Universal Life Litigation: Unraveling an Unbundled Product
Distinguishing Universal Life Insurance from Whole Life Insurance
THE RHA REVIEW
Volume 8, No. 3, Second Quarter 2002
By Tim Ryles, Ph.D.
At one company it was "the only insurance policy you will ever need"; at another, it was "the ideal vanish" product in vanishing premium sales; to a threatened industry of insurance producers and companies dependent upon whole life sales, it was the silver bullet necessary for warding off "buy term and invest the difference" advocates during the hectic high interest rate days of the 1980s.
I am speaking of a life insurance product known as Universal Life (UL). Although regulators were initially skeptical of UL, insisting that it be filed as "Flexible Premium Adjustable Life" insurance, UL had captured almost 40 percent of the market by the mid-1980s. Proponents embraced it for its disclosure elements, referred to as "transparency." What this meant was that policyholders could "see" from annual reports provided by the insurer where the money was going because UL "unbundled" expenses, mortality charges, premium payments, cash value, interest credits, loans, and withdrawal activity at least once a year. In addition, premiums were flexible; the death benefit was flexible; one could adjust life insurance to suit needs at different stages of the life cycle; partial withdrawals could be made to meet financial emergencies or goals; and the earnings represented current interest rates rather than fixed (usually lower) rates of return that are characteristic of whole life.
UL's policy design was a ready answer to the "buy term and invest the difference" challenge because one could indeed have a term insurance policy AND an investment program at current interest rates, all in one plan. For some policies, however, experience is raising questions about whether purchasers knew what they had bought and whether insurers' policy language added to the confusion. In short, the unbundled product may now become an unraveled one, partly because of failures to make proper distinctions between UL and traditional whole life products and partly because the policy language contributes to confusion and subsequent policyholder disillusionment.
Distinguishing UL and Whole Life
Consumer experience with life insurance prior to the 1980s was limited to two types of policies: term and whole life. Certainly there were different variations of whole life products, but the mental paradigm was that of an insurance policy with a level premium payable for life, a fixed death benefit, and a contracted for cash value. Arguably, that is also the stereotype shared by many agents, as reflected in a number of cases I have reviewed. Thus, without taking additional precautions to differentiate whole life from UL, both agents and consumers were likely to confuse the two.
Figure 1 details some key differences between UL and whole life. Note that the death benefit, cash value and premium obligations in UL, compared to whole life, are "unfixed," meaning that they are subject to variation depending upon the buyer's choice of options and upon market fluctuations. Similarly, whereas the mortality charges in a whole life policy are fixed at time of issue, they increase in a UL policy as the insured ages. UL policies include the maximum mortality charges that can be assessed, but actual costs may vary up to the maximum, based on company experience. Essentially, this shifts mortality risks from the insurer to the buyer.
COMPARISONS OF WHOLE LIFE AND UNIVERSAL LIFE
|Whole Life||Universal Life|
|Fixed death benefit||Unfixed death benefit|
|Fixed cash value||Unfixed cash value|
|Fixed premium||Unfixed premium|
|Fixed mortality charges||Unfixed mortality charges|
|Mortality risks all on insurer||Mortality risks on buyer|
|Market risks all on insurer||Some market risks shifted to buyer|
|Policy elements independent||Policy elements interdependent|
|No market/stock savvy necessary||Investment, market knowledge necessary|
Significant market risks are also shifted to buyers in UL policies. For example, although a minimum interest rate guarantee is part of a UL product, the additional risk of market performance in the form of dividends or excess interest credits rests on the buyer. Hence, if the interest rates in a company's investment portfolio remain high, cash values will grow accordingly; if interest rates decline, cash values also go down. And since UL investments are designed to reflect "current market conditions," volatility may be more pronounced than in more conservative investment strategies. Thus the interplay of market factors and the values accumulating in a policyholder's cash value account require a UL policyholder to assume an aggressive role in managing the policy and an appreciation of the fact that lower interest rate income may have to be "made up for" with higher premium payments. Unlike the whole life policy that one can place in a shoe box and forget about (except for paying premiums), UL demands constant attention and more than a passing acquaintance with how the stock market is doing.
The aforementioned characteristics of UL show it to be a product whose essential elements of premium dollar inflow, interest credits and expenses are highly interdependent. Since expenses, mortality and other charges are paid out of the cash accumulation account of a UL policy, declining interest rates may exhaust the funds available to keep the policy from lapsing, despite regular premium payments. This is sometimes described euphemistically as "under-funding" of the policy. Additionally, this problem of underfunded UL policies seems to arise from overly optimistic assumptions about interest rates and confusion about what is meant by the UL terminology "Planned Periodic Premium" or similar language. (I will use Planned Periodic Premium here.) This confusion, often linked with sales illustrations showing a level planned periodic premium payment plan, apparently led many buyers to believe that premium payment obligations under UL policies were identical to those in the more familiar whole life policies, i.e., level. The fact that many UL policies were replacements for whole life policies reinforced this belief, especially if the buyer was led to believe that he or she was simply getting more insurance for the same price.
Generally, confusion about whether a policy owner's premium obligation is level would be resolved by a plain reading of the insurance policy. However, a reading of many UL policies does not disclose to an average person that premiums are subject to increases above levels shown as "Planned Periodic Premiums." To illustrate, I review one company's UL policy, the language of which is quite similar to that found in UL policies issued by several insurers. In this policy, the Policy Data Sheet shows a Planned Periodic Premium of a given payment per month. On the Policy Data Sheet, the following appears: "It is possible that coverage will expire prior to the maturity date shown where either no premiums are paid following payment of the initial premium or subsequent premiums are insufficient to continue coverage to such date." To what does "subsequent premiums are insufficient to continue coverage" refer? Is it the number of premiums? After all, "flexible premium" means that a policyholder can pay premiums when he or she chooses and may even skip premium payments. Is it the amount of premium? If so, how is the policyholder to know? The policy simply fails to disclose that a Planned Periodic Premium may have to be increased to prevent a policy from lapsing.
