Survival Kit

• Ronald J Panko
• April 2001
• 

by Ron Panko

Transamerica Occidental Life Insurance Co. moved ahead in February with plans to launch a flexible-premium survivorship variable universal life policy, the latest of several insurers in recent months to introduce second-to-die products.

Under normal circumstances, this would have been a no-brainer. The big run-up in stock prices over the past decade has made millionaires of many and has prompted them to plan for the federal estate tax. According to Limra International, the Windsor, Conn.-based marketing and research organization, about 47,500 estates paid estate taxes in 1998. Of those, about 2,900 estates were worth more than $5 million, and they paid $10.4 billion in estate taxes, more than half the total collected.

But since the presidential election of George W. Bush, who campaigned on getting rid of "death taxes," the odds have risen that death taxes will be phased out, a change that could adversely affect a product like survivorship life. In his address outlining the budget to Congress Feb. 27, Bush again called for repeal of the estate tax. "It's not fair to tax the same earnings twice--once when you earn them, and again when you die--so we must repeal the death tax," he said.

"We obviously followed this closely," said Bill Tate, chief marketing officer for Transamerica Occidental. "But we've seen tax legislation come and go through the years. If we had a crystal ball, we'd feel better. But today we have an estate tax, and dealing with it is important to clients. So we believe our timing on this product is good, and we feel good about it."

Survivorship life is a great fit for estate planning, because it insures two lives and pays a death benefit only after both die. Annual insurance costs, therefore, are less than for single-life coverage, and the product is well-suited for passing the estates of married couples to the next generation. The product was created shortly after the 1981 Economic Recovery Tax Act, which deferred estate-tax liability for married couples to after the second death.

But even if estate taxes are removed as a planning concern, second-to-die products would continue to serve other purposes, and insurers and producers say they would find other ways to serve aging and wealthy clientele. "We're confident we would adapt to new circumstances," Tate said. "We've been serving this market many years. Regardless of tax law changes, the needs of this market will be dependent on good, solid advice."

Growth Spurt

Survivorship products have grown rapidly in the past four years. According to Limra, annualized premium grew by about 1% in 1996, but at about 8% in 1997, 9% in 1998 and more than 23% in 1999. (See "Growth in Survivorship Sales," below.) Last year, premium growth fell to 10%, apparently due to concerns over potential estate-tax legislation. "We've seen an uptick in the sales of survivorship policies, and the average size has gotten much larger," said Thomas E. Norton, vice president and managing actuary at Aon Consulting. But all of the talk about an estate-tax phase out has had a "chilling effect" on the product line, he said.

"They've become more efficient, and certainly the repeal of the estate tax would have a great effect on their sales," said Chuck Osmond, vice president of advanced underwriting at Union Central Life Insurance Co., Cincinnati. "It wouldn't eliminate the policy's effectiveness in providing a low-cost death benefit, however."

Transamerica, based in Cedar Rapids, Iowa, has been selling second-to-die products for about 12 years and has about $18.5 billion in force. "It's been a significant growth segment for us," Tate said. "Last year was huge. Our average policy size was $2.3 million, and our average premium was just over $32,000."

According to A.M. Best Co. data, John Hancock Variable Life Insurance Co., a part of the John Hancock Financial Services Group, issued $3.7 billion worth of the product in 1999. New York Life Insurance Co., Manulife Financial and New England Financial (an affiliate of MetLife Inc.) all announced new survivorship products within four days of each other in October.

Phase-Out Effects

Last fall, Congress voted overwhelmingly to phase out the estate tax, but then-President Bill Clinton vetoed the legislation. As of late February, Congress again was considering several versions of estate-tax reduction. While they would clearly cut into the smaller end of the survivorship market, the top end probably still would have needs. "At the high end, there's still going to be some tax, and there's always going to be the fear that what goes away today comes back tomorrow," said Amy Loether, a vice president and consulting actuary with Aon Consulting. "If you're 60 years old and you think it might come back in 10 years, you're not going to wait 10 years to buy survivorship. You need to buy it today, because it's the most efficient way to do it. It may be very difficult to obtain when you're 70."

Limra has come to a similar conclusion based on its research. In a September report, the organization estimated that if an estate-tax repeal ended all survivorship life sales--and they were not replaced by other sales--new premiums for the life industry would drop by about 8%, or $1 billion. But the report's author, Elaine Tumicki, said the actual effect probably would not be that drastic, because estate taxes are likely to be phased out gradually. And survivorship life has other functions: It can be used for estate equalization, wealth replacement and in some small-business applications.

Survivorship policies also can be structured as efficient cash accumulators, said Osmond of Union Central. Under tax law, policyholders can withdraw amounts up to premiums paid without penalty, and then they can access additional cash value through low- or no-cost loans. However, enough money must remain in the policy to avoid lapse, which can trigger high costs. Osmond said younger affluent couples often use survivorship policies in this way to build cash values and to ensure a guaranteed asset for their children, if the parents die prematurely. Cash values also can be used in corporate-owned life policies as supplemental employee retirement benefits, Osmond said, and for a corporation to recoup its contribution to the plan.

