Issues with Life Insurance
Issues with Life Insurance
The low interest rate environment of the past decade has led to disappointing performance for certain types of life insurance policies.
Term insurance is typically the first type of insurance that most people take out, and it is generally used to insure against future loss of wages. There are two generic forms of term insurance: annually renewable term and level term. Renewable term begins with a very low annual cost that rises each year. Younger people often choose this option to save on the expense of insurance. The low cost makes it affordable when they are starting their careers and budgets are tight. Level term policies have a fixed annual premium for a set period of time, typically 10 or 20 years. Beyond age 50, premiums for both types of term insurance get increasingly expensive. After age 65, term insurance is usually more expensive than whole life. A substantial number of term life insurance policies, by some estimates as many as 99% of them, expire or are cancelled before death.
Whole life policies, also known as “permanent insurance,” are bought with the intent of keeping the policy in force until one dies. Premiums are substantially higher than term insurance premiums. Insurance companies set the premiums based on the number of years they expect the insured to live and the rate of return that the insurance company expects to earn over this period of time.
A universal life policy can be thought of as a combination of term and whole life. These have been used by irrevocable life insurance trusts (ILITs), most often by couples who buy “second-to-die” policies that that will pay out on the passing of the survivor. They typically “mature” between ages 85 and 121. The problem with both universal and whole life policies is that the rate of return that the insurance companies have been earning is below the average return assumption that was imbedded in the policy illustrations before the 2008-2009 financial crisis. Life insurance companies typically have a very high allocation to fixed income or bonds. For example, Northwestern Mutual had 65% of their total assets in bonds as of 12/31/17.
Before 2008, bond returns historically averaged between 5.5% and 6.5%. This return assumption was part of the calculation used to produce a typical life insurance policy illustration. Since 2009, fixed income returns have averaged about half of this amount. As a consequence, the dividends that policies produce have been well below the pre-2008 projections. This has meant that policy owners have had to continue paying into their policies long after the original illustrations showed that they would be self-sustaining.
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