Further, "The Introduction" says, "The initial premium payment is due on the policy date. Subsequent premiums may be paid at any time before the maturity date." A plausible interpretation of this provision is that "If I pay all of the premiums due before the maturity date, everything will remain in force, no matter what. Flexibility means I might even wait until the day before the maturity date and pay all premiums due in one check."
Under the heading, "When This Policy Will Terminate," the contract states:
"All coverage under this policy will terminate when:
You request that coverage terminate and you return the policy;
The insured dies;
This policy matures; or
The grace period ends without sufficient premium being paid."
Under the section "Premiums After the Initial Premium," the policy states: "Any premium payments after the initial premium may be made under a periodic plan or at any time while this policy is in effect.
Periodic Plan. You may request that we send reminders of your planned periodic premium. You may choose to pay annually, semi-annually or quarterly. We can also arrange for pre-authorized monthly payments from your bank account or similar facility. Planned periodic payments will be subject to our rules on minimum amount.
You can change the frequency of payments or the amount of a premium. We can limit the amount of any increase in premium payments.
Unscheduled Payments. You can make an unscheduled premium payment at any time while this policy is in effect before the maturity date if there is no policy debt. Each payment must be at least $250. We can limit the number and amount of unscheduled payments.
When And Where to Pay Premiums
Each premium is payable in advance. Pay each premium to our home office or to an authorized agent. If you pay our agent, you will get a receipt signed by one of our officers and our agent. If you pay our home office, you will get a receipt if you ask for it.
If the cash value less policy debt on the day before a monthly anniversary day is insufficient to cover the next monthly deduction, we will allow a 61-day grace period to pay a premium sufficient to cover the monthly deduction. This grace period will begin on that monthly anniversary day. We will mail you notice of the sufficient premium. Coverage continues during this 61-day period. The monthly deduction is described in the Cash Value Benefits section. (There is no heading labeled "Cash Value Benefits" in the policies I examined.)
If the insured dies during the grace period, the proceeds will be reduced by any overdue monthly deduction. If sufficient premium is not paid by the end of the grace period, the policy will terminate without value."
Then, under the heading "Insufficient Cash Value," the policy says, "On the day before the monthly anniversary day, if the cash value less any policy debt is not enough to cover the monthly deduction for the next month, the Grace Period provision will apply." Directly beneath, under "Continuation of Coverage," we learn, "If periodic premium payments are not made as planned, this policy and any riders will remain in effect as long as the cash value less policy debt covers the monthly deduction. But in any case, the policy will not continue beyond its termination date."
Reading the above-cited portions of the policy in their entirety, it is not unreasonable for policyholders to conclude that policy language expresses more concern about overpayment of premiums than underpayment, while the Continuation of Coverage paragraph could easily be construed as a reminder to make the planned periodic payment of an agreed-upon amount per month in a timely manner. Further, spreading the sections around in the policy, as insurers tend to do, and failing to include a definitions section covering all material terms result in an illogical order to policy format.
What Is Not Stated
Aside from demonstrating the limitations of regulatory requirements that insurance policies pass a Flesch Readability test (Flesch tests for readability, not comprehensibility), what the policy wording does not say is also pertinent. For example, while illustrations tend to show only one mode of premium payment, how frequently one pays premiums (annually, semiannually, quarterly or monthly), whether one varies payment mode and whether payments arrive on time may dramatically affect policy performance. This is generally not discussed in a policy. Similarly, policy loan activity may also have a depressing effect on a policy, especially if the loan is accompanied by surrender charges or if the company practices Direct Recognition (a method of assigning less dividend or interest credits to borrowers than non-borrowers). And, as indicated above, a vital piece of information about UL is the shifting of some of the risk to the policyholder; however, the UL policy is silent on this point.
Courts Step In
Recently, courts are construing the UL language in a manner similar to the foregoing assessment of UL policy wording. In Clarke County, Alabama, a trial court held in 1999 that "nowhere does this [policy] language indicate that the premium payments will have to be increased in order to maintain existing coverage should interest rates decline." Further, "To inform the consumer of the right of the insurance company to call for increased premium payments, language could have very simply been so stated in the policy."
In February 2002, a Federal District Court in Georgia construed a similar policy, opining, "The policy does not contain any sort of clear explanation of the circumstances under which the premiums would increase or decrease, of what the true meaning of cash value is in relation to the continuation of the policy or of how Plaintiff could avoid lapse of his policy." The court further noted that the language could easily be construed to mean that coverage would lapse only if the scheduled planned periodic monthly premium noted in the Policy Data Sheet is not paid. The court described the language of the policy as "extremely vague, ambiguous and misleading" and "confusing."
It is most likely that the unraveling of UL policies through the courts is in its initial stages as increasing numbers of policyholders discover inherent flaws in both the marketing and policy language of UL policies. Insurers are largely at fault for rushing products to market to meet the economic and competitive exigencies of the 1980s without adequate training of sales personnel and with too little attention to details of policy language. And though it is a weak defense, regulatory acceptance or approval of poor policy wording adds to the problem. Furthermore, since many UL policies were sold with a vanishing premium option and as a replacement for whole life policies, UL will be associated with the abuses for which these practices are well known. Accordingly, one of the life insurance industry's most useful products is likely to be tarnished as a result.