With policy loans, the policyowner can access policy values when needed. The policy values become the collateral for the loan. When the insured dies, any outstanding loan balance is paid out of the death proceeds and the remaining balance is then paid to the policyowner’s beneficiary. The insurance company charges interest on the policy loans. The interest is specified in the life insurance policy. Some products credit interest to the policy cash values that equal the outstanding policy loan. This makes the net cost of the loan less. For example, let’s assume that a life insurance policy charges 8% on policy loans, but continues to credit the cash values associated with that loan with the guaranteed interest rate of 3%. The “net” impact would be that the loan is costing the policyowner 5%. Policy loans are different than loans from lending institutions. Banks require borrowers to make regular cash payments to reduce the amount of their loan. However life insurance policy loans can remain outstanding until the policy is either surrendered or the insured dies. In addition interest charged on a policy loan does not have to be paid in cash, although the policyowner may choose to do this. Rather, the interest can continue to accumulate and add to the outstanding loan balance (and increase the interest due). However, if the policy loan, plus accumulated interest, ever exceeds the policy cash surrender value, the policy may lapse. Also the outstanding loan will be deducted from the death benefit, reducing the amount received by the beneficiaries.
A policyowner in need of money may choose to withdraw money from the cash surrender value. This money reduces the cash value in the policy, but does not have to be paid back and no interest is charged on this amount. Withdrawals from the policy cash value will reduce the death benefit in most cases. Withdrawals can also impact whether or not the policy will remain in force in the future. If the policyowner makes significant withdrawals, the level of premium payments may need to be increased to ensure sufficient dollars are in the policy to cover the monthly fees and charges.
If at any point the cash surrender value, plus interest, is insufficient to cover the monthly deductions for fees and cost of insurance, then the policy will enter the grace period. Once in the grace period, the policyowner has 61 or 62 days (depending on the policy) to send the company sufficient money to cover these charges or the policy will lapse. So, although the policyowner has flexibility in the amount and timing of the premium payments, if too little premium is paid into the policy, if too many premiums are skipped, or if interest rates drop significantly from what was assumed, the policy will not have sufficient cash value to cover the monthly charges and the policy will eventually lapse.
Fixed UL with “Secondary Guarantees”
Policyowners may choose to pay different premium levels for the same death benefit, or stop and start premiums as their financial situation changes. But, if at any time, the cash value in these policies is insufficient to pay the monthly deductions, the policy may lapse unless the policyowner sends in additional money. Therefore, although the policy has premium flexibility, paying consistently low premiums may not be sufficient to keep the policy in force or to counter the impact of fluctuating interest rates or possible increases in charges for the cost of insurance (COI). To counter these risks, many of today’s UL polices offer a guaranteed death benefit for some specified period of time or for life. These guaranteed death benefits are known as “secondary guarantees.” They are also referred to as no-lapse guarantees or lifetime guarantees.
This feature guarantees the existence of a death benefit even if the cash value in the policy is not sufficient to cover the monthly deductions, provided certain conditions are met. [NOTE: This is different than a pure current assumption policy that requires cash value (or additional premium) to keep the policy in force.] To keep the guarantee, the policyowner must pay a specific premium and pay it by the premium due date. If premiums are missed or paid late, the length of the death benefit guarantee period may be shortened. In some cases, the guarantee may actually terminate. Using the withdrawal or policy loan features may also shorten or terminate the guarantee. * Lifetime guarantee is a long-term conditional guarantee that can keep the policy in force when policy values are too small to do so. Certain policy rights, if exercised by the Owner, will end this guarantee. In addition, an unpaid loan may terminate coverage.
In the illustration excerpt below, notice how the death benefit continues on the guaranteed side even though there is no cash value to pay the monthly deductions. This is true even though the maximum COI is being charged and the minimum interest rate is being credited.
The corresponding excerpt from the numeric summary shows that the death benefit is guaranteed to last for life under the illustrated premium pattern.
Let’s change the premium just a little and see what happens to the guarantee. We dropped the premium only $43 per year. The impact is clear – the death benefit is guaranteed to last until the insured is only 69, rather than for life as above. This emphasizes the importance of paying the specific premium in order to maintain the guaranteed death benefit. A lower premium results in a lapse in the death benefit (on a guaranteed basis) in year 40 when the insured is only 69.
This raises a critical question. Since UL is a flexible premium policy, what happens to the guaranteed death benefit if the policyowner varies the amount and timing of his premium payments? A policyowner still has the flexibility to vary the premium and the amount. But, if premiums are less than required for the lifetime guarantee, or if premiums are paid late, the policyowner may jeopardize the length of the guaranteed period. And, in some cases, the guarantee may actually terminate. It is very important for the policyowner to understand this point.
If a lifetime guarantee is shortened because payments are inadequate or late, catch-up provisions in the policy allow the policyowner to pay back premiums, plus interest, to bring the lifetime guarantee back. Depending on the policy language, this catch-up feature may last for the life of the policy or only for a limited number of years. In other words, if the catch-up feature is available for three years, policyowners have only three years from the time they fell behind, to pay the back premiums. However, if the catch-up feature is for the life of the policy, policyowners can pay the back premiums, plus interest, throughout the life of the policy to restore the lifetime guarantee. Note that the catch-up provision cannot be used if the policy’s death benefit guarantee has actually terminated. The death benefit guarantee may terminate if the:
Loan balance exceeds the policy’s cash surrender value;
Policyowner increases the specified amount of death benefit;
Policyowner changes the level death benefit option to an increasing option
If the policy lapses (reinstating the policy will not reinstate the death benefit guarantee)
Grace Period And Secondary Death Benefit Guarantees
As noted in an earlier module, the grace period on a UL policy is not tied to the premium payments. Rather, it starts when the cash surrender value of the policy is insufficient to pay the monthly fees and charges. However, when the UL policy also has a secondary death benefit guarantee, then the grace period doesn’t start until BOTH:
The cash surrender value is insufficient to pay the monthly fees and charges; AND
The secondary death benefit guarantee is no longer active.
In the example above, you can clearly see that the death benefit continued even though the cash value was exhausted. This shows that the lifetime guarantee was still active on this policy. But, in policy year 41, the lifetime guarantee ended. Since there is no cash value to cover the monthly deductions and the lifetime guarantee has ended, the policy will enter the grace period. If additional premiums sufficient to cover the monthly deductions are not paid, the policy will lapse at the end of the grace period.
Lifetime guarantee policies provide long-term death benefit protection at a guaranteed premium. They remove the risks associated with current assumption policies where policy values can be adversely impacted by declines in interest crediting rates and increases in cost of insurance charges. However, these policies require the policyowner to pay the specified premium and pay it on time. Failure to meet this requirement, as well as taking policy loans or withdrawals, can adversely impact the lifetime guarantee on the policy.