What is Behind the
Increase in COI Costs?
Melvin Warshaw, JD.,
insurance carriers have begun to announce increases in the "cost of insurance"
(COI) on certain closed blocks of outstanding universal life (UL) products. Payments
of claims are referred to as COI and are the largest single cost incurred by
life carriers. COI charges can account for 75% to 85% of the total premium. An
increase in COI charges will have an immediate economic impact on
non-guaranteed policies, forcing policyholders to make some hard economic
As an advisor, what steps should
you take to pro-actively represent an ILIT trustee, who must look out for the
best interests of the trust beneficiaries? Do you have clients or ILIT trustees
who do not know what they are actually charged for COI? Would you know if the
cost of a client's or trustee's policies have been increased?
policy elements within a life insurance policy are those that cannot be changed
unilaterally by the carrier. For UL type products, guaranteed policy elements
include the maximum loading and COI charges, the minimum guaranteed interest
crediting rate (sometimes collectively referred to as the guaranteed
assumptions) and the policy face amount. For traditional whole life (WL) and
term policies, guaranteed pricing elements include the policy face amount, cash
values (on WL) and premiums. Guaranteed policy elements cannot be changed
unilaterally by the carrier.
policy elements within a life insurance policy are those that the insurer can
change unilaterally. For UL type policies, non-guaranteed policy elements
include the excess of the actual interest credited to the policy over its
guaranteed minimum crediting rate and the difference between the actual loading
and COI charges assessed to the policy cash value and those guaranteed maximum
charges. Current assumptions are the actual loads, COI and credits being
applied to the policy, but they are subject to change based on evolving carrier
experience. For WL type policies and term policies, non-guaranteed policy
elements include dividends. A carrier cannot unilaterally increase premiums or
lower guaranteed cash values for in-force WL policies, although it can lower or
even eliminate the dividend payments on participating (par) policies (i.e.,
policyholder has a contractual right to share in favorable or unfavorable
operating experience of carrier).
In a UL policy the premiums
contributed become part of the cash value, and the cash value grows
tax-deferred based on the carrier's investment return. In a current assumption
UL policy, the cash value is invested primarily in fixed income investments
(general account of the insurer). The crediting rate movements of carrier UL
portfolios have historically tracked closely to movements in the five-year
rolling average of the Moody's AAA Corporate Bond Yield. The current Moody's
AAA Corporate Bond Yield benchmark is about 4%. Crediting rates on UL policies have
dropped over the years and have now been at or near historical lows for an
extended period, leaving carriers without sufficient interest rate spread on
certain blocks of older business.
In a UL policy, each month the
carrier deducts various charges from the policy cash value. The largest
component of these monthly charges is typically the COI charges, which
increases each year as the insured ages. All insurance policies are assessed
mortality charges to pay for the pure insurance or death benefit coverage for
that year. The recently announced increases in COI rates by some carriers is on top of the natural annual COI increases that
occur steadily as the insured ages.
Once a policy is issued the life
insurance companies have two ways to make money: COI charges and interest rate
spread (the difference between what they earn and what they credit to the
policy). As noted, a current assumption UL policy has a current rate being
credited to the policy and a guaranteed rate, below which the current crediting
rate cannot fall. For those current assumption UL policies issued between 1980
and 2005 it is estimated that roughly 60% have dropped to the guaranteed minimum
crediting rate. For those policies issued between 1980 and 1995 roughly 78%
have dropped to the guaranteed minimum crediting rate. For UL policies issued
between 1980 and 1995 the average guaranteed crediting rate is roughly 4.3%, so
there is virtually no spread available on these blocks of business as the
carrier cannot lower the crediting rate below the guaranteed crediting rate. In
prior periods of higher interest rates, a 150 bps spread between the portfolio
income generated by the carrier and the actual crediting rate on a policy could
be realized. On older blocks of business where the guaranteed minimum crediting
rate is 4% or higher a carrier cannot generate profit since there is
insufficient spread. If the carriers cannot make money on the interest rate
spread, where can they make money? On the cost of insurance (COI).
date, a handful of carriers have sent notices to policyholders indicating their
plans to increase the COI on closed blocks of existing UL business. Years ago
it would have been unheard of for a carrier to increase the COI on a policy as
it was viewed as a sign of financial vulnerability. To see increased COIs on a variety of products
across multiple carriers in such a short time frame is remarkable. Today even
highly rated carriers view targeted COI increases as a short-term business
decision to generate new revenue from older currently unprofitable closed
blocks of business.
have used a variety of different language in their policies for examining the
factors that carriers may or must consider when reviewing and resetting COI
rates. In a single consideration policy, any change in COI must be based on
only one consideration: the carrier's "expectation as to future mortality
experience." In a multiple consideration policy, the carrier's review and
redetermination may be based on a number of considerations, which typically
include "expectation as to future mortality, lapse (persistency) expense and/or
investment income expense. The multiple consideration policy often lists these
considerations as being non-exclusive, which increases the scope of the
carrier's discretion. In a silent consideration policy the factors that the
carrier may or must consider are not listed, reciting that the carrier
generally has discretion to reset the COI without identifying the factors or
Why Have the Carriers
Increased COI Costs?
