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The IRR Case for Life Insurance

Allan Goldstein

Most advisors are familiar with the benefits of life insurance as a vehicle for transferring wealth, but few realize how attractive it is from an internal rate of return (IRR) perspective. Often advisors’ perceptions of the costs and IRR potential of life insurance are based on outdated information about policy design and performance. That is why we encourage advisors to revisit the potential benefits of life insurance as a tool for high-net-worth clients to not only transfer wealth, but also to build and protect wealth.

Over the past 20 years, three major advancements in the insurance industry have combined to significantly improve the capacity for life insurance products to create and preserve wealth.

1. More Efficient Engines

The advent of indexed universal life (IUL) products and improvements to other types of universal life products have resulted in policies with more efficient engines for harnessing equity market growth within the policy.

Generally speaking, IULs offer interest-crediting rates that are linked to an equity index (often the S&P 500), allowing for upside potential while providing downside protection for the insured. After being introduced around 2004, IUL sales began to gain traction in 2006 and have become increasingly popular over the past four years. The extended bull run of the stock market has highlighted the crediting power of IULs, especially relative to non-indexed products, which typically offer crediting rates in the 3% to 4.5% range in today’s low interest-rate environment.

With IULs, interest is credited to the policy based on the performance of the linked index at certain agreed-upon intervals, which can be as short as one month or as long as five years. Shorter intervals can help reduce risk for clients by allowing them to lock in gains more frequently during growth periods. An IUL’s crediting rate is confined by a ceiling on the upside and a floor on the downside. We believe this can create an attractive risk/reward-sharing arrangement between the client and the insurance company. In exchange for giving up any gains above the ceiling, the client gets downside protection at the floor. The floor is usually between 0% and 2%, which prevents previous years’ gains from being lost during down years. The crediting rate is also affected by the participation rate, which can be as high as 150% or as low as 50% in some cases.

The floor, ceiling and participation rates and crediting intervals can all vary considerably from policy to policy. These variables will have a significant impact on the performance of the policy and the cost of insurance, so it is vital to fully understand all of these variables when evaluating a policy. It is also important to note that with most IUL policies, the crediting rate is based on index returns that do not include dividends.

In addition to IULs, other types of universal life policies have seen significant improvements in policy performance in recent years. The choice of the right type of policy is always a function of the client’s unique circumstances and diversification needs. For clients who are looking for even more upside potential and who have the capacity to take on more risk, variable universal life policies can be very effective. Conversely, for clients looking to minimize risk exposure, guaranteed universal life policies can be an attractive option.

2. Lower Mortality Rates

Of all the factors that affect life insurance premiums, life expectancy and mortality charges have the greatest impact. Due to advancements in medicine and increased access to healthcare, people are living longer, healthier lives than they were even a few decades ago. For example:

  • As of 2012, the average life expectancy in the U.S. has increased to 78.8 years
  • According to data compiled by the Social Security Administration, a man reaching age 65 today can expect to live, on average, until age 84.3; a woman turning age 65 today can expect to live until age 86.6
  • About one out of every four of those 65-year-olds will live past age 90, and one out of 10 will live past age 95
  • The prevalence of cigarette smoking among U.S. adults has declined from 24.7% in 1997 to 17.8% in 2013 

All of these improvements in life expectancy add up to lower premiums for clients.

The improvements in mortality charges have been particularly strong for clients working with firms that are members of the M Financial Group, such as Goldstein Financial Group. Because of its reputation in the industry, the size and quality of its client base, and the effectiveness of its reinsurance practices, M Financial is able to use its leverage with carriers to secure very attractive mortality charges in the products M Financial offers clients.

3. Increased Efficiency in the Industry

Insurance companies have learned how to operate the back-office aspects of their businesses more efficiently over the past decade, and these savings have contributed to lower premiums for clients.

Technological advancements such as cloud computing and server virtualization have lowered the costs of creating and running a large business, resulting in slimmer IT budgets for large insurance companies and increased competition from new online providers. The proliferation of mobile devices and sensory technologies has allowed for greater individualization, more informed pricing, and greater opportunities to engage with consumers to promote healthy lifestyle choices. Additionally, sophisticated data analytics and greater access to public information (through social media, industry databases, etc.) have led to better fraud risk profiles and increased fraud detection capabilities. 

Together, these improvements have enabled providers to streamline operations, decrease costs and, ultimately, pass on some of those savings to consumers in the form of lower premiums.

Projected IRR: A Look at the Numbers

Now that we understand the dynamics that have led to improved policy performance, it is helpful to look at an example of how these improvements translate to projected IRR. We will use an IUL policy as the basis for our projections.  

Because there are so many different variables that can be built in to an IUL policy, it is critical to understand a policy’s specific features before looking at projected performance. In addition to the variables that determine crediting rates, policies can differ in terms of a) whether they are designed to maximize death benefit or cash value and b) whether premiums are “life pay” (paid throughout the life of the policy) or “short pay” (front-loaded and only paid during the first 5-10 years of the policy).

Another critical factor is the assumed annual performance of the index during the life of the policy. Because no one knows exactly how equity markets will perform over the next year (let alone over the next 30 years), it is important to use an assumed rate of return that is reasonable and achievable given the historical performance of equity markets.

To illustrate the IRR potential of an IUL policy, we created a projection based on the following assumptions:

  • Client: a 60-year-old couple in the preferred best underwriting class
  • Policy: IUL “life pay” policy, allocated 100% to a one-year, point-to-point S&P 500 account
  • Crediting rate: floor of 0%, a ceiling of 12%, and participation rate of 100%
  • Assumed S&P 500 rate of return (excluding dividends): 6.5% annually
  • Policy endows at age 120

Under these assumptions, the couple could purchase a policy projected to generate a $50 million death benefit for approximately $485,000 in annual premiums. The policy would generate the following IRR, net of tax, on the death of the surviving spouse at:

  • Age 85 (policy in place 25 years) = 9.70%
  • Age 90 (policy in place 30 years) = 7.11%
  • Age 95 (policy in place 35 years) = 5.38%

Clearly, the opportunity to avoid estate tax on the $50 million death benefit is compelling. In this context, the IUL policy allows the couple to preempt a large estate tax bill by making annual payments that equate to less than 1% of the projected death benefit. Besides these wealth-transfer benefits, the relative predictability of the policy’s returns and death benefit allows clients and their investment advisors to be more aggressive and take on more risk with other aspects of the portfolio.

Learning More About Improved Policy Performance

Due to more efficient policy designs, as well as advancements in public health and technology, the performance of universal life insurance policies has improved dramatically in recent years. For many high-net-worth individuals and families, these policies can provide tremendous opportunities to transfer wealth—as well as opportunities to create and preserve wealth for younger generations.

At Goldstein Financial Group, we are dedicated to helping advisors learn more about tools that can be used to protect and grow their clients’ estates. Please do not hesitate to contact us if you would like more information about the various types of universal life policies or if you would like us to create a projection based on a client’s specific circumstances and goals.

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