Originally published in the Fall 2021 Philadelphia Estate Planning Newsletter
A key technique of great writing is that when you don’t have anything specific to say, make a list. As we come to the close of 2021, here are seven observations on how the current economic, financial and social landscape are affecting the life insurance marketplace. We’ll look at both industry-specific trends, along with several general topics that our clients and their advisors are focused on so far this year.
Industry Trends: A Summary of Product, Pricing, and Underwriting
1. Product: Continuing a theme that was already starting pre-COVID, many insurance carriers are limiting their balance sheet exposure to products that rely on secondary guarantees. After significant price increases throughout 2020, the existence of “true” Guaranteed Universal Life (GUL) products has diminished; we anticipate those products that are still available will see price increases in the future, particularly in single pay and short pay (10-ish years) situations.
The industry response has been to add flexible secondary guarantees to cash value-driven policy types along the universal life chassis (current assumption, indexed and variable). A popular design is to solve for the premium necessary to guarantee the coverage around life expectancy with the policy illustrated on a non-guaranteed basis to last beyond life expectancy. Depending upon the age of the insured and risk class, this type of design can build significant cash value and illustrate the policy entering corridor in later years.
There has been a differentiation for Indexed Universal Life and Variable Universal Life designs segmenting the chassis into “protection” and “accumulation” products. By either front-loading or back-loading the cost of insurance, the policies can be designed to more efficiently either grow cash value (focus on growth = accumulation) or provide more cost-effective death benefit (lower premiums = protection).
While not a sub-topic of its own, the use of Long Term Care and chronic care riders continue to be a popular planning tool to add onto permanent policies. The state of Washington passed legislation that starting January 1, 2022, there will be a 0.58% payroll tax on all W2 income to fund long-term care coverage for individuals who do not opt-out. In order to opt-out, individuals must place long-term care coverage (as defined under Section 7702B) inforce prior to November 1, 2021 and file a waiver. It will be interesting to see if other states follow suit in the future.
2. Pricing: If you’re a loyal reader to these updates, please say it along with me “Due to continued downward pressure in fixed income” general account products have continued to see decreased interest crediting rates and dividend rates over the first half of the year. A study completed by Lion Street (Whole Life Dividend Report 2021, For Financial Professional Use Only) showed that of the eight most prominent participating whole life providers six have reduced their previous dividend rate from -0.20 to -0.50. At the time of this writing there is significant discussion around Federal Reserve rate hikes and maybe-not-so transitory inflation – even if interest rise in the general marketplace, it will take several years for the crediting and dividend rates on insurance policies to swing in the positive direction.
The cap rate on many traditional capped 1-year point-to-point accounts is also going through a prolonged period of reduction. The driver of decreasing cap rates is a result of the increased cost of options. At a very, very, very high level, insurance companies use the excess premium beyond the expected yield of the general account to buy an “at the money” call option on a security (such as an ETF) that mirrors the benchmark of the indexed account and sell an “out of the money” call option to create a bull call spread. This is a hedge which limits the potential return of the long position but while also reducing the net cost of the option. As the price of options increases – due to a combination of short-term interest rates, volatility and dividend yields (on market equities, not Whole Life insurance) – the caps on IUL react in the opposite (down) direction.
A sneaky part of the HEROES Act enacted by Congress in late 2020 was a change in the previously static interest rate under section 7702 that determined the maximum funding for life insurance under the two definitions tests (CVAT and GPT). Back in 1988, this rate was set at 4% and would not change based on market conditions. AND SAY IT WITH ME AGAIN “Due to continued downward pressure in fixed income”, these policies – primarily Whole Life contracts – were in danger of lapsing because the premium needed to overcome the suppressed dividend rates couldn’t be applied to policy. This change to 7702 created 1% temporary interest rate for the testing that will ‘float’ in the future. While this was technically a fix for Whole Life, current assumption products will benefit significantly. In short, with a lower threshold for the interest rate assumption to meet the CVAT and GPT tests, more premium can be applied per unit of death benefit while remaining a non-Modified Endowment Contract … for overfunded policy designs, policy owners will be able to get more money into a smaller policy, meaning less insurance charges and fee friction. That leads to better cash value accumulation potential.
3. Underwriting: The subject of my last Write From Home piece (https://www.1847pcg.com/single-post/medical-underwriting-manage-the-process), life insurance underwriting continues to be influx following the pandemic.
For many providers, COVID-19 restrictions on limited rate classes or age maximums are being lifted. In addition, several carriers have begun to re-introduce Table Shave programs that provide a beneficial improvement on rate class – typically moving a sub-Standard to Standard for permanent policies – and product-specific rate class improvements from Standard to Preferred.
