We recently received a really good question regarding whole life insurance and modified endowment contracts that seems like it should have already been the subject of an Insurance Pro Blog article, but alas we skipped over this excellent opportunity to discuss a minor—although interesting and potentially important—quirk to modified endowment contract calculations.
The question was pretty simple:
Looking at various over-funded whole life proposals and I’m noticing that some products appear to hit the modified endowment contract limit sooner than the other, why?
It’s an excellent question, and we encourage everyone to reach out to us with questions they have as they can become great motivators for future articles. The answer, though, is somewhat complex but can pretty easily distilled into a really simple answer.
The Modified Endowment Contract Calculation
As we know, the calculation for modified endowment contracts is simply the premium that needs to be paid over a seven year period to guarantee all of the policy benefits to maturity. The premium that would be required to do this is considered the 7-Pay Premium and it represents the maximum amount of premium that can be placed into a life insurance policy without causing it to be reclassified as a modified endowment contract.
For the most part, the “benefits” in question are the policies death benefit and the formula used to calculate the premiums required to cover the death benefit within a seven-year period is found in the article I linked to in the above paragraph. Given this, it seems intuitively correct to assume that the 7-Pay Premium would be the same across carriers because the expectation that you will die is going to be the same regardless of what product you buy. Or is it?
Buying from One Carrier vs. Another could make you Live Longer?
Realistically no, but from a regulatory/mathematical point of view…kind of sort of—or at least that’s what it looks like on paper. We’ve mentioned before, and those will a moderate grasp of actuarial life insurance design will know, that carriers can price their products based on experience. Meaning if a carrier has shown that is personal mortality experience given a certain product and a certain cohort of the population is better than the mortality experience found in the CSO (Commissioners Standard and Ordinary Tables, which are the mortality tables used as a general guideline for mortality and therefore life insurance pricing and reserving) then the carrier is free to use it’s experience in mortality probability to price it’s product.
So while buying life insurance from a carrier that tends to have a lower mortality experience than another with a certain product doesn’t mean you’ve now decreased the probability of an early death (necessarily) the carriers do use different assumptions regarding the probability of mortality events and therefore have different internal 7-Pay Premiums based on the fact that their assumptions regarding the probability of your dying varies a bit.
It seems incredibly counter-intuitive, but buying from the carrier with a higher mortality experience can assist in keeping your 7-Pay Premium limit higher. And this higher limit can allow for over funding that cancels out the draw back of a higher mortality charge assumption (keep in mind also that if the experience is better, then this additional upfront expense is refunded through dividends, win win).
But that’s not All
There’s one more consideration for varying 7-Pay Premiums, and it too is a tad quirky like varying mortality assumptions. Every time a life insurance policy undergoes a material change the modified endowment contract calculation resets (i.e. the seven years start over). The most common way to reset a modified endowment contract calculation is to cause a death benefit increase (which will do every time we place paid-up additions into a whole life policy).
When the calculation resets, the current cash value in the policy is included in the calculation that determines the premium needed to cover all policy benefits to maturity. And how that cash value is determined matters a good bit.
The Interpolated Terminal Reserve
The Interpolated Terminal Reserve sounds like a super complex thingy most of us would rather avoid. In truth, it’s just a really fancy way of saying “the cash value in a life insurance policy before the end of a policy year.”
But what matters about the interpolated terminal reserve is how insurers look at it when calculating MEC limits at any given time.
Anyone who owns a whole life policy and has looked at the policies account values prior to the end of a policy year has likely noticed that cash values appear a bit wonky from time to time, this is most commonly driven by a refund of premium factor that is added to the cash surrender value of the policy. In other words, the insurer refunds unearned premiums that were received in advance (e.g. you paid annually and the insurer can only book revenues from premiums on a monthly basis, so if you cancel the policy they owe you whatever premiums have yet to be earned). It makes perfect sense then, that they would add this to the cash surrender value.
What is up for debate, however, is whether or not they need to include this amount in the cash value amount that is used to calculate the new 7-Pay Premium following a material change. Some do, some don’t. The IRS has offered no guidance on whether or not this is necessary (typical) so those who do are being more conservative about modified endowment contract calculations then those who don’t.
It should be intuitive that if a carrier chooses to add this refund to the cash value in the new 7-Pay Premium calculation then it would cause a MEC violation with a lower amount of incoming premium than a carrier that does not include it.
How would know if a carrier does or doesn’t include this refund?
You don’t, these are actuarial assumptions that are always considered proprietary. But we can infer a bit based on how quickly one product appears to warn us about 7-Pay violation. Ultimately, I would recommend that one not get too hung up on this as a consideration.
Ideally, slightly higher mortality assumptions with a carrier that does not include the refund in the calculation following a material change is preferable based on the higher 7-pay limit, but being able to precisely know when and where that is is, practically speaking, impossible. But for at least some explanation (for the inquisitive types) this is why we can see varying modified endowment contract limits on different whole life insurance contracts.