When someone buys a life insurance policy, the amount owed in premiums is determined based on a combination of several factors. The most significant considerations include:
Problems arise when people do not pay the premium amounts initially planned. It is important that policyholders stay true to the planned premium, especially in the beginning years, to ensure their policy’s continued solvency. If the premiums are not being paid, a policy can become underfunded, and will not benefit the insured as it was intended to at the time of purchase.
The 3 most common types of plans and the problems that can result if premiums are not paid into them regularly:
Variable universal life policies that were drafted years ago: Many of these were written in the 1980s and 90s. Because of prosperous economic times during those years, very optimistic assumptions regarding the market and interest rates were made, and unfortunately many of these factors have not panned out nearly as well as expected. Policyholders had been told for years that they did not need to make monthly premium payments because they were in such good shape that the premiums could be automatically deducted from the policy's cash value, and the market performance would maintain their values – or even provide growth. So every year, premiums (plus internal fees) have been deducted from the cash value of the policy, without any new premium being added. Add this deficit to the financial crisis in 2008 and you can see why these policies are now at risk of failing.
Ironically, we have found that flat market years have a worse outcome for these types of policies than down markets. With down markets, there is typically a rebound of an upmarket to help recapture losses. In a flat market, the same may not be true. All the while, the cost of insurance and expenses keep being taken out.
One of the most unfortunate issues with these older policies is that many of them are owned by senior citizens, now in their 70s or 80s. It is much more difficult for them to get new insurance if their older policies should fail since their health and age may make it cost prohibitive.
Guaranteed universal life policies: These have been very popular over the last 5 to 8 years. People wanted death benefits that were guaranteed, without having to worry about external matters such as market fluctuation. The problem is that the guarantees are dependent upon premiums being paid on time and as planned. A lot of people did not realize that if they missed a premium, they may not receive any notice that their policy guarantees had been compromised. The insurance companies just took the premium amount owed out of the policy’s cash value to maintain its solvency.
If a policyholder with one of these types of plans has missed premiums, he or she may still be able to “catch up” with the payments and restore the guarantees in their policy. The longer they wait, however, the more expensive it will be to accomplish this.
Whole life insurance policies: Premium issues with these often surprise people because they think that whole life policies are not “flexible premium” products, meaning that you have to pay your premium or the policy lapses. This can be true, but many of these policies have a built in APL (Automatic Premium Loan) which means that if a policyholder fails to pay the minimum premium within 60 days from the due date, the premium will automatically be deducted from the cash value of the policy, in the form of a loan. Of course, this loan accumulates interest, eating into the policy’s cash value and death benefit if not promptly paid off. And in fact, some people don't even realize that they're even taking these Automatic Premium Loans, even though it has been happening for multiple years in a row. Fast forward 10 years down the road, and they suddenly discover that their policies are underwater.
Takeaway: Advisors should be telling their clients, pay your premiums on time, every time. And at least once every 3 years, clients should consult with you to make sure their plans are still meeting the financial expectations in place at the time they were purchased. Providing your clients with insurance reviews that include in-force illustrations to explain exactly how their policies are expected to perform is another great way to show them that you're taking good care of them and their finances.