Adjustable Premiums

What Is Adjustable Premiums?

Adjustable premiums refer to a feature of certain insurance policy contracts, primarily within the realm of insurance, that allows the amount the policyholder pays to change over the life of the policy. Unlike policies with static payments, adjustable premiums offer flexibility, enabling the insured to modify payment amounts, frequency, or even skip payments, often subject to certain policy provisions and a sufficient cash value accumulation. This adaptability is designed to accommodate changing financial circumstances of the policyholder, but it also introduces complexities regarding policy performance and longevity.

History and Origin

The concept of adjustable premiums gained prominence with the introduction of universal life insurance in the United States in the late 1970s and early 1980s. Prior to this, most permanent life insurance policies featured rigid, fixed premiums. As interest rates fluctuated and consumers sought more adaptable financial products, insurers developed universal life policies that unbundled the insurance protection component from the savings or investment component. This innovation allowed for flexible premium payments, which could be adjusted based on the policy's accumulating cash value and the prevailing economic environment⁵. The National Association of Insurance Commissioners (NAIC) later developed model regulations, such as the Universal Life Insurance Model Regulation, to address the unique features and disclosures required for these new flexible premium products⁴.

Key Takeaways

• Adjustable premiums offer policyholders the ability to vary the amount and timing of their payments, providing financial flexibility.
• This premium structure is a hallmark of certain permanent life insurance policies, like universal life and variable universal life insurance, as well as some annuity products.
• The flexibility of adjustable premiums means that payments may need to increase in the future if the policy's cash value underperforms or charges rise.
• The actual premium required to maintain coverage depends on factors such as policy fees, mortality costs, and investment returns on the cash value.
• Policyholders must actively monitor policies with adjustable premiums to ensure sufficient funding and avoid unexpected lapsing.

Formula and Calculation

While there isn't a single universal "formula" for adjustable premiums, the amount required to keep a policy in force is influenced by the interaction of several factors. The policy's cash value is crucial, as it often funds the internal costs when premium payments are insufficient or skipped.

The minimum premium needed to sustain a policy at any given point is typically calculated by:

Where:

• ( P_{min} ) = Minimum premium required
• ( C_M ) = Cost of insurance (mortality charges)
• ( C_E ) = Expense charges (administrative fees, surrender charges, etc.)
• ( I_C ) = Interest credited to the cash value

In practice, insurers provide projections based on current assumptions of mortality, expenses, and interest rates, guided by principles of actuarial science. The actual premium paid by the policyholder can be more or less than this minimum, as long as the cash value remains positive and can cover the internal costs.

Interpreting Adjustable Premiums

Interpreting adjustable premiums involves understanding that while they offer flexibility, they also shift some of the responsibility for managing the policy's longevity to the policyholder. A lower premium payment might be feasible initially, especially if the policy's cash value is substantial or market conditions are favorable, leading to higher credited interest. Conversely, if interest rates decline, internal policy charges increase, or the policyholder makes withdrawals, the policy's cash value may deplete more quickly. In such cases, the policyholder would need to increase their premium payments significantly to prevent the policy from lapsing. Regular communication with the insurer and reviewing annual statements are critical for effective interpretation and management of these policies.

Hypothetical Example

Consider Maria, who purchased a universal life insurance policy with adjustable premiums. Her initial target premium was $200 per month. In the first few years, the policy's cash value grew well due to favorable interest rates, allowing her to occasionally pay only $100 or even skip a payment when facing unexpected expenses.

However, after 15 years, market conditions changed, and the interest credited to her policy's cash value decreased. Simultaneously, her mortality charges increased as she aged (a standard feature of such policies, determined through [underwriting]). The insurer notified her that her policy's cash value was depleting faster than expected. To keep the policy in force and ensure it would last until her desired age, Maria now needs to increase her monthly premium payment to $350. Had she continued paying only $200, the policy might have lapsed within a few years due to insufficient funds to cover the internal costs.

Practical Applications

Adjustable premiums are most commonly found in:

• Universal Life Insurance: This type of life insurance allows policyholders to vary premium payments within certain limits, offering flexibility in response to changing financial needs or market conditions.
• Variable Universal Life Insurance (VUL): Similar to universal life, VUL policies also feature adjustable premiums, but the cash value is invested in sub-accounts chosen by the policyholder, exposing the policy to investment returns and market risk.
• Flexible Premium Deferred Annuities: These financial products allow individuals to make multiple, flexible contributions over time into an annuity contract, rather than a single lump sum, accumulating funds for a future payout³. This offers adaptability for retirement savings or income planning.
• Long-Term Care Insurance: Some health insurance policies for long-term care may have adjustable premiums, where the insurer can raise rates across a class of policyholders, often due to changes in claims experience or risk assessment.

Limitations and Criticisms

Despite their flexibility, adjustable premiums come with limitations and criticisms. A primary concern is the potential for unexpected premium increases later in the policy's life. If the policy's internal costs (mortality charges, administrative fees) rise faster than expected, or if the cash value growth is lower than initially projected due to poor investment returns or low interest rates, the policyholder may be required to pay substantially higher premiums to keep the policy from lapsing². This can be particularly problematic for older policyholders on fixed incomes.

Another criticism revolves around the complexity of these policies. The intricate interplay between premiums, costs, and cash value accumulation can be difficult for many policyholders to fully comprehend, leading to misunderstandings about their long-term viability and true costs¹. The responsibility for managing the policy to ensure it remains adequately funded often falls heavily on the policyholder, requiring diligent monitoring and potentially significant financial adjustments to offset the effects of [inflation] or adverse [market conditions].

Adjustable Premiums vs. Fixed Premiums

The core distinction between adjustable premiums and fixed premiums lies in their payment structure and associated risk.

While adjustable premiums offer immediate payment flexibility, fixed premiums provide certainty of cost over the policy's duration. Confusion often arises when policyholders believe that initial low adjustable premiums will always remain low, not fully understanding the mechanics of how rising internal costs or fluctuating interest credits may necessitate future increases.

FAQs

Can adjustable premiums increase indefinitely?

While technically adjustable premiums can increase, there are usually contractual limits or mechanisms within the insurance policy that govern how and when they can change. However, if the internal charges (like mortality costs) increase and the cash value cannot cover them, the required payment to keep the policy in force could rise significantly.

Are adjustable premiums common in all types of insurance?

No, adjustable premiums are primarily a feature of permanent life insurance policies like universal life and variable universal life insurance, as well as some annuity products. Term life insurance, for instance, typically has fixed premiums for the duration of its term.

What causes adjustable premiums to change?

Adjustable premiums change due to several factors, including the policyholder's age (which affects mortality costs), the insurer's experience with its investment portfolio (affecting credited interest rates), administrative expenses, and any policy loans or withdrawals made from the cash value. External economic factors like general interest rate environments and inflation can also play a role.

How can a policyholder manage adjustable premiums?

Policyholders can manage adjustable premiums by regularly reviewing their annual statements, understanding the policy's internal mechanics, and communicating with their insurer or financial advisor. Making premium payments higher than the minimum required in early years can help build a larger cash value buffer, which can then absorb future cost increases or periods of lower payments.