Separate Flexible Premiums from Investment Risk

Two Questions That Sort These Policies

Universal life, variable whole life, variable universal life and indexed life have similar names, which makes them easy to confuse. You can tell them apart by asking two separate questions about any policy:

1. The payment question: Does the policy set a fixed premium schedule, or can the owner change how much and when to pay?
2. The value question: What makes the policy's internal value grow or shrink: interest the insurer credits, investments the owner chooses, or a formula linked to a market index?

The word flexible answers the payment question. The word variable answers the value question. The most common mistake is treating them as one idea. A policy can have flexible payments without investment risk, investment risk with fixed payments, or both.

Before You Start

You should already know what a premium schedule is and how guaranteed values differ from illustrated values. If not, review Understand whole life and premium schedules first.

What You Will Be Able to Do

• Sort universal, variable whole, variable universal and indexed life by payment pattern and by what drives their value.
• Explain why skipping a premium can be harmless in one year and dangerous in another.
• Read a stated guarantee or no-lapse feature and say what it covers and what it does not.
• Calculate a stipulated index credit and explain why it is not the same as account growth.

Three Words You Need First

Account value. This is the running balance inside the policy. Payments go in, interest or investment results are added or subtracted, and charges are taken out. Some sources call it the accumulated value.

Charges. These are the amounts the insurer takes from the account value, usually monthly. They include the cost of insurance, which is the charge for the death-benefit protection, plus expense and administrative charges. The cost of insurance depends on factors such as the insured's age and health. It generally rises as the insured gets older.

Lapse. A lapse means the policy ends without paying a death benefit. Lapse and grace-period rules are covered in Keep coverage in force and understand a lapse. Here you only need one idea: in these policies, a lapse threat comes from the account value running too low to pay the charges.

Universal Life: Flexible Payments, Not Free Coverage

Takeaway: You can change when and how much you pay, within the policy's limits. The account value still has to cover the charges every month.

This is how ordinary (non-variable) universal life works:

• Each premium goes into the account value.
• The insurer credits interest at a current rate. The policy also states a guaranteed minimum interest rate, which the credited rate cannot go below.
• Charges are taken out of the account value.
• The owner may pay more, pay less or skip a payment, as long as enough value remains to cover the charges.
• The death benefit can usually be adjusted more easily than in traditional whole life, within the policy's rules.

Worked Case: Skipping One Payment

Fictional case. All amounts are stipulated for practice.

Rafael owns an ordinary universal life policy. At the start of the year:

• The account value is $3,000.
• The planned premium is $1,200 for the year.
• The year's charges total $1,500.
• The interest credited for the year is $90.

If Rafael pays the planned premium: $3,000 + $1,200 + $90 − $1,500 = $2,790.

If Rafael skips the premium: $3,000 + $90 − $1,500 = $1,590.

The policy stays in force in both versions, because the account value was large enough to pay every month's charges. Skipping did not cancel the charges. It only meant the charges came out of the existing balance instead of out of new money. The cushion shrank by $1,200 more than it would have.

Change One Fact: A Smaller Starting Value

Keep everything the same except two numbers: the starting account value is $1,000, and the interest credited is $30.

If Rafael skips the premium, only $1,030 is available to pay $1,500 of charges. The charges are about $125 a month, so the account value runs out partway through the year. Once the value cannot cover a monthly charge, the policy is at risk of lapse. Its grace-period and lapse provisions decide what happens next.

The choice was the same in both versions: skip the payment. The result changed because the cushion was different. Flexibility depends on having enough value to pay for it.

The Tempting Mistake

"Flexible means I can stop paying and the coverage continues." Flexibility applies to the timing and amount of payments. It does not apply to the charges, which keep coming. Two things can also raise the premium needed later:

• The cost of insurance generally rises as the insured ages.
• Lower credited interest means less growth to help pay the charges.

A planned premium that was once enough can stop being enough. That is why universal life owners need to read their annual statements and act when the value is falling.

What the guarantee means here: The guaranteed minimum interest rate sets a minimum for the rate. It does not promise that the policy stays in force no matter how little you pay. Any values projected at the current rate are not guaranteed, the same guaranteed-versus-illustrated distinction you saw with whole life.

Checkpoint

Fictional, stipulated amounts. A universal life policy starts the year with a $2,000 account value. The year's charges total $1,500, and the interest credited is $60. The owner skips the premium. What is the account value at year-end? If the charges and interest are the same next year, can the owner safely skip again?

Answer: Explanation

$2,000 + $60 − $1,500 = $560. The policy got through this year because the value covered the charges. Next year, $560 plus about $60 of interest cannot cover $1,500 of charges, so skipping again would put the policy at risk of lapse. The tempting mistake is to think that because skipping worked once, it will keep working. Each skipped year draws down the cushion that made the skip possible.

Variable Means the Value Follows Investments

Takeaway: In a variable policy, the owner chooses among investment options. The cash value, and often the death benefit, rise or fall with how those investments perform. The owner, not the insurer, bears that investment risk.