There are a variety of
reasons why the life insurance carriers have begun to increase COIs on UL and
The persistent low interest rates the carriers
currently earn on their general account investments provides every carrier with
strong motivation to decrease crediting rates on in-force UL policies and
dividend rates on WL policies. New money bond yields have been decreasing since
the early 1980s. Consequently, portfolio earnings have faced downward pressure
for some time, resulting in decreased crediting/dividend interest rates passed
through to policyholders. Since it takes time for investments to mature, there
is a time lag between the change in new money rates and the resulting change to
portfolio earnings. If new money rates increase, then eventually portfolio
earnings should also rise which will lead to higher crediting/dividend interest
rates. For policies now operating at their guaranteed minimum crediting rate,
the interest rate spread on these policies have never performed as originally
priced and illustrated. Five to twenty year-old UL and WL policies have higher minimum
guaranteed crediting rates than the depressed minimum guaranteed rates now
offered on new policies. To date, these are the older policies that have been
the focus for the carriers that have raised COI rates.
mortality experience on specific blocks of closed business may also account for
why some carriers are increasing COIs. The primary driver of worse than expected
mortality experience was overly aggressive underwriting assumptions on issuance
of these UL and WL policies. Competition back five to ten years ago was intense
and carriers aggressively competed for UL business. Many of the closed blocks
of UL business rely heavily on reinsurance to backstop their guarantees. When
performance is poor and more claims are paid out earlier than expected,
reinsurers increase their rates charged to life insurance companies. Moreover,
in the past carriers have managed mortality charges on new policies to keep
them competitive. Experience has shown that most carriers have not passed on
better mortality experience to in-force policies, instead retaining the excess
mortality margins for themselves. Other carriers, typically mutual companies,
have a track record and a stated intent to pass on favorable gains to
policyholders of in-force policies. Since it is difficult for a policyholder or
advisor to predict which carriers will pass on favorable mortality experience
in the future, many select guaranteed policies which insulate the policyholder
making such selection.
UL policies have traditionally been sold as
flexible premium policies permitting the policyholder to initially pay
term-like costs and deferring significant premiums until and after life
expectancy. The case was sold by optimizing the internal rate of return (IRR)
on premium outlay to death benefit, locking in permanent coverage at reduced initial
cost and providing the policyholder with an option to pay higher premiums for
continued coverage later in life. If structured as no-lapse guarantee (NLG),
the policyholder - but not the carrier - holds an option to change premiums in
the future to retain coverage. Minimal early year funding combined with
compressed interest rate spread put pressure on the carriers to properly price
and assess mortality risk at issuance of these policies. Slight
underperformance could result in too many claims and an unprofitable block of
Some have suggested that excessive policy
persistency, or too few policy lapses, has contributed to the COI increase.
Clearly, policy persistency or unexpected lower than anticipated policy lapses,
due perhaps to the emerging life settlement market where policies of unhealthy
insureds are purchased by third parties and held to maturity, may contribute in
some small way to the COI increases.
A few carriers acquired certain blocks of closed
business from other carriers. Discrepancies between the acquiring carrier
current assumptions and the issuing carrier's original assumptions may suggest
a COI increase.
Some speculate that current and future changes
to European accounting standards for insurance have prompted their U.S.
subsidiaries to increase COIs.
Specific Carrier Actions and Comments
carrier, AXA, increased COIs on those policies originally issued on insureds over
age 70 and with a policy face amount of $1M or more. This particular policy
type contained a death benefit guarantee rider (NLG rider). AXA noted that the
COI rate increase will not increase the premium needed to keep the death
benefit guarantee rider in force so long as no loans are taken on the policy,
no changes are made to the policy and sufficient premiums have been paid to
keep the rider in force. Policies without the rider (i.e., policies that do not
have NLG rider / guarantee on premiums) will need additional premiums to keep
the policy from lapsing. The exact amount of the COI increase appears to be
determined by the age at issue, with those policies issued on insureds in their
80s seeing a much higher increase than those issued on insureds in their 70s.
carrier, Legal & General America, explained the COI increases were due to
unfavorable "experience factors (mortality, persistency, investment income and
expenses)." The carrier said: "When the cost of insurance rates were originally
set, the company had certain expectations for the number and timing of death
claims, how long people would keep their policies, how well the company's
investments would perform and the cost to administer policies." The carrier had
previously raised rates on some products in 2012 citing the "current interest
rate environment as the most challenging they've ever faced, and the future
interest rate environment as the most uncertain."
carrier holding companies that have increased COIs are domiciled in Europe.
Some have rotated new business away from UL and specifically NLG policies. For
most carriers that have increased COIs the common theme is that these products
have not been as profitable as originally projected.