The underwriting guidelines and temporary programs vary carrier-by-carrier. Clients who were postponed or declined coverage in the past 18 months may want to consider engaging the informal underwriting process with select carriers to determine if coverage at better rates is now available.
General Planning Topics: What’s Happening with Comprehensive Financial Planning, Premium Finance, Estate Tax Uncertainty, and Income Tax Planning
4. Comprehensive Financial Planning: The objective of comprehensive plan is that the result of an iterative, in-depth fact-finding process leads to the framework from which future financial decisions are made. Before any recommendations are put forth, there is an agreement from the client and the planner on an understanding of risk tolerance; short, intermediate, and long-term cash flow needs; debt and large future expense management; liquid and illiquid assets, and how they are titled; and a strategy for eventual estate distribution. Going forward, assets are evaluated as to their effectiveness in reaching the goal. Financial product selection (life insurance, income generating annuity, long term care or disability protection) can be inserted or removed from the baseline scenario and analyzed to reflect, under various conditions, the potential changes to the overall outcome.
5. Premium Finance: If you’ve made it this far, you know what’s going on with interest rates. While the low interest rate environment has resulted in challenged product pricing, it does provide individuals the ability to borrow money extremely effectively. By arbitraging the low cost of money with policy performance (generally linked to Indexed Universal Life policies), policy owners are able to keep out of pocket costs down and redirect the premium ‘savings’ into higher earning assets.
While the idea of using leverage looks attractive on paper, the discussion around using leverage purchase large amounts of life insurance is complicated and adds several additional moving parts. As ambient interest rates tick up in the future, this type of design requires a significant commitment to annual reviews, both of the policy performance and debt/loan management.
In late 2020, the National Associate of Insurance Commissioners (NAIC) adopted Actuarial Guideline 49A (AG-49A) which changed the way some IUL policies were illustrated. First, products that include return multipliers were limited to reflecting only the illustrated return and not the bonus enhancements; second, the maximum illustration crediting rates was reduced from 100 basis points higher than the policy loan rate to 50 basis points. The net effect of this was a less favorable sales presentation than what was previously available, which, in the case of premium financing, showed a more conservative (tighter) spread between the assumed loan interest rate and policy performance.
6. Estate Tax and Gifting Uncertainty: Though the topic of this piece is to discuss themes from the first six months of 2021, the threat of changing estate tax legislation is ever-present. Democratic control of Congress and White House combined with spending in reaction to the pandemic make this current point in time particularly volatile. Various proposals have been put forth containing some adverse change to the amount of the lifetime exemption (a potential reduction to $3.5M), treatment of capital gains at death, and limitations to annual gifts that can be made to trusts (twice the annual exclusion amount).
Flexibility continues to be a key component of long-term planning when faced with temporary rules. Advisors are using several techniques to take action under the current favorable rules while maintaining several options to pivot should the strategies no longer be needed. In our practice, there are two primary insurance designs we are utilizing with clients who are unsure about the need for permanent insurance for tax planning: 1) a Wait-and-See design (https://www.1847pcg.com/single-post/a-wait-and-see-legacy-planning-approach-maintain-flexibility-while-getting-a-foot-in-the-door) and 2) implementing convertible term insurance.
In the Wait-and-See approach, we are putting second-to-die coverage inforce with a modest first year premium (in some cases, using capital from existing individual policies that are below cost basis and no longer needed for income protection purposes) to put the coverage inforce and owned by the insureds. The policy is then illustrated to remain inforce for a period of time with no additional premiums. At some point in the future, perhaps when we have more clarity on tax law, we can either let the policy lapse with no additional payments, transfer to an Irrevocable Life Insurance Trust and resume funding, or keep as part of the estate and fund at a higher level to create a tax-preferred accumulation vehicle.
For younger clients or those without cash flow necessary to start a second-to-die policy as detailed above, we encourage those individuals to purchase convertible term insurance as a placeholder. Several highly rated insurance companies will allow term policies on both spouses to be converted into a single survivorship product without the need for any medical re-qualification; other providers will allow one policy to be converted and the other insured will be required to complete full medical underwriting. The purpose of the term insurance is to secure more death benefit than what might be needed for true income protection reasons as a way to lock-in current favorable insurability.