After any fees are taken out, premiums go into a separate account. This money is kept apart from the insurer's general funds and invested in options the owner selects, often stock, bond or money market funds. If those investments do well, the value can grow. If they do poorly, the value falls, and the owner can lose money, including amounts paid in. A variable policy comes with a prospectus, a disclosure document describing the investment options, fees and risks.

Notice what "variable" does not tell you: it says nothing about whether premiums are fixed or flexible. That is the payment question, which you answer separately.

Variable Whole Life: Fixed Schedule, Investment Risk

In this lesson, variable whole life means a variable policy with scheduled premiums: the amount and timing are fixed. The Illinois Department of Insurance calls this "scheduled premium variable life."

The tempting mistake is to carry over the guarantees from traditional whole life. In a traditional whole life policy, cash values follow a guaranteed table. In the variable account, there is no guarantee of investment earnings or cash values. The death benefit can also go down with poor performance. Some policies offer optional guarantees for an added cost, so read exactly what the policy states. The word "whole" refers to the policy's lifetime design and fixed schedule. It does not guarantee the cash values.

Variable Universal Life: Both Kinds of Flexibility and Risk

Variable universal life combines universal life's flexible payments with a separate account's investment risk. The owner chooses the premium amount, the face amount, and how the value is invested.

Fictional, stipulated amounts. Go back to Rafael's first case: a $3,000 starting value, $1,500 in charges, and a skipped premium. This time the policy is variable universal life, and the chosen investments lose $400 instead of earning $90 of interest:

$3,000 − $400 − $1,500 = $1,100

In ordinary universal life, the same skip left $1,590. The investment loss and the skipped payment both reduced the cushion. That is why poor investment performance can force a variable universal life owner to pay extra premiums just to keep the policy in force.

Many of these policies also offer a general account option. Money placed there goes into the insurer's general account and is credited at interest rates the insurer guarantees. That guarantee covers only the money in that option, not the investment choices.

A variable policy also states how its death benefit is figured. Common options are:

• the face amount;
• the face amount plus the account value; or
• the face amount plus the premiums paid.

Read which option the policy uses before predicting what a beneficiary would receive.

Indexed Life: A Crediting Formula, Not Owning Stocks

Takeaway: Indexed universal life is a universal life policy whose interest is calculated with a formula that looks at how a stock market index changed. Your money is not invested in the index or in its stocks.

A market index is a published measure of how a group of stocks performed. Three policy terms control how the index change becomes a credit:

• Participation rate: the share of the index gain that counts. A 40% participation rate counts 40% of the gain.
• Cap: the most interest that can be credited for the period. Not every strategy has one.
• Floor: the least interest that can be credited for the period. Floors vary by policy. In this lesson's examples, the floor is stipulated as 0%.

Worked Calculation

Simplified, fictional formula and amounts. Use these steps:

1. Multiply the index change by the participation rate.
2. If the result is above the cap, use the cap.
3. If the result is below the floor, use the floor.
4. Multiply the final rate by the value in the indexed account.

Stipulated facts: the index rose 10%. The participation rate is 40%, the cap is 6%, and the floor is 0%. The indexed value is $20,000.

• 10% × 40% = 4%
• 4% is below the 6% cap and above the 0% floor, so the rate stays at 4%.
• $20,000 × 4% = $800 credited

Change only the participation rate to 100%: 10% × 100% = 10%. That is above the cap, so the rate becomes 6%. $20,000 × 6% = $1,200 credited. A higher participation rate helped, but the cap limited it.

Change only the index result to an 8% drop: −8% × 40% = −3.2%. That is below the floor, so the rate becomes 0%. $0 credited. The index loss is not subtracted from the value.

A Credit Is Not Net Growth

Return to the 4% year. Suppose the year's charges are $1,100 (stipulated) and no premium was paid:

$20,000 + $800 − $1,100 = $19,700

The credit was positive, but the account value went down. In the 0% year, the result is worse: $20,000 − $1,100 = $18,900.

The floor protected the credit from going below zero. It did not protect the account from charges, which continue no matter what is credited.

Tempting Mistakes with Indexed Life

• "Indexed means I own the stocks in the index." No. The index is only used to calculate the credit.
• "I get the full index gain." Not necessarily. The participation rate and cap can limit it.
• "A 0% floor means my value can never drop." No. Charges still come out every month.

Compare indexed life with variable life using the value question. In a variable policy, investment losses flow straight into the account value. In indexed life, a falling index can bring the credit down to the floor, but the loss itself is not subtracted. The trade-off is that caps and participation rates can limit the upside.

Reading Guarantees and No-Lapse Features

Rule: A guarantee covers exactly what it states, only under its stated conditions, and only as far as the issuing insurer can pay.

Apply that rule to each guarantee in this lesson:

• Universal life minimum interest rate: sets a lowest rate. It does not keep the policy in force.
• Variable universal life general account option: guarantees interest only on money placed in that option.
• Indexed life floor: sets a lowest credit. It does not set a lowest account value.
• No-lapse feature: keeps the policy in force even when the account value cannot pay the charges. It usually comes with conditions. It may apply only in certain years or only if a required level of premiums has been paid. It often costs extra and may significantly reduce the death benefit. It is not unconditional.

