As Seen in National Underwriter AdvisorFX

By Barry D. Flagg, CFP, CLU, ChFC Founder & Inventor of Veralytic

Last month we talked about the relevance of policy cash values to the overall suitability of a permanent life insurance policy. This month we will talk about how cash value is generally influenced by the number of cash value investment options, the historical performance of such cash value investment options, and cost-effectiveness of the various cash value allocation options.  Cash values of traditional products (i.e. indexed life, universal life and whole life) are invested in the insurer’s general account managed by the insurer and required by regulation (as a practical matter since they are responsible for ensuring their ability to pay any guarantees) to be invested predominantly in fixed‑income securities like high‑grade bonds and government‑backed mortgages^[1]. 

Cash values in variable products are directed by the policyowner among a family of separate accounts offering a wide range of asset classes typically including an assortment of domestic and foreign stock funds, an array of domestic and foreign bond funds, a money market account, and usually a fixed account (typically the same as the insurer’s general account).  The sub-accounts in variable insurance products fluctuate with market conditions and when surrendered the principal may be worth more or less than the original amount invested. Also, be aware that market volatility can lead to the possibility of the need for additional premiums.

To evaluate the suitability of the cash value investment options for a policy; review the performance of invested assets underlying policy cash values, the number and diversity and asset class coverage of cash value investment options, and the expense ratios for invested assets underlying policy cash values, as follows:

Superior Historical Performance is Typically More Suitable – Better historical performance contributes to suitability.  While past performance does not guarantee future performance, the historical performance of invested assets underlying policy cash values is among the most helpful gauges in the fund selection process.  Measure the historical performance of invested assets underlying universal life and whole life cash values by comparing the net portfolio yield on the insurer’s general account against the average net portfolio yield on the general accounts for all other insurers.  Also consider the policyowner’s risk profile and corresponding asset allocation. 

Greater Diversity Options Help Improve Suitability – It is generally accepted under the principals of Modern Portfolio Theory demonstrates that diversification lends to a potential to improve the overall return expected from a given portfolio and reduces volatility expected within a given portfolio.  As such, since cash values of a variable life policy are invested in a given family of funds, the greater the diversity among separate accounts, and the greater the coverage of the different type of equity and fixed income asset classes allow for more favorable cash value allocation options.  In other words, the greater the number of separate accounts and the greater the number of different types of funds, the greater the asset class coverage, and the more opportunity for diversification and broad asset allocation, allowing for greater potential for a suitable cash value allocation options.  For the variable life products, compare the total number of underlying separate accounts with the average number of underlying separate accounts for all policies of the same product type.  However, because traditional universal life and whole life products must be invested by regulation (as a practical matter) predominantly in fixed‑income securities like high‑grade bonds and government‑backed mortgages, and because such fixed‑income investments are managed by the insurer and generally not disclosed, traditional products should not be penalized for lack of diversity provided such conservative type allocations are consistent with the policyowners risk profile/investor temperament.

Lower Expense Ratios are More Suitable – Since investment expenses are paid before returns are passed through to cash values, consider expense ratios in determining the suitability of underlying cash value allocation options. Morningstar, who created a system for ranking risk-adjusted performance, released a report^[2]on August 9, 2010 stating that “Low fees are likely to be the best predictor of a mutual fund’s future success”. The study went on to say that “using low fees as a guide would give investors better results than even Morningstar’s own star-rating system”. Typically, investment expenses include investment management fees, investment advisory fees, and fund operating expenses, which are together commonly referred to as fund management fees or FMEs.  To assess relative cost-effectiveness of cash value investment options, compare these investment expense ratios (i.e., the ratio of investment expenses to investment values) for the policy with the average expense ratio for all policies of the same product type.  In general, lower expense ratios are considered more suitable.  However, traditional universal life and whole life products generally do not disclose such investment expenses.  Also, because the neither cash‑value‑based investment expenses, cash‑value‑based insurance expenses (e.g., M&Es discussed in the Cost Competitiveness section above), nor life insurance policy earnings are generally reported in a standardized manner, measure cash value performance and cash‑value‑based expenses. Variable life insurance has fees and charges associated with it that include costs of insurance that vary with such characteristics of the insured as gender, health and age, underlying fund charges and expenses, and additional charges for riders that customize a policy to fit your client’s individual needs. Investors also can be subject to surrender charges, administrative fees, which are used for recordkeeping and other administrative expenses.

It is important to note with a variable policy that guarantees do not apply to the investment performance of any variable accounts, which are subject to market risk. Of course, one of the best resources for researching investment objectives, risk factors, expenses, fees and surrender charges that may apply would be the prospectus for the specific policy. Be sure to read it carefully. It is also important to note each subaccount will have its own separate prospectus that provides details on the investment style, focus, risks and expenses associated with the subaccount. The prospectus for the underlying investment options which is also available from the issuing insurance company.[i]