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Cash value tanking? What to do when your life insurance takes a hit

There is nothing more alarming than having your retirement savings at risk — or feeling that your child's college education funds may be lost.

Since the start of the economic downturn in 2007, variable life (VL) and variable universal life (VUL) insurance policies have seen a 30 to 50 percent decline in value, according to a report by the Consumer Federation of America, a Washington, D.C.-based consumer advocacy group. If you own a VL or VUL policy and thought your policy was "paid up," you may have received a notice from your insurer telling you that the cash value in your policy can no longer support the premiums for your death benefit. That means you'll have to start paying the premiums again to keep your policy in force.

VL and VUL insurance policies are a class of permanent life insurance where your death benefit amount can fluctuate depending on the amount of cash value that accrues over the life of the policy, and the cash value grows tax-free. A portion of your premium goes toward this investment account.

Strategies to protect your investment in a VUL

There are other strategies you can employ to protect your investment in a VUL:

  • Open your mail and read your annual review of your VUL's performance. If you don't understand it, contact your agent. "If problems with the policy are caught early, it can be replaced with a safer policy," says Hinerman.
  • If you aren't certain about how your policy is performing, get another opinion. "Take the illustration and get it evaluated by an independent agent, and not the agent that sold the policy to you," says Hinerman.
  • Look at the guaranteed section and ignore the nonguaranteed section. The guaranteed section truly reflects what you will be paying into the policy and if the death benefit will remain in place.
  • If you learn that you are losing a large amount of cash value yearly, get out of the policy. "We can do a 1035 tax-free exchange and take the cash value out and put it into another policy," Hinerman says.
  • If you exchange your policy for a new one, make sure the new policy is guaranteed and that the premium will remain level. "Ideally, you want a policy with a premium that will remain fixed until age 100," says Hinerman.

The reason for the crash in cash values is that VL and VUL policies are linked to the performance of investments — that's the "variable" part. The policyholder takes on certain amount of risk when he purchases the policy. That's fine — if your agent points out that the death benefit could disappear under poor investment performance.

Once the policy grows enough cash value, you can elect to stop paying premiums by allowing the cash value to pick up the tab. This is known as a "paid up" policy.

Most people have their cash value invested in stocks, which means these policies have been directly affected by stock market fluctuations. But this is only one of the many pitfalls a policyholder can face.

"[Some] variable and universal variable life policies have a risky investment component that cannot guarantee the death benefit will remain in place once the cash value goes south," says Ed Hinerman, owner of Hinerman Group, an independent life insurance brokerage in Salida, Colo., "It doesn't take a lot of change to make these policies go bad. The interest rate can change, the mortality rate can change, and if [the insurer's investment] performance is down, all policies that are nonguaranteed will take a major cash value hit."

Variable universal life policies are primarily sold to high net-worth individuals, who often include business owners and others who have a sizable income. In addition to using VLs and VULs to fund retirement, they are also commonly used to pay estate taxes, so heirs can inherit an estate and use the life insurance proceeds to pay taxes.

Deciphering the illustration

When you purchase a VL or VUL policy, the agent gives you a detailed "illustration" that shows how the policy accrues cash value, with theoretical projections (assumptions) on the investment performance of the policy. In addition to providing a view of how the investment portion may perform, the illustration shows how much the policy could generate under current interest rates and how inflation could impact the policy in the future.

The illustration also provides a predicted yearly breakdown of your age, premiums paid into the policy, withdrawals, loans taken out with interest, total death benefit, account value and the cash surrender value. These illustrations typically demonstrate the next 40 years, while some map out 60 years or more, depending on the insurance company.

"Arguably the most important part of the illustration that policyholders overlook is the interest rate percentage at the top," says Hinerman, "The guaranteed and nonguaranteed section shows what interest rate percentages are guaranteed by the insurer and the nonguaranteed portion shows what could happen if the policy continues at the current interest rate."

When a policyholder does not fully understand what is guaranteed on a variable life insurance policy, or does not grasp how the investment performance affects the cash value, this could spell big trouble later— especially in a weakening economy.

Misunderstanding your purchase

Variable life insurance became popular in the 1990s. According to a report by the Consumer Federation of America, when equity values were on the rise in the 1990s, the sale of VLs and VULs increased from 400,000 in 1990 to 1.4 million in 2000. The VUL market alone captured more than 94 percent of those sales. At their peak, total annual premiums paid by policyholders reached $9.6 billion in 2000.

Shop for a good agent before you shop
for a policy

Unscrupulous life insurance agents can make shopping for a VUL all the more difficult. An insurance agent has a great deal to gain from the sale. Upon closing, the agent collects a 60 to 65 percent sales commission, according to Hinerman.

Cleveland of Prudential notes that universal life policies are sold only by life insurance agents who are registered representatives of a broker/dealer, and the priority of the agent should be to make certain that a cash value policy is suitable for their customer.

"It is not suitable in all cases, and a good agent will not sell one of these policies to someone who cannot afford them, or doesn't have the resources to take on the risk they bring," says Cleveland.

Cleveland recommends that VUL shoppers check the agent's credentials by contacting the state insurance department. "They have to be authorized to sell securities," says Cleveland. "If they don't have this authorization, they cannot sell cash value policies."

In addition to checking the agent's credentials, VUL insurance shoppers should examine the surrender charges before they purchase a policy.

"The problem really started in the 1990s on the nonguaranteed side, assumptions were based on the very high interest rates when the policies were sold," says Hinerman. "The agent would tell a potential client that the guaranteed side looks very weak and then direct their attention to the nonguaranteed side. They would tell him that there is no reason to believe that their stock will not continue to perform. The reality is that no one can foresee the condition of the economy 10, 15, 20 years from now."