Some professionals in the industry already have seen effects from the pending legislation. Norton of Aon Consulting said he had encountered at least one insurer that had delayed plans to build a survivorship product until there is more clarity on the tax-reduction package. And Eleanor I. Johnson, a principal with Highland Capital Brokerage, said clients have postponed decisions on large purchases, initially because of the presidential election, then the Florida election recount and then to wait for the outcome of potential estate-tax modifications. Seattle-based Highland Capital is one of the nation's largest life brokerages specializing in the affluent market, said Johnson, who is the firm's designated insurance specialist in Washington state for PaineWebber, a national stock brokerage firm.

Inevitability of Change

David Potter, a spokesman for Hartford Financial Services Group, Simsbury, Conn., said the industry has been saying reform is more likely than repeal. Government revenue needs will increase dramatically by 2010. Government spending has grown at a 5.5% annual rate the past three years, and if that continues, the surplus will be dramatically smaller.

Potter said both Republicans and Democrats agree on many points about tax reduction, but phasing out the estate tax is not one of them. A proposal by moderate Democrats to reduce the estate tax's top rates from 55% to the top ordinary income rate, currently 39.6%, may garner support on both sides, he said. The proposal also would provide relief for small businesses. Potter also pointed out that the Republicans have a very slim majority, so blocking legislation can be easy.

Highland's Johnson predicted that there would be some change to the estate-tax system. "But if it turns out there is only a tweaking of the system, such as taxing estates of $5 million or more, it would really only make it like it was five years ago," she said. "We would still have a huge opportunity with clients [whose estates are worth] over $5 million, and they're everywhere. We regularly deal with estates of $10 million to $100 million, and they don't believe their tax liability will be eliminated."

Part of that liability could be triggered if Congress repeals the step-up in cost basis. This is a provision in the tax code that allows beneficiaries to report the current value of inherited securities to determine capital-gains tax liability--even if the deceased had bought the securities at a lower value. Johnson said clients with high-net-worth estates have not paid much income tax on stocks and bonds that they have held for many years. Those assets, she said, have built up large, unrealized gains. If the step-up in cost basis is repealed, these clients' heirs will face high capital-gains taxes, which could be funded with a survivorship life policy.

Johnson acknowledged that wealthy clients are skeptical of the proposal to repeal the estate tax over the next eight to 10 years--at which time a different presidential administration will be in control. "But let's say the tax is eliminated," she said. "Then the kids and charities get more, and that's not such a bad thing. It's really the clients who aren't excited about doing the planning in the first place who are using this [skepticism] as an excuse."

But Johnson is not ready to discount people with estates of $2 million as new customers, because their estates might need liquidity after they die. New distribution rules on individual retirement accounts, for example, allow minimum withdrawals to be stretched over generations. Insurance could help keep those tax-deferred plans in place by providing money for estate liquidation to other parties, legal expenses or future estate taxes, she said. "It can be a diversification tool," Johnson said. "If you look at the internal return of even some of the fixed universal life contracts, clients are repeatedly surprised at how favorable those rates of return are. If they die early, the returns are huge. In later years, they still provide bond-like returns."

Considerations like that could drive insurers to modify their life products. Johnson said they could become more investment-oriented. Without having to worry about the death benefit adding to an estate, clients might use survivorship life policies as tax-deferred retirement vehicles. Clients interested in charitable giving would be more inclined to use life policies as asset-replacement vehicles--they would donate to charities while alive and enjoy the tax deductions, while passing a replacement estate to children through the life policy. The same advantages could be applied to estate-equalization needs when a business owner dies; the deceased owner's life policy provides cash to a child not interested in maintaining the business, while the other child receives the business. And life insurance would become more attractive in buy-sell business agreements, in which life insurance would pay off the estate of one of the business's owners and leave the other(s) with the business financially intact.

Survivorship policies are well-suited for such uses, not only because their insurance costs are lower than those of individual contracts, but also because they can be made more cash-intensive, Johnson said. "Every time there's a change, there's an opportunity," she said. "We'll position ourselves for that shift. The type of producers and the number of them in the market may change, but we feel well-positioned to take advantage of opportunities and work with carriers to develop products that fit those opportunities."

A phase out of the estate tax would probably have a more muted effect on in-force life policies. According to A.M. Best Co. data through 1999, nearly $96 billion was in force among 26 companies that responded to a questionnaire.

A lot of in-force business is likely to stay that way for a couple of reasons, said Loether of Aon Consulting. One is that many policies are in irrevocable life insurance trusts, so the insureds do not have much, if any, control of them. But beyond that, she doesn't expect any dramatic increase in lapse rates. "If you have a couple of 45-year-olds with a $2 million estate and they just bought a policy last year, maybe they wouldn't keep it," she said. "But there are a lot of other people who would."