|Let us get our hands dirty and lift the hood on my '96 Policy WL. Inside we will see that there is not just one engine. Four interrelated "machines" function together to keep this baby running smoothly.|
To fully understand what is under the hood, we also need to examine several concepts underlying the operation of the machines.
In 2001, the Equitable Life Assurance Society in the United Kingdom virtually collapsed. This is a very old mutual, older than the United States of America. One of the primary reasons for the collapse was that they had no surplus reserves. The surplus did not run out; in utter hubris the management at the time felt that no surplus was necessary. Hard times hit, and now they face a huge shortfall.
There are sites on the web which claim to represent the interests of the
policyholders. A common complaint is that the huge surplus of such&such
a mutual insurance company is cheating the policyholders. These folks
have it backwards. A large surplus, with
conservative actuaries guarding it from shortsighted managers and marketers,
is the main guarantee
policyholders and annuitants have that their funds will still exist 30 years
down the road.
Each secondary policy has two kinds of earnings:
(2500 - 1000) / (100 - 50) = $30
LIV may be thought of as a ramp or as a percent of goal (%g). As a ramp, it is simply a straight line from $1000 to $2500. As a percent of goal, no matter which year, it is 30/2500=1.2%g. (The previous two sentences continue the example.) For reasons only Fred the Actuary fully understands, LIV isn't exactly linear. It is pretty close, though, and at age 100, PUA Cash Value will be equal to PUA Death Benefit.
LIV is to Paid-Up Additions what GCV is to Base Death Benefit. About the only difference is that GCV accumulates even less linearly.
Quote from Policy... The loan interest rate will not be more than the Monthly Average Corporate yield shown in Moody's Corporate Bond Yield Averages published by Moody's Investor Services, Inc., or any successor to that service ...
Ricky's Guide for the Participating Whole Life Connoisseur|
|direct recognition||non-direct recognition|
|dividend rate lowered by loan||dividend rate unaffected by loan|
|fixed loan interest rate||varying loan interest rate|
NYL is split this way for several reasons. Fixed annuities and universal life insurance involve conservatively invested funds, but their rate of return is expected to vary more frequently as the economy changes. Thus the reserves backing up those policies must be more dynamically invested than those for whole life and term policies. The reserves of NYLIC tend to be invested for maximum stability, typically in long and medium term bonds. It is also generally wise to separate the assets of the owners ("participants" with whole life polices) from customers (all other policyholders).
The variable products involve separate accounts, with the policyholders having direct control of their investment. They can move their cash value as they like between a variety of these accounts, which are basically mutual funds. Essentially, the policyholders of these products are responsible for their own reserves. However, unlike whole life, universal life, and fixed annuity policyholders, the variable policyholders directly own and manage their cash value. For everyone else, their cash value is owned by the policy, not the policyholder. This cash value is in the "general accounts", which make up most of the reserves.
Much of the income related to a mutual insurance company derives from earnings on its reserves. There are two main classes of reserves:
Let us peek into New York Life. Information in the following table is derived from their 2001 Annual Report.
|(millions)||31 December 2001||31 December 2000|
total legal reserves|
(incl. deposit funds)
|total surplus reserves||$8,534||$1,542||$8,516||$1,308|
|bonds (part of reserves)||$44,936||$19,273||$41,141||$15,604|
(incl. deposit funds)
|increase to reserves||$3,868||$4,193||$1,016||$3,046|
|net gain after taxes||$2,602||$-40||$2,331||$8|
|increase to surplus||$18||$234||$61||$-37|
There is a lot more data in the official Report. I only display the information necessary for this topic. I wanted to illustrate:
I believe this pattern to be generally true for American mutual insurance
companies. In the United Kingdom and many other countries, the
economies do not have a long history of available high-quality bonds.
Thus the mutual life insurers (and stock companies) have a much higher
reliance on stocks within their reserves.
The other two parts involve the two PUA sub-accounts (PUA purchased by dividends, and PUA purchased directly via a policy's OPP rider). As stated above, the cash value of these sub-accounts gets a little higher each year, and at policy maturity, the PUA cash value equals the PUA death benefit. However, if you die before the policy matures, then there is a cost of insurance relating to the PUA. However, this cost is not paid by the premium. The premium remains the same whether there is $0 PUA or $77,000 PUA. A feature exclusive to participating Whole Life policies is that the mutuality as a whole pays the cost of insurance for PUA. It is like a last tribute bestowed to an owner upon his death.
