Since the inception of universal life insurance in the late 1970’s, the whole life world has felt threatened and rightfully so. Universal life insurance boasted a myriad of benefits that improved upon many of the drawbacks that long plagued whole life insurance.
And the one argument the whole life insurance champions have long leaned on is the guaranteed aspect of whole life insurance vs. universal life insurance.
But does this angle really work for whole life insurance? Conceptually it makes sense. And the guaranteed column is guaranteed. But practically speaking does this argument matter? And if it doesn’t, does this spell trouble for whole life insurance?
The Universal Life Insurance Guaranteed Column
The guaranteed column of most universal life insurance proposals is rather underwhelming. The column generally displays a policy that, despite a fairly healthy premium, lapses.
This happens primarily because many universal life insurance policies are designed with very small guarantees. But this design is less evil Corporate America trying to screw defenseless consumers and much more about a specific strategy that can be employed by universal life insurance.
Modified Endowment Contract and 7702 Test: Two Important Considerations
Life insurance is more complex than many people realize. And I don’t mean this in the sense that stock hawkers and money managers who vilify other investments and savings options so as to ensure they can protect their assets under management mean it when they try to argue against the use of life insurance. Instead I merely want to point out that life insurance has a degree of nuance that affords certain opportunistic features that most ignore and never appreciate.
Step One: Modified Endowment Contract
We’ve discussed the modified endowment contract a few times. An important consideration for the modified endowment contract test is that the test clock continues to reset every time a material change takes place. However, there is a portion of premium that is excluded from the modified endowment contract calculation, and this premium is the amount deemed necessary to keep the policy in force.
The modified endowment contract test stipulates that 100% of the premium used for contracts qualifying as life insurance under the Guideline Premium Test (the test that usually qualifies universal life insurance as life insurance) is necessary to keep the policy in force. This means that after the first policy year, it’s nearly impossible to violate the MEC test on a life insurance policy that qualifies as life insurance under the guideline premium test.
Step Two: Guideline Premium Test
As I already mentioned, the guideline premium test is the 7702 test that usually qualifies universal life insurance as life insurance. The Guideline Premium Test establishes a maximum premium that can be placed into a contract based on the death benefit and a cash value that can exist relative to the death benefit–a “gap” in essence between cash and death benefit that must be maintained. The gap declines as the policy ages, but the key here is what the gap is based on.
The key piece here is that both the premium and the allowable cash relative to the death benefit are based on the guaranteed rate of the policy. Mathematically, this means that a lower guaranteed interest rate afford more premium and more cash to exist within the policy before a Guideline Premium Test violation has taken place.
So the low guarantees in a universal life contract are less about competitive disadvantage and more about building a competitive advantage. But we’re not done just yet when it comes to guarantees and life insurance contracts.
What does it Really Mean to go to the Guarantee?
We’ve said it before and I’ll say it again here, going to the guarantee requires a financial circumstance that will leave us worried about much more than what our life insurance contract is doing. But since we’re entrusting a life insurance company with a large portion of our money we do want to make sure that we are placing that money with a strong life insurer.
Truth be told, this life insurance as an asset class business doesn’t work at the life insurer’s guarantees. Just like stock investing doesn’t work at the guarantees (hint, it’s zero).
But whole life insurance or universal life insurance doesn’t really matter as we’re trying to pick companies that are well known for their profitability and strong financial position. A well capitalized life insurer with strong earnings should never cause us pause regardless of the type of life insurance products they offer.
Meaning a strong looking universal life product issued from a financially fit insurance company is just as reliable as a whole life product issued by a similarly strong life insurer.
Focusing on the guaranteed column sounds intuitive and reasonable, but the purpose behind the guaranteed numbers in a universal life insurance contract eliminates any chance to make an apples to apples comparison between the two product types. They function differently, and we have to appreciate them differently.