Fictional illustration. Suppose a variable universal life policy has a no-lapse feature that requires the owner to pay a stated minimum premium every year for the first 15 years. In year 9, the owner has met that requirement, and investment losses drain the account value to zero. The feature keeps the policy in force. Now change one fact: the owner paid less than the required minimum in an earlier year. The feature's condition was not met, so the policy falls back on its normal rules, and an empty account puts it at risk of lapse.

Guarantees still carry insurer risk. Every guarantee, including the death benefit, is backed by the financial strength of the insurer that issued the policy. If that insurer is in financial trouble, it may not be able to pay everything it promised. A guarantee does not remove risk. It moves the risk onto the insurer's ability to pay. For what happens when an insurer fails, see Explain the guaranty association accurately.

Four Product Profiles

Universal life - Payments: flexible, within the policy's limits. - Value driver: interest credited by the insurer at a current rate. - Stated guarantee to look for: a minimum interest rate. - Watch for: rising charges or lower interest requiring more premium.

Variable whole life - Payments: scheduled, with fixed amount and timing. - Value driver: separate-account investments the owner chooses. - Stated guarantee to look for: none on investment earnings or cash values in the variable account. Check for optional guarantees. - Watch for: assuming traditional whole life guarantees apply.

Variable universal life - Payments: flexible. - Value driver: separate-account investments, often with a general account option. - Stated guarantee to look for: the general account option's interest, and any no-lapse feature and its conditions. - Watch for: skipped payments and investment losses both draining the account.

Indexed universal life - Payments: flexible. - Value driver: interest calculated with an index formula, not direct stock ownership. - Stated guarantee to look for: the floor, which applies to the credit. - Watch for: caps and participation limits, and charges reducing the value even when the credit is 0%.

Practice: New Cases

Work each case on your own before opening the explanation. All cases are fictional, and all amounts are stipulated.

Case 1. A policy requires the same premium on set dates each year. The owner divides the policy value between a stock fund and a bond fund. Which of the four products is this? What guarantee should you not assume just because of its name?

Answer: Explanation

This is variable whole life. The fixed schedule answers the payment question (scheduled), and owner-chosen funds answer the value question (variable). Do not assume a guaranteed cash value table like traditional whole life. The variable account has no guarantee of investment earnings or cash values, and the death benefit can also fall. The trap is reading "whole" as a promise about values.

Case 2. In an indexed universal life policy, the index rose 12%. The participation rate is 50%, the cap is 5%, and the floor is 0%. The indexed value is $15,000. The year's charges are $700, and no premium was paid. What is the credit? How much did the account value grow?

Answer: Explanation

First, 12% × 50% = 6%. That is above the 5% cap, so the rate becomes 5%. The credit is $15,000 × 5% = $750. The account value is $15,000 + $750 − $700 = $15,050, so it grew by only $50. The mistake is to report $750, or 6%, as the growth. The cap limited the credit, and the charges absorbed most of it.

Case 3. A variable universal life policy has a no-lapse feature that applies during the first 10 years if the owner pays a stated minimum premium every year. In year 6, after an investment loss, the owner skips that year's payment, and the account value can no longer cover the charges. Does the no-lapse feature protect the policy?

Answer: Explanation

No, not under this feature. Its condition, paying the stated minimum every year, was not met in year 6. The policy now depends on its normal account value and lapse rules, and an account that cannot pay the charges is at risk of lapse. The trap is treating a no-lapse feature as unconditional. Even if the owner had paid every year, the protection would end after year 10.

Case 4. A buyer states two preferences: "I want to vary my payments from year to year," and "I don't want investment losses subtracted from my policy value." Which two product profiles fail at least one of these preferences? Explain which preference each one fails.

Answer: Explanation

• Variable whole life fails both. Its premiums are scheduled, and its value follows the owner's investments.
• Variable universal life passes the payment preference but fails the value preference. Its separate-account losses reduce the account value.

Universal life and indexed universal life both have flexible payments and do not subtract investment or index losses from the value. That still does not mean their values cannot fall: charges reduce the value in every one of these policies. The trap is thinking "flexible" and "variable" belong together. They answer different questions.

What to Remember

• Ask two separate questions. Flexible describes payments. Variable describes what drives the value.
• Universal life: flexible payments and insurer-credited interest with a minimum rate. A skipped premium works only while the account value covers the charges.
• Variable whole life: scheduled payments and investment-linked values. "Whole" does not guarantee cash values in the variable account.
• Variable universal life: flexible payments and investment risk. Skipped payments and investment losses both drain the account.
• Indexed universal life: the credit comes from a formula using participation rate, cap and floor, not from owning stocks. A floor protects the credit, not the account value.
• Every guarantee covers only what it states and is backed by the issuing insurer. No-lapse features have conditions and limits.

To practice, make up your own numbers for an index change, participation rate, cap and charges. Calculate the credit, then the net change in account value, and explain why the two numbers differ.