A flexible premium policy (such as most universal life policies) can have substantial benefits for consumers. But it can lead to unmet expectations for consumers who do not understand what “flexible premium” means. Many consumers, unaware of how flexible premiums work, are surprised when, after many years of faithfully paying their premiums, they are told by the insurance company that their policy will lapse if premiums are not increased, sometimes by very large amounts.

 

What is a “Flexible Premium?”

The premium of a typical whole life or term policy is set and guaranteed by the insurer and must be paid on time to keep the policy in force for the coverage period. However, the premium for a universal life policy is initially set by the policyholder, usually based on the agent’s recommendation. The initial premium recommended by the agent is almost always based on non-guaranteed assumptions that are most favorable at policy issue but can degrade over time.

The premium is “flexible” because the policyholder can, to some degree, pay more or less than the premium that is set without breaching the insurance contract. This flexibility can be helpful to consumers, but calling a flexible premium a “premium”—as regulators require—can be confusing to consumers who have little or no experience with premiums not specified by the insurer.

Flexible premiums are not typically available with other types of insurance, such as auto, homeowners, health, or term life.  A consumer who pays monthly for an auto policy or term life policy with an annual premium of $1200 cannot pay only $50 this month with the intention to pay $150 next month.  But a universal life insurance policyholder can often do exactly that, and insurers tout this flexibility as one of the policy’s benefits.

The problem is that paying the flexible premium amount does not guarantee the policy will remain in force.  In the above example of an auto or term life policy with a $100 monthly premium, the payment will keep the policy in effect until the end of the term.  But that is not necessarily true of a life insurance policy’s flexible premium, and consumers who have faithfully paid their premiums for many years may face a rude awakening when the insurer tells them that the premiums they have been paying are not sufficient to keep the policy in force.

 

How is the “Flexible Premium” determined?

The policy owner usually agrees to pay the “premium” listed on a policy sales illustration at the time of purchase.  That premium results from a computer calculation that identifies – given a host of assumptions such as the insured’s current age and state of health, the desired death benefit, the current crediting rate to be paid by the insurer, and the expenses to be charged by the insurer – the amount of money the insured must pay into the policy each year (the “premium”) in order keep the policy in force (i.e., pay all policy charges) until a specified “end age” such as 95 or 100.   The illustration may also make assumptions about the levels of “income” the policyholder may want to withdraw or borrow from the policy —for example, to supplement retirement income—and those assumptions would increase the “premium” calculated by the sales illustration software.

What is often not explained at the time of sale is that the “premium” necessary to keep the policy in force is likely to change, as the policy expense variables in the calculation are based only on the current, non-guaranteed schedule of charges, which could fluctuate in the future. Future policy credits to the account value will almost always vary from what’s derived from a constant accumulation rate in the sales illustration.

What can prompt those changes?  Some examples:

• Skipping a payment – or even varying the timeframe in which payments were assumed to be made.
• The way the account is credited with interest is typically under the carrier’s control. Notwithstanding the sales illustration’s assumption of a constant interest crediting rate forever, the crediting rate will fluctuate over time.  Perhaps it will be higher; often it is lower.
• If policy credits are derived from an external reference, such as the S&P 500,®️ carrier-controlled cap rates could limit cash value accumulation.
• And while the expenses to be paid out of the policy’s account value are based on a current schedule, they’re not guaranteed. The carrier can lower them – but more likely may increase them – above the currently planned scale of expenses.

 

All of these things are likely to change the amount of “premium” needed to sufficiently fund the policy over time.  The increase in premium demanded by unfavorable changes to non-guaranteed elements is never automatic, rarely suggested by the insurer (or agent), and usually not realized by even the most attentive D.I.Y. policyowners.

