#24 | Right Funding CAUL

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As discussed in The Neutral Money Myth in Universal Life, the risks in thin funding a UL policy are outsized due to the fact that dollars in a UL product either have plusses (interest credits) or minuses (policy charges). There are no neutral dollars. Underfunding creates disproportionally large penalties because it deprives the policy of credits shown on the illustration and also creates additional policy charges. This has been the bane of UL since its inception in the 1980’s because interest rates have been falling since then and policy performance has been consequently suffering. Everyone is quick to distance themselves from what happened back then but, ironically, appears willing to embrace new UL products with the same risk. We’re still illustrating higher rates on UL products than the prevailing interest rate environment can deliver and still not managing the risk.

So what are the consequences for underfunding? Let’s use John Hancock’s wildly popular Protection UL 13 as an example. For a 50 year old Preferred male, the level pay premium for $1M of death benefit is $8,547 at the current 5.05% rate. Assuming that the current 5.05% rate stays for one year and then drops to 4% but the client doesn’t change his premium, the policy would require a $74k catch up premium starting at age 90 to maintain coverage. The IRR at age 95 drops from 3.74% (level funding at 5.05%) to 1.69% (level funding assuming 5.05% when policy actually does 4% then paying catch up premium). At 3%, the catch up premium starts year 36 and the age 95 IRR drops to 0.57%. At 2%, the catch up premium starts at year 30 and the age 95 IRR drops to -0.83%. Level funding without adjustments for crediting rate changes essentially constitutes living in denial with major consequences down the road either in the form of a premature lapse or catch up premiums that cripple the economics of the policy. Just so you don’t think I’m picking on Hancock, I ran the same scenario with PacLife’s PIA 4 product and got remarkably similar results, although the downside was quite as extreme at 2%.

So how should we manage this? Fortunately, the solution is simple and straightforward. Illustrate CAUL assuming current policy charges and guaranteed interest credits. This establishes the reasonable worst case scenario for the product and requires much higher funding. In the case of JH’s Protection UL 13, the premium jumps from $8,547 at 5.05% to $17,233 at 2%, pushing the IRR at age 95 from 3.74% down to 1.07%. On a relative basis, earning 1.07% in a 2% rate environment is better than earning 3.74% in a 5.05% rate environment. In other words, the product has huge premium penalties but maintains a fair interest rate risk split. But that’s not really a fair fight. Let’s assume that the client funds the policy at $8,547 but the rate drops to 2% anyway. The IRR at age 95 assuming a $54,173 catch up premium is -0.83% versus 1.07% on a level funding basis at $17,233. The same effect shows up using age 90 IRRs – 1.35% with the catch up premium versus 1.73% with level funding. The downside from level funding is clearly worse than the downside from paying the catch up premium.

Here’s where things become counterintuitive. The upside is worse for level funding at 5.05% as well. Let’s assume that the client pays $17,233, the 2% worst case scenario, but actually earns 5.05%. He can stop paying premiums at year 11 and the IRR at age 95 is a whopping 4.39%, which is 0.65% over the level funding scenario at 5.05%. The same holds true at age 90 – 4.68% vs. 5.01%. Pacific Life’s PIA 4 shows the same results. Level funding at 7%, the premium is $8,791 and the IRR at age 95 is 3.64%. Paying premiums under the 2% assumption ($16,190) and stopping at year 11 under the 7% assumption, the policy IRR at age 95 is 4.56%. Again, the same goes at age 90 – 4.57% vs. 5.22%.

I’ll put it concisely – funding CAUL should start at the worst case and then work backwards. Not only does it hedge downside risk but it also has more upside potential. The reason goes back to the idea that there’s no neutral money in life insurance. Paying more means that the policy has fewer charges because the cash value is higher earlier. More cash value means more money that earns credits rather than more dollars of NAR that are assessed policy charges. Funding CAUL at a higher level isn’t overfunding – it’s right funding. It allows the product to do what it does best and delivers a host of benefits in the process.

Ah yes, but funding at a higher level is “expensive” and lowers early IRRs. That logic only exists on the false and fabricated world of the sales illustration. I make three arguments. First, clients do not complain when you deliver an early death claim that the product was too expensive. Second, thin funding is more expensive than right funding if rates fall. Third, thin funding delivers less upside than right funding if interest rates rise, so the thin funding is more expensive because it loses out on the upside. The only way thin funding wins is if the client dies young – and let’s be honest, that’s not really a win.

Final point. You may be saying to yourself that I’m arguing for Guaranteed UL. I’m not, although I obviously think simple and flexible Guaranteed UL products have their place. I’m arguing that CAUL offers a superior overall value proposition that gets muddied by aggressive sales practices based on thin funding. One thing I particularly like about Whole Life is that it structurally requires right funding and delivers a similar package of benefits as CAUL but with better guarantees and slightly less flexibility.  But even there, companies muddy the value proposition by selling Whole Life policies with premium reduction schemes based on current dividend scales. So, in short – avoid the price trap. In this case, paying more really is better. Funding for the worst case actually delivers the best case.

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