Life Insurance Options, and What Lies in the Shadows

Journal of Financial Planning: November 2011


Peter C. Katt, CFP®, LIC, is a fee-only life insurance adviser and sole proprietor of Katt & Company in Kalamazoo, Michigan. His website is

A good way I can help you understand life insurance issues you can apply in your practice is to present case examples in sort of a Socratic method of critical thinking, by taking apart the planning and purchases sometimes foisted upon unsuspecting clients. In this column we’ll distill the case of Doug (76) and Helen (75), who are in good health. They have accumulated significant wealth primarily in marketable securities. Their situation contains eight specific topics I think can help you. After the initial narrative I will list them with comments.

In 2007, Doug and Helen (then 72 and 71) decided to consider the purchase of a large amount of life insurance ($50 million). They decided to seek the advice of and buy from the son of Doug’s long-ago college roommate, Marty. Marty recommended they buy no-lapse UL policies with premiums guaranteed to Helen’s age 100, when they will terminate. He recommended two companies for the purchases. One of the company’s premiums were 20 percent higher than the other. In 2007, the amounts of premiums were at the outer limits of Doug and Helen’s comfort zone. Marty handled this objection by stating that if they wished to reduce the amounts of life insurance (and premiums), they could sell them in the life settlement market and actually make a profit. Early in 2011, with very low fixed-income rates the new reality, Doug and Helen realized the premium burden could not continue. I was hired. Let’s carefully examine Doug and Helen’s situation and expose some problems.

  1. Marty really had little experience or ability to put together this program. Shortly after I was hired, contact with Marty ceased. Clients and advisers should be wary of buddy-buying. They now realize more due diligence should have been done in 2007.
  2. Selling life insurance amounts that border on or breach clients’ tolerance for premium amounts should always be avoided. Doug and Helen don’t really need estate-tax liquidity life insurance at all because their estate is mostly marketable securities. Clearly Doug and Helen were over-insured.
  3. Although it makes some sense to diversify the life insurance purchase between multiple companies, there is no justification for one of the company’s premiums being 20 percent higher than the other. Certainly there were other companies with much lower premiums that could have been used. Neither company chosen had such spectacular financial ratings that this could be justified.
  4. Marty didn’t consider other life insurance options; he only used level death no-lapse UL with premium and death benefit guaranteed to 100. He should have advised Doug and Helen of two sets of other options. One is to compare level death benefits (no-lapse UL) with increasing death benefits (participating whole life)—based on the same premium amounts. Level death benefits are better for insureds who live to around life expectancy. Increasing death benefits are better for insureds who live longer than life expectancy. This is an option that should have been provided. Some clients wish to bet the long term, and others, vice versa—but they need to know the differences. The other set of options is to compare no-lapse with premium guarantees with current assumption UL with target premiums that change as interest rates change. No-lapse works best with low interest rates; current assumption UL works best with higher sustained interest rates because this reduces the target premiums. Clients can decide whether they want to bet on sustained higher interest rates versus the status quo. Again Doug and Helen were not informed of this choice.
  5. Funding the policies to only 100 was a mistake because Helen has a 12 percent probability of making it to 100. The premiums need to be increased to extend how long the policies will remain in force. I recommended to 106. I have had a plethora of cases in the past year of old insureds headed for outliving their life insurance because they were not funded properly. What a problem if Helen were closing in on 100 and it was then realized how much it would cost to continue the policies for a few more years. In fact, had Doug and Helen known the true cost of lifetime (106) coverage, they would not have bought so much life insurance in the first place.
  6. Doug and Helen decided to reduce the amounts of life insurance by 40 percent ($20 million). Obviously the company whose premiums are 20 percent higher will go. This policy has no surrender value because of surrender charges. Therefore, Doug and Helen’s first thought was that these policies could be sold for a profit in the life settlement market (as Marty had promised). This claim was never true, although in 2007 the life insurance/settlement industries had conspired to create the myth that life insurance was so mispriced that the elderly could buy it and two years later sell it for a profit. This was false, and I have had numerous clients who have bought more life insurance than they ever wanted based on this fable and lost substantial monies. The fact is that unless insureds have a significant deterioration in health (more than just the passage of time) there is no mortality arbitrage available necessary to make them saleable in the life settlement market. And when insureds’ health does significantly decline, they are probably better off keeping their own policies anyway. Bottom line for Doug and Helen: there is no possibility of selling any of their policies because they are still in the same good health.
  7. Upon the decision to terminate a $20 million policy I began research to determine whether this policy has a shadow account—that is, the hidden value of a no-lapse policy that doesn’t show up as policy accumulation value. For no-lapse policies you can see this by obtaining an illustration with no further premiums. If the policy is guaranteed to continue beyond the time it has any listed accumulation value, the policy has a shadow account that will pay the cost of insurance until it terminates. It is referred to as a shadow account because it really isn’t detectable except when viewing such an illustration. The illustration doesn’t show what the value of the shadow account is. You know when it runs out only because the policy terminates in a specific year illustrated. (In other words, you can’t find shadow account information by reading the policy contract itself). Doug and Helen’s policy has a shadow account. It will continue without premiums, with no accumulation values, to September 2020. The most dramatic thing to learn from this is to never just terminate a policy whose premiums you wish to stop paying. In Doug and Helen’s case there is no policy surrender value to weigh against just letting the policy continue until it terminates in September 2020. There isn’t any choice.
  8. Knowing when the policies run out helps future planning. As should be done with all UL policies, I will keep track of Doug and Helen’s health status, because this will tell us how to manage not only the $20 million intended to terminate in 2020 but also the $30 million they intend to continue lifetime. Let’s say that Doug and Helen reach 2020 in excellent health. They will just let the $20 million terminate and continue paying premiums as planned for the $30 million. But let’s change that scenario. Doug died in 2019 and Helen has been diagnosed with cancer with the strong probability she won’t live another five years. We would respond to this in two ways. First, in 2020 start paying the catch-up premiums for the $20 million policy. Second, stop paying premiums for the $30 million policy because it’s accumulated value and shadow accounts will continue the policy for more than five years. This is the most efficient way to manage these policies.

Although Doug and Helen initially believed that I could come in and make better sense of their life insurance and we would go our separate ways, they have come to realize that properly managing their life insurance is an ongoing process.

Risk Management & Insurance Planning