No Lapse Guarantee Universal Life Policies
Many of the UL policies
affected by the COI increase were sold as NLG policies. So long as the
policyholder continues to pay the premiums on time to maintain the carrier
guarantees (payment of death benefit, no change in premiums for life or an
extended duration), the policy will remain in force. Guaranteed premiums cannot
be higher nor death benefit lower than originally illustrated at issuance if
the guaranteed premiums are paid on time. Cash value performance can be worse
than illustrated. Most importantly, individuals purchase NLG policies for the
death benefit protection and relatively low but flexible premiums, not for cash
value accumulation. The COI will be charged against the cash value with the
result that the anticipated reduction in cash value in the NLG policy will be
accelerated. Remember, however, that the cash value in a NLG policy cash value
can be reduced to zero, however, the policy and its guaranteed death benefit
amount will remain in-force so long as premiums are paid on time.
that issued NLG policies have few options on outstanding blocks of closed
business. While they can reduce the crediting rate to the contractual minimum
or raise COI charges perhaps up to the contractual maximum, the policyholder
has no immediate out-of-pocket risk and the death benefit remains unchanged. Of
course, the policyholder - especially a trustee of an ILIT - must continue to
monitor the long-term claims-paying capacity of the carrier to ensure the
future financial viability of the carrier. The carrier may be able to justify
raising COI charges on other non-guaranteed blocks of policies but this comes
at an out-of-pocket cost or change in coverage for those policyholders.
Diversification among a number of highly rated carriers is essential to
mitigate long-term risk exposure to the insured and beneficiaries of the death
benefit promises of the NLG carriers. Some suggest that the carriers can more
readily raise COIs on NLG products because there is no out-of-pocket or
economic impact to the policyholder, just acceleration of the cash value
What to Expect in the Future
Will we see more life
insurance companies increase their COIs on UL policies in the coming months? In
all likelihood the answer is yes. All of the carriers that have raised COI
rates to date have been public companies, some of them owned by foreign holding
companies. These public companies measure profitability by the quarter and
foreign holding companies may have to mark to market their life insurance assets.
Mutual companies and privately-held insurance companies may be able to
withstand the need to increase COI revenue to generate near-term profits.
course, movement by the Fed to raise rates may prompt larger carriers to hold
off raising COIs in anticipation of increased fixed income investment returns
that eventually will translate into higher crediting rates. Some carriers may
be unwilling to wait out the time lag of two to three years before policy
crediting rates can be raised and passed through to policyholders, and will
raise COIs to increase profits in the interim.
National Association of Insurance Commissioners (NAIC) reports that over 60% of
people who own life insurance do not really know what type of product they
have. To reassure clients and ILIT trustees that they made the appropriate
choice in life insurance products and share with them when there are
opportunities for improvement in coverage, it is vital to understand what a
client or ILIT expects and does not expect from a life insurance portfolio.
What Are the Options Available to a Policyholder?
1. Purchase a more competitive policy if possible. If the policy is
a non-guaranteed UL policy, and the insured is in good health, consider
purchasing a new NLG policy. Test different premium payment and guarantee
options. To what extent will the existing cash value subsidize a new policy
purchased in a 1035 tax-free exchange? If no new premiums are paid into the new
policy for an extended period of years can the coverage be guaranteed? Perhaps
there can be an initial premium holiday (no premiums due) after which premiums
resume. It may also be possible to structure optimized step premium increases
that defer significant premium payments until after life expectancy. Purchasing
a diversified portfolio of NLG policies issued by top-rated carriers protects
against future COI increases while providing the best strategy for ensuring
that all policy death benefits will be paid as promised.
2. Pay the higher suggested premiums and the keep the same death benefit
amount, or lower the death benefit to an amount that will allow the policy to
run to maturity with no further premiums. Paying higher annual premiums on a
non-guaranteed policy or on an unhealthy insured may be the least desirable
option available to keep coverage in-force. Lowering the death benefit by
perhaps 25% may sustain the reduced policy death benefit through age 100
without further premiums. However, if the policy matures during the insured's
lifetime there will be minimal value paid out. Either way there is potential
risk that carrier may come back in the future and again raise COI costs.
3. Surrender the policy for existing cash value. If the existing
policy is a cash accumulation-oriented UL or WL policy, there will be tax due
on any gain equal to the difference between the accumulation (cash) value and
the premiums paid. This amount is taxed as ordinary income which could exceed
40% for federal income tax purposes, excluding state income taxes. The balance
will be available for the policyholder to reinvest. If the existing policy is a
NLG policy there will likely be little if any cash value in the policy but there
could be a tax loss if the premiums paid exceed the cash value.
4. Sell the policy in the secondary life
settlement market. If the insured is unhealthy with a substandard life
expectancy, it may be appropriate to explore a sale of the policy in the secondary
life settlement market. An insured with a normal life expectancy may be unable
to sell a policy in this market.
5. Keep the death benefit the same, pay no premiums for a period of
years and resume significantly higher premiums after life expectancy. This
is a bet that the insured will not live to life expectancy. If the insured does
live beyond life expectancy the annual cost of coverage will quickly become
very expensive, which requires timely planning.
6. Convert the policy to a paid-up reduced death benefit policy with no
further premiums. If the existing policy is a non-guaranteed UL policy,
lowering the death benefit by 30% or more may allow the policy to be placed on
a reduced death benefit, paid up status. The advantage of converting the policy
to a paid-up policy is that if the policy matures, full value will be paid.