The Whole Story on Life Insurance Persistency (Did the Wall Street Journal miss something?)

What if someone told you that the problem with having an automobile is the engine may seize up if you neglect to change the oil? Would this stop you from using a car? Would it convince you that cars are a substandard means of transportation and  you’d be better off riding a bike?

Probably not. It’s pretty clear the “problem” lies with the user, not the vehicle.

Occasionally, well-meaning reporters make similarly skewed assessments of financial products. They dismiss the value of a financial instrument because they believe some consumers, through misuse, could lose money. Life insurance, particularly whole life insurance, seems to regularly incur this type of criticism. An example:

A June 18, 2012, Wall Street Journal article titled “Life Policies: The Whole Truth,” concluded that whole life insurance – with its flexibility, guarantees, and tax advantages – could “make sense” for some consumers. This acknowledgement was immediately followed by…

But many buyers underestimate how difficult it can be to pay the premiums year after year, and they end up canceling their policy before they break even.

In a study released in December [2011], the Society of Actuaries found that 20% of whole-life policies are terminated in the first three years, and 39% within the first 10 years.

What is it about whole life premiums that buyers “underestimate?” How is it harder than making monthly mortgage or car payments “year after year”? And people default on home and car loans all the time to their financial detriment, but there isn’t a cry against houses or cars. Why hate on whole life?

A misreading of the numbers?

Some might say that the WSJ article’s qualifying statement is akin to warning prospective homebuyers not to buy more house than they can afford, and then using statistics to imply this often happens with life insurance. However, an investigation of the Society of Actuaries’ (SOA) study referenced in the article doesn’t indicate that consumers tend to miscalculate the affordability of whole life. If anything, the opposite is true.

Titled “US Individual Life Insurance Persistency,” the SOA has published this report on a regular basis since the mid-1990s. “Persistency” refers to how long policies remain in force, while policies which are terminated by nonpayment of premium, insufficient cash values or full surrenders are considered “lapsed.” The 2011 report used data provided by 30 insurers from as far back as 1910 through 2009 for term life, whole life, universal life, and variable life policies, and was updated in 2012. Some of the findings:

  • Overall, approximately 4 percent of all in-force life insurance policies lapse in a particular year. This rate has remained fairly static over the past two decades.
  • The annual lapse rate for all in-force whole life policies was 3.0 percent. For term life policies, it was 6.4 percent. Long term, individuals who purchase whole life policies are less likely to surrender them compared to other versions of life insurance.
  • The greatest lapse percentage – for all types of life insurance – occurs in the first year. The 2011 report found that 11.2% of all life insurance policies lapsed in the first year. For whole life, the first-year lapse rate was 13.8%, while term life matched the overall average at 11.2 percent.

Some of these numbers might seem to support the WSJ implication that “year after year” premiums are problematic – but for all life types of life insurance, not just whole life. And there are some other quirks in the stats.

The SOA study breaks down lapses in several ways, including the size of the insurance benefit and the age of the policyowners. Two consistent findings: smaller insurance death benefits (under $5,000 up to $50,000), and younger buyers (between ages 20 and 30) have much higher lapse rates, especially in early policy years. These factors distort assessments of consumer behavior, particularly for whole life.

Whole life policies under $5,000 had a 24.6 percent lapse rate in the first year, a significant outlier compared to the first-year rates for other types of life insurance. In contrast, larger whole life policies (like the ones consumers reading the WSJ article might use for cash accumulation, estate planning, or supplemental retirement income) have first-year lapse rates well below the overall average.

The lapse rate for new whole life policies between $200,000 and $500,000 was 8.2 percent, 27% below the first-year average for all types. For policies above $500,000, the first-year lapse rate was 6.4 percent – 43% below the overall average. As time goes by, the annual lapse rate drops to 1-2 percent, and stays there. These numbers suggest that individuals who purchase larger whole life policies – which come with larger premiums – are less likely to lapse them. Compared to other types of life insurance, whole life buyers are not underestimating their ability to pay premiums.

Individual consumer decisions about life insurance can be hard to quantify at a macro level, but multiple studies suggest financial setbacks and policy replacement are the most common reasons for lapses. A July 2012 white paper titled “Life Insurance Lapse Behavior,” by University of Mississippi researchers Stephen Fier and Andre  Liebenberg concluded that “voluntary lapses are related to large income shocks” such as unemployment or an unexpected expense. This was found to be particularly true for policy owners under 30. The authors also cited a 2011 LIMRA study that found “13 percent of survey respondents indicated they purchased life insurance to replace another life insurance policy.”

Some practical observations

The SOA’s persistency report and Fier and Liebenberg’s lapse study provide several insights about successfully funding a whole life insurance program.

1. The importance of emergency reserves. Whether it’s avoiding foreclosure or keeping life insurance in force, emergency reserves are critical to withstanding financial shocks from a job loss or unexpected expense.

2. Paying premiums monthly improves persistency. The SOA study found that lapse rates varied significantly by the mode of premium payment. Policy owners who paid premiums monthly by automatic withdrawal from a checking or savings account had significantly lower lapse rates; the premium was part of the monthly budget, not an irregular chunk that caught them by surprise.

3. Over time, whole life policies become easier to keep in force. Once the routine of regular premiums is established, the steady increase in cash values tends to reinforce the benefit of on-going deposits. Additionally, accumulated cash values and/or dividends* may be used to reduce or even replace premiums for periods of time. This can be a great benefit if income suddenly declines, or an opportunity requires a higher percentage of current cash flow.

* Dividends are not guaranteed. They are declared annually by the company’s board of directors.

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Posted in Financial Blog, Life Insurance