 

An Illustrative Case

Because the agent wants the consumer to buy a policy, the agent will typically recommend a structure with a low premium, often the lowest premium that will illustrate the policy’s ability to sustain to the end age, based on the policy’s current assumptions.  In doing so, the agent builds in no “cushion” to keep the policy in force in case the assumptions underlying the initial premium calculation turn out to be less favorable to the policyholder in future years.   

Let’s assume the agent quotes, and the policyholder accepts, a “premium” consistent with the most favorable non-guaranteed policy crediting and charges permissible.  Although insurance costs increase as the insured ages, the illustrated account value appears to grow sufficiently to cover those rising expenses.  But suppose policy credits do not increase as rapidly as projected and/or policy expenses turn out to be higher than expected. In that case, the “premium” won’t increase the account value sufficiently to pay all the policy expenses, and the cash value will start to decline. Such a policy will eventually run out of money and lapse unless premiums are increased.  If the agent had initially recommended a higher premium to act as a cushion, the policy would have built up more cash value and would be more likely to sustain until the policy’s end age.  Still, the agent wants to sell policies, and quoting lower “premiums” can increase the likelihood of sales. 

So, the consumer pays the initially calculated premium every month for 30 years, but without realizing it, account values are declining. Eventually, the consumer receives a notice from the insurer stating that the policy is about to lapse. The premium increase required to keep the policy active is often very high because the consumer is now 30 years older, making insurance costs high and likely to increase by progressively larger amounts each year. Many consumers in this situation have been forced to abandon a policy they expected would remain in force to protect their spouse or other beneficiaries. Lapse is the fate of the vast majority of universal life policies, as detailed in The Lapse Problem.

 

POTENTIAL PUBLIC POLICY APPROACHES

We need to improve consumer understanding of flexible premiums. Consumers should be repeatedly informed in various contexts that paying a flexible premium does not ensure the policy will stay in force. A premium amount that does not guarantee the policy’s continuation should not simply be called a “premium” because that term suggests payment will keep the policy active; it should instead be called a “flexible premium” or another term such as “nonguaranteed premium.” New policy forms and illustrations should reflect this terminology. Clear disclosure must be provided at the time of purchase, stating that the required premium is a flexible premium that is not guaranteed to keep the policy in force. This disclosure should come in a separate document specifying the premium amount and explaining that it is a “flexible premium” set by the policyholder and not guaranteed to sustain the policy.

But mere disclosure of the nature of the flexible premium at the time the policy is purchased is insufficient.  Even a consumer who understands that the initial premium was a flexible premium may forget that fact 30 years later and believe that continued payment of the premium will keep the policy in force.  Therefore, annual statements summarizing each year’s progress must disclose not only the amount of premiums paid in the past year, but also that the policyholder has set the current (flexible) premium they are paying, which is not guaranteed to keep the policy in force.

But even these disclosures are not enough because consumers often do not read their annual statements, let alone their policies. Insurers should be required to notify the policyholder whenever the policy’s “trajectory” of the current premium, policy credits, and policy expenses is insufficient to maintain the policy until the end age specified by the policyholder when they bought the policy.

Some insurers are already implementing such strategies. For example, John Hancock offers an option called Life Track for its flexible premium policies. The Life Track disclosure outlines the policyholder’s original goals and the assumptions underlying them. Each year, it gives the policyholder the option to instruct the insurer to automatically increase the premium if needed to meet the policyholder’s initial objectives (e.g., ensuring the policy remains in effect until at least a specified age).

The Life Track option offered by John Hancock shows that insurers know how to monitor policies and to identify when continued payment of the current premium will not be sufficient to keep the policy in force.  At that point, insurers should be required by law to notify the consumer, suggest a new premium level, and advise the policyholder to consult their agent or a company representative.  This would make owning a flexible premium policy more like owning an auto or homeowner’s policy, where the consumer is given notice of premium increases that are necessary to continue coverage.

Automatic premium increases should not be imposed without the consumer’s consent.  Still, consumers should have the option to opt into automatic premium increases, as they can with John Hancock’s Life Track billing service.