Hinerman says that it's easy for a policyholder to misunderstand the projected value of a policy because on paper most VULs look very attractive.

For example, in a high interest-rate financial climate, if a policy has an annual premium of $3,700 with interest rates that are 12 to 14 percent, the cash value would far surpass the amount of the death benefit in fairly short order.

"You have a group of policyholders who have been led to believe that they will be millionaires by the time they are 47 years old," says Hinerman. "They forget that this ‘assumption' isn't guaranteed. When they look at these illustrations, what they should be focusing on is the guaranteed assumption, because this is truly what the policy could be worth after 15 to 20 years."

When a variable life insurance policy is guaranteed, even if the cash value disappears, the death benefit remains in place. In a nonguaranteed policy, if the underlying investments do not perform well, the death benefit disappears along with the cash value.

The result is a severely under-funded VL that no longer has sufficient cash value to support the death benefit and keep the policy in force. In order to keep the death benefit in force, the policyholder would have to start paying the premium at a much higher cost. In addition to losses taken in the stock market, policyholders often do not think about the policy's mortality and expense charges and administrative fees that eat into cash value.

Another wrinkle: Given the turnover rate at some insurance agencies, a client could end up with a policy that's tanking and no agent with whom to follow up.

"For example, in the 18th year, if a nonguaranteed policy falls apart because the investments are not doing well, the client receives a premium notification telling them that instead of paying $3,700 in premiums, they are now paying $8,450 to keep the policy active," explains Hinerman. "Most people decide to let the policy lapse rather than paying such a high premium."

Catherine Theroux of LIMRA, an industry research and consulting group, says that some insurance companies have experienced increased customer lapse rates since early 2008 but, as a whole, policyholders are not walking away from their life insurance.

"We think consumers aren't touching their life insurance because they realize that in this economic climate they need a safety net," says Theroux.

Joan Cleveland, senior vice president of business development in Prudential's individual life insurance division, says that the company contacts policyholders when account values have gotten low in their VULs.

"No one likes to lose the value of an asset. It is our understanding that the impact of the market conditions were understood by most policyholders," says Cleveland. "We make sure that policyholders are contacted before there's a problem."

Hinerman points out that clients who want to abandon their crashing policies may not always be able to do so – at an older age and with possibly deteriorating health, they may not be able to get approved for a new policy.

LIMRA reports that sales of all variable life insurance products have been on a steady decline of 50 percent or more every quarter since the first quarter of 2008. In the second quarter of this year, sales in VULs dropped 79 percent from the first quarter of 2008.

Seeking solutions

Once a policyholder finds that his cash value has depleted, he does have options. In extreme cases, if the policyholder learns that he was misled at the time of purchase by the agent, or that the insurance company failed to inform him that the policy is in trouble, he does have recourse: He can file a complaint with his state insurance department.

Surrender charges
lock you in

Getting out of a VUL policy isn't easy, especially if you haven't held it a long time. You could walk away from the policy and lapse it, essentially flushing all that you've paid down the drain. Or you could see if it has any "surrender" value, meaning the policy has built up enough cash value that the insurer will give you a chunk of it and let you wave good-bye.

For example, we looked at a VUL illustration for a 54-year-old male with a death benefit of $250,000. The policyholder pays a fixed premium of $3,793 per year, totaling $18,965 in premiums by year five. The surrender value at year five is zero. By year 10, the policyholder has paid $37,930 and the surrender value has crept up to $5,386.

"If they decide to surrender the policy, they may loose a large percentage of the money they put in, so it's important to know how much it will cost them if they decide to surrender the policy prematurely," says Cleveland.

If a policyholder decides to cancel their VUL before, say, 10 to 13 years, the surrender charge can be so high it would absorb all of the money built up in the policy, says Cleveland. For example, if you had paid $10,000 into a policy and decided within the first year that you wanted out, it's possible to have an $8,000 surrender charge, according to Cleveland. This high surrender charge can lock an unhappy policyholder in for the long haul. Surrender charges decrease as the policy matures.

"The state insurance department/commissioner and the SEC should be able to help because they will investigate a consumer complaint," says James Hunt, an insurance advisor for the Consumer Federation of America. "Once the consumer files a complaint against the agent that sold them the policy, they can also contact an attorney."

John Capuano, an insurance examiner for the New York Insurance Department, says that the department has received complaints regarding VULs. Though the department could not quantify the number of complaints, he says they primarily involve the misrepresentation of the sale.

"It really speaks to the issue of suitability because these products are not for people who are risk-adverse," he says. "If you have an elderly individual with acute health problems, and the agent wasn't clear that it would be a bad idea for this individual to have their savings locked up in a variable product with high surrender charges for a period of 7 or 8 years, we would work to get the policy rescinded on those grounds."

The New York Insurance Department has begun conducting suitability hearings about variable life insurance products involving the public, consumer advocacy groups and industry representatives.

"We are hoping we can put a standard on the books when it comes to enforcement and having companies take remedial action when there is a problem with these policies," says Capuano.

How should you proceed if you hold a VUL policy right now?

"We suggest that policyholders meet with their insurance agent at least once a year to understand the [annual] report that is issued to them," says Cleveland. "Values will fluctuate and there are ways to mitigate that if they manage their insurance reallocation of their separate accounts" — meaning investments that fuel the cash value.

For example, Cleveland suggests shifting from equity funds to less volatile bond offerings.

"The rule of thumb is to diversify your portfolio so if you start to take a loss with one stock, there are other stocks that will continue to perform to balance out the risk. You don't want all of the same eggs in one basket," she says.

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