whether the illustrations accurately reflect the mortality experiences of the insurance company. If the illustrations use different data points, you should ask why because if mortality is worse than illustrated, the insurer’s increased costs are generally passed along to the insured.

Investment

The insurer’s investment experience directly affects the interest or dividends it pays out to its policy holder’s cash value. Thus, a term policy does not depend on the insurance company’s investment performance because there is no cash value accumulating (although investment performance can affect the insurer’s continued viability, and, therefore, will not be able to payout death benefits if it goes bankrupt caused by poor investments).

This being said, you should be aware that life insurance agents typically use higher investment performance estimates when illustrating a policy’s performance.

Policy Lapses

Lapse rates look at the rate of removal or expiration of an insurance policy due to the passage of time or inaction by the insured. Low lapse rates increase profitability because insurance companies front load its expenses (such as underwriting and commissions) rather than amortize those costs over time.

Thus, insurance companies actually lose money in the first year, but are able to recover those losses (if the lapse rate is low) by collecting premiums for long periods of time.

Final Point

The insurer’s overhead is the least important of the risk factors. Mortality and investment performance have a greater impact on product performance. Poor management practices may, however, result in a decreased crediting rate. The insurer’s expenses are reflected in the discussion of earnings in most rating reports.

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