A popular planning device that allows married couples to utilize the current limits on irrevocable gifts while having the ability to receive distributions from their beneficial trust during life – it’s like having your cake (moving assets and future growth out of your estate) while eating it too (being able to use the money) – is implementing non-identical Spousal Lifetime Access Trusts (SLATs). An issue arises when one of the spouses passes away: the surviving spouse no longer has access to the assets which their spouse gifted into Trust. Fortunately, there’s a solution to this problem, and, you guessed it … it’s life insurance! Some of the SLAT assets can be used to fund a life insurance policy on the other spouse’s life to replace the value that is no longer available to the deceased spouse.
In situations where access and control of assets are not a priority – for those clients in the “Bonus Round” where gifting the maximum $11.7MM per person doesn’t negatively impact lifestyle – making large gifts under current law should be considered. An approach we’ve seen increase in popularity is to gift assets to an Irrevocable Life Insurance Trust (ILIT) and fund a permanent insurance policy on an annual basis. The balance of the gift not needed for the premium is then invested in marketable securities with the tax responsibility shifted to the Grantor. Stretching out the insurance premiums over the insureds’ lifetime both improves the Internal Rate of Return on the death benefit through expected mortality and allows the invested assets to continue to grow outside of the taxable estate.
7. Income Tax Planning: With the anticipation of higher income and capital gains taxes, the third tax characteristic of life insurance – tax-free growth and distribution – creates additional planning opportunities. For high-income earners, allocating a portion of their after-tax investible income to a cash accumulation life insurance strategy can create policy cash value that can be withdrawn with ROTH-like tax treatment, without any ERISA-defined contribution limits. Life insurance, when designed properly, can be a cost-efficient long-term saving vehicle compared to a taxable account by trading taxes (and trade fees) for insurance costs.
Accessing life insurance policy cash values through loans and withdrawals may be subject to costs, terms, and conditions, and may reduce policy values and stated benefits. Policy must not be a modified endowment contract (MEC) and withdrawals must not exceed cost basis. Partial withdrawals during the first 15 policy years are subject to additional rules and may be taxable. Policy must not be surrendered, lapsed, or otherwise terminated during the insured's lifetime. Life insurance is subject to costs, terms, and limitations not outlined here.
The Variable Universal Life (VUL) chassis provides the most long-term potential for returns and cash value build-up, the greatest diversification of investment options, flexibility, control, and overall transparency (charges, interest crediting rates) of any insurance product available today. The policy cash value is updated mark-to-market based on the performance of the underlying funds. Fund options include Indexed (interest credited based on the performance of a widely held Index, but with floors and caps) and Fixed Account (stated interest rate declared by the issuing company) options. Investment options can be changed without charges or tax impact.
Private Placement life insurance and annuities are experiencing a period of interest. One of the biggest drags on investment performance is taxation, particularly with alternative investment/ hedge fund strategies and investment portfolios that contain a high amount of turnover, generating short-term and/or long-term capital gains. Through the creation of an Insurance Dedicated Fund (IDF), these niche investment vehicles can eliminate current taxation on gains.
These products are only available to accredited investors and are not registered investment products. This attribute allows for significantly more flexibility in the design and underlying charges of the insurance chassis: there are no surrender charges imposed by insurers, no limitations on contributions (subject to contract terms and design), and a transparent pricing structure. Since these assets are invested in the Separate Account of the insurer, there is the additional benefit of creditor protection (depending upon the state). This strategy also eliminates K-1s from the underlying investment issuers.
For the fund manager, Private Placement insurance allows these assets to continue under their management. In situations where an investment strategy is tax-efficient, Private Placement may provide an extra level of asset retention, as the life insurance or annuity is generally positioned as a long horizon plan.
The SECURE Act, passed in December 2019 and effective as of January 1, 2020, made significant changes to retirement planning. To offset the benefits of delaying Required Minimum Distributions (RMDs) and extending how long IRA contributions can be made, the Act essentially ended the “Stretch” provision of passing an IRA down a generation (certain exemptions apply). Now, Inherited IRAs must be distributed – and paid at the beneficiary’s normal tax rate – within 10 years instead of being able to take RMDs at their life expectancy. In situations where RMDs or IRA assets are in excess of what is needed to meet lifestyle expenses, using those dollars to fund a tax-free life insurance death benefit is a strategy to mitigate the income tax on the eventually beneficiary, either through a replacement of the assets that would have been inherited in the IRA or as the funding source to pay for the eventual taxes upon distribution of the assets.
The Takeaways
Change is a constant for financial professionals and their clients. There is always an ongoing balancing act between reacting to the now (and the anticipated soon) and strategizing for the future. Developing strategies that allow for flexibility and positive outcomes independent of transient tax law is where professionals can provide the most value to their clients.