Within the Base Policy Machine, cost of insurance is in an arithmetic
war for the life of the policy. On the one hand, as a policyholder
ages, it gets more expensive to insure him. (I.e., he is more likely
to die.) This drives COI up. On the other hand, the amount
which needs to be insured grows less and less. I call this amount
the Insured Death Benefit (IDB). IDB grows smaller
because guaranteed cash value (GCV) will cover part of the death benefit
should the policyholder die. In other words:
The total amount paid for a life insurance policy is called cost basis. On a whole life policy it includes the sum of all premium payments made with out-of-pocket cash. It also includes the price paid for extra PUA bought under an OPP rider (Option to Purchase Paid-up additional insurance). Any distributions you receive from the policy are subtracted. Dividends which you choose to reinvest in the policy (via normal PUA purchases) do not affect cost basis. If dividends are not reinvested, they are considered refund of excess premium and are not added to the cost basis.
Money you borrow from your policy does not lower cost basis.
A policyholder has the right to permanently withdraw cash value from his
policy, so long as the remaining cash value within the policy is greater
than or equal to cost basis. In a participating Whole Life policy,
this involves PUA sell-backs. (I am not sure, but it is likely that
any orphaned cash value would be withdrawn first.) These withdrawals
are not loans; part of the policy's cash value is transferred tax-free to
the policyholder. It is considered a tax-free event because you paid
for the policy with after-tax dollars, which you are simply getting back.
If the policy allowed a withdrawal below cost basis, then there would be
a taxable event. Of course, any money that is withdrawn lowers
the policy's cost basis.
It is possible to sell back some or all of the accumulated Paid Up Additional Insurance. This is commonly done is to help pay the premium internally to the policy, so that the policyholder does not have to pay it from out of his pocket. Dividends are the normal means to pay internally. However, if one wishes to stop paying in as few years as possible, dividends by themselves will not be sufficient. By selling back some of the PUA, enough money can be generated to pay the premium. Eventually, dividends are projected to be sufficient, and PUA need not be sold back any more.
New York Life projected that my policy might begin "paying for itself" after 12 years. For the next nine years, it would be necessary to supplement the dividends by selling back PUA. Each year, dividends would be higher and the amount of PUA sold-back would be less. During this period, total Death Benefit would reduce from $110,052 to $103,425. In the tenth year (my 22nd policy year), dividends would finally be sufficient in and of themselves. Dividends would once again start purchasing PUA if I so chose, and total Death Benefit would begin rising again.
There is a negative side effect to all this, however. When PUA is sold back, the linear earnings gained by that PUA are not fully recovered. Much of it remains within the policy as orphaned cash value (OCV). Why is this negative? Because the "orphaned" cash is no longer part of the PUA Cash Value Machine. It will no longer have linear earnings of its own. It is still part of the cash value basis eligible to earn dividends, but it has been cut off from the guaranteed earnings of the PUA machine. In other words, orphaned cash value acquires the same status as cash value accrued via Guaranteed Cash Value.
I personally choose not to sell back PUA. If for some reason I was not able to sufficiently fund my policy to avoid this (due to unemployment, etc.) then I might do so out of necessity. Otherwise, it would annoy me too much, watching the PUA insurance drop $7000 or more while inflation is decreasing the spendable value of my base death benefit. PUA is a feature of Whole Life insurance not available to other types of permanent insurance. Selling it back when one does not need to do so essentially robs the policy of one of its advantages.
Why does Orphaned Cash Value Exist? Don't worry; nothing unethical is happening. The cash still belongs to the policy. In addition to earning dividends, it is available as loan value. If the policy is surrendered, the policyholder gets it all back. It is used to help pay the Death Benefit associated with PUA remaining within the policy. Here are some values from my policy illustration, with the aforementioned nine years of PUA sell-backs:
PUA Cash Value|
¹TCV = $37,068||
¹TDB = $103,425|
²TCV = $53,270||
²TDB = $137,828|
²Estimate if payments had continued for 6 more years.|
$33,000 vs $21,168 out-of-pocket dollars.
The first Year 21 is shaded because PUA DB is lowest then. As you can see, PUA CV plus OCV is actually higher that year than the associated Death Benefit. As the notes show, Total Cash Value is still significantly less than Total Death Benefit.
In the 22nd year, dividends become high enough so that PUA can begin to build up normally again, and PUA DB is soon higher than its Cash Value. Policyholders who do not sell back PUA get more bang for their Death Benefit buck.
The second Year 21 represents a case where normal premium payments continued
until dividends were high enough that no PUA sell-backs were necessary.
(This "extra-payment" case is referred
to as XP elsewhere on the site.)
No content within The Visible Policy has been approved,
authorized, or verified by New York Life or any of its representatives.
I have attempted to fairly and accurately portray the policy, but there are
likely to be mistakes. Over time, I shall endeavor to correct any
misinformation found herein.|