Many survivorship life plans involve combinations or blends of permanent and term insurance. Critical questions include what are the proportions of term and permanent insurance and what term cost is built into the sales illustration. What is the difference between the illustrated term cost and the maximum cost the company may charge in the future under the contract?
The objective of the term/perm blending technique is to reduce the required premiums. Because term insurance generally builds no cash values and premium costs increase with age, the initial term premium typically is only a fraction of the premium cost of the permanent insurance. In theory, dividends on the permanent insurance should be sufficient to buy paid-up additions that reduce the amount of term insurance required over time before the escalating cost of the term insurance explodes. The death benefit of a term/perm plan will generally remain level until the term insurance is entirely replaced by paid-up additions.
The period until the term insurance is phased-out depends on the proportion of term to permanent insurance, the design of the term rider, the dividend performance of the permanent insurance, and the term rates. Insurers use variations on essentially three types of term riders in their term/perm plans, which involve varying degrees of risk to the policyowner.
- Term rider cost paid by dividends – The riskiest plan, but also, all else being equal, the lowest premium plan, is where policy dividends pay the entire term insurance cost. This plan uses excess dividends to buy paid-up additions that theoretically will ultimately entirely replace the term insurance. This type of plan is the riskiest because its performance depends on two variable and nonguaranteed factors: (i) the dividends that will actually be paid on the underlying permanent policy; and (ii) the term rates actually charged for the term coverage. Although term rates may not exceed guaranteed maximums, most illustrations use current term rates that are below the guaranteed maximum. If dividends fall short of projections and/or term rates increase, the dividends available to purchase paid-up additions will fall short of projections. If the paid-up additions grow too slowly, the ever increasing cost of the term at each advancing age may ultimately exceed the dividends available to pay for the term coverage and the policy will “explode.” The policyowner is then left with the choice of paying significantly higher premiums or reducing the amount of coverage. Most experts suggest that one can minimize the risk of an exploding policy if this type of term insurance does not exceed 50 percent of the total coverage.
- Term rider cost paid by additional premium – The risk of an exploding policy is reduced but not entirely eliminated, depending on the term/perm blend, if an additional premium is charged for the term rider. In the typical additional-premium plan, the additional premium is a level annual amount that vanishes once paid-up additions entirely replace the term coverage. Because the premium is level, it initially exceeds the actual term cost. This plan uses the excess term premium in the early years and policy dividends to buy paid-up additions that grow more quickly than in the dividend-only-pay-term/perm plan. Because the term rates may increase to guaranteed maximums and insurers do no guarantee projected dividends on the permanent insurance, the policyowner still may bear some risk that the policy will explode. However, for term/perm blends of about 50/50 or less, this risk is virtually eliminated. The only risk is that the premium vanish may take longer than projected.
- Convertible term rider – A convertible term rider is the least risky, but generally the highest premium alternative, all else being equal. This plan uses dividends to buy paid-up additions and to increase the total face amount of coverage, but they otherwise may be applied against premiums to keep the face amount of coverage level while net premiums decline over time. The principal risk with this plan is that the conversion right may expire before the second death. To keep the coverage in place, the policyowner must convert, which will require an increase in premiums. Also, charges often are associated with the conversion.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM