Life insurance guarantees are sometimes heralded as a key benefit. Many whole life insurance contracts are sold with a focus on the fact that the policy boasts various guarantees that—while admittedly impressive in a relative sense to all other financial products—are often overplayed.
But do these guarantees actually matter? And what does the guarantee represent—I mean in a practical application—for life insurance contracts as they relate to cash accumulation strategies? Today we’ll explore this consideration.
Understanding Why Guarantees Exist
Guarantees on life insurance contracts don’t generally exist because the life insurance company itself was feeling particularly generous. Guarantees are often a result of legislative imperative and they cost life insurers in terms of required reserves to ensure they can adequately meet these guarantees.
I assure you, lots of insurers would much rather not be burdened with capital requirements these guarantees impose. And most of them wouldn’t hold the guarantees at the levels they do if not required. One need look no further than legislative change that came about a little over a year ago that lowered the reserving requirements for most whole life insurance contracts from 4% to 3.5%.
A flurry of new life insurance products hit the market place for the sole purpose of lowering guaranteed rates inside contracts.
Still, the legal requirement to design a financial product with a given guaranteed minimum interest rate doesn’t really place a negative impact on us, and perhaps this is one area where “big” government makes our lives better. Or maybe not.
Those guaranteed minimums impose some hefty capital requirements that most life insurers would rather not face. Additionally, for those of us who like to manipulate policies to optimize cash value, higher guarantees limit us in terms of “over-funding” since the modified endowment contract and 7702 Tests use the guaranteed rate of the contract to determine the allowable annual premium.
The higher the guarantees, the more death benefit we need per dollar of incoming premium, and this is counterproductive to our goals of creating more cash rich policies.
Why Don’t Whole Life Insurance Carriers Offer Higher Guarantees?
The short answer is because they don’t have to, but think in these terms. Life insurers know that for some applications of their products, cash accumulation is important.
It’s a key aspect to most whole life insurance sales, so if I wanted to eat everyone else’s lunch, why not just roll out a product with a guaranteed rate that was 1% higher than everyone else? There are numerous reasons.
For starters, the cost of reserving for this product would be astronomically high. That 100 extra basis points that I’ve decided to guarantee to the minimum return of the policy reserve requires load more reserved capital that is already hyper conservative with respect to money I must have on hand to prove I can adequately provide the benefit—and locked up capital comes with significant opportunity cost.
Further, why do something that the payment of dividends will do for free?
If I instead keep my minimum guaranteed rate low, and assume that my dividend award will make me competitive, I face no additional reserving requirements. Should I ever find myself in a less optimal financial situation, I simply lower the dividend and move on to the following year.
Additionally, since I’m not burdened by higher capital requirements, I can hopefully delivery higher profitability and continue to pay stellar dividends. None of this is guaranteed, but the probability of the upward potential is favorable.
Why Don’t Universal Life Insurance Carriers Offer Higher Guarantees?
For the most part, the guaranteed rate on a universal life insurance contract is lower than whole life insurance contracts.
It seems reasonable at first glance that an easy competitive work-around would simply be to raise the guaranteed rate to a level that strongly competes with whole life guarantees. But this doesn’t happen, and again it’s because the insurance company neither has to, nor wants to due to the same basic considerations already mentioned above.
Reserving for these higher guarantees is expensive. And why bother guaranteeing a higher rate, when you can already offer a rate that is very competitive against the other options that exist?
Further, universal life insurance has an additional incentive for a lower guaranteed interest rate especially as it related to contracts that seek to accumulate cash values. Lower guaranteed interest rates (and/or higher guaranteed cost of insurance schedules) lower the amount of required death benefit per dollar of premium especially well for universal life insurance contracts.
What needs to Happen for the Guarantees to become Important?
The future is all about risk and it’s proper management. Does the job that pays more with less security pay enough more to justify the risk that you might be without a job for a while? Does the house in the more expensive neighborhood have a justified price tag assuming that it diminishes the probability of less desirable neighbors?
The guaranteed aspect of a life insurance contract when it relates to cash value development is concerned with the probability that insurance contracts will only perform at their guarantees, something we’ve never before seen in any company wide fashion.
For whole life insurance this would mean the suspension of paying dividends. For universal life insurance, this would mean minimum guaranteed interest with maximum possible insurance costs.
Three very important things have to happen in order for this to become a reality:
- Insurer investment results must fall below their benchmark for the product and stay there indefinitely
- More people who bought the specific policy in question must die than the insurer assumed would die and further more people in every age category must die in higher frequency that was assumed, again for an ongoing/indefinite period
- The insurance company must face operational expenses that exceed their assumed benchmark for expenses, and again this must happen for a sustained period of time.
It’s not enough for one or even two of these things to happen long term.
Insurance contracts are designed and priced with a breakdown that places these three considerations: investment return, claims experience, and operational expense as the main pillars of a life insurance contract price and performance—and it’s done this way for a reason.
The economic circumstances that would need to arise in order to make this a highly probable event are quite substantial. If these circumstances were to materialize, it’s unlikely that any of us would be particularly worried about whether or not our life insurance contract was performing more or less favorably than ones issued by a different company.
Guarantees are Important
This isn’t to say that guarantees are necessarily unimportant.
There are various elements to consider vis-à-vis guarantees, but they are much more micro considerations than they are macro considerations. Keep in mind that no two life insurance contracts are alike and while most of the pieces and parts may be present, sometimes there are very critical minor details to consider while evaluating a life insurance contract. It’s within this thought that guarantees can more often matter.