The Current State of Living Benefit Riders
Living benefit riders, or accelerated death benefit riders (ABR), have been prevalent in the life insurance arena for many years and as the industry searches for ways to attract new customers, their use has intensified. With increased use comes the need for expanded analysis of their risks versus benefits. Before delving into the design, marketing and current state of these three different types of riders, let's begin with definitions.
Terminal Illness Rider
This rider has been around the industry since the late 1980s. It's designed to allow policyholders to accelerate a portion, or the entire face amount, of their policies when the insured is diagnosed with a terminal illness with a life expectancy of "X" months, typically 12 or 24. The purpose of this rider is to provide an early payment of the death benefit to assist in medical costs prior to death.
Critical Illness Rider
The concept of Critical Illness insurance has been around since the mid-1980s, originating in South Africa. The goal is to provide a benefit to insureds who survive a critical illness event, such as heart attack, cancer, stoke, renal failure or major organ transplant. These events, known as triggers, can include many other ailments than the five mentioned above. This coverage can be issued as a standalone policy, but for our discussion, we address its use as a rider to a life contract. Upon the insured receiving a diagnosis with one of the pre-defined triggers, the insurance company accelerates a portion or the entire face amount of the policy. The amount accelerated often depends upon the severity of the event.
Chronic Illness Rider
This is a relatively new rider concept, but the benefit itself has been around for many years in the form of Long Term Care (LTC) insurance. The Chronic Illness rider is a modified version of LTC insurance, which addresses either the insured's inability to perform activities of daily living (ADL) without assistance from another person, or the insured's cognitive impairments. ADLs include bathing, continence, dressing, eating, toileting and transferring. If the insured is unable to perform two or more ADLs, he or she would be considered chronically ill and eligible for the benefit. The rider benefit is not dependent on the cost of care, but on a stated figure up to the total face amount of the policy. The payment can be made in a lump sum, annual or monthly installments.
Benefit Structure Designs
There are various benefit structure designs for each type of rider.
Terminal Illness Rider
There usually is no charge for this rider. It is included on all Individual Life policies issued and many companies offer this rider on in-force policies. Since this acceleration rider is simply a short-term advancement of the death benefit, the discount factor is typically relegated to the time value of money. The company discounts the death benefit at some pre-determined interest rate. If the insurance company defines the terminal illness as greater than, let's say, 12 months, the company may also factor in the value of lost premium revenue.
Critical Illness and Chronic Illness Riders
For both the Critical Illness and Chronic Illness Riders, the calculation of benefits becomes more complex. Three different structures are used to determine the impact of the acceleration related to the face amount of the policy.
- The most common structure is a discounted or "no-charge" method. In this version of the accelerating rider, no additional premium is collected at the time of issue, but if a claim is filed for the benefit, an "actuarial" discounting of the face amount would be applied for the amount being accelerated. In this methodology, the company either re-underwrites the policy or employs a standard industry table to determine the life expectancy of the insured, based upon the severity of the impairment.
To determine the accelerated amount, typically the company calculates the premium lost due to acceleration and the time value of money for the early benefit payout.
For example, if the insured requests to accelerate $50,000, the face amount may be reduced by $80,000 due to this "actuarial" discounting. Since the policy face amount has been reduced, the future required premium would also be reduced as the policy is now smaller.
- The second acceleration method is the lien approach. This could also be classified as an enhanced policy loan. Under this method, the amount accelerated plus interest is held as a lien against the death benefit of the policy. In this design, the policyholder continues to pay the full premium. The cost is the interest associated with the lien. The lien and interest would reduce the amount of cash value available for surrender or loan as well as the death benefit.
- The third method charges the policyholder an explicit additional premium at the time the rider is issued. In this calculation, the death benefit is reduced by the amount of the requested acceleration on a one-for-one basis. No actuarial discounting or interest charge is associated with this method.
Each method discussed above references lump sum acceleration payments. However, the Chronic Illness Rider frequently is paid out in monthly installments, with those payments being tax-free, up to a limit stipulated by the Internal Revenue Code (IRC). Anything paid above this amount is treated as ordinary income. For the monthly payouts, IRC 7702B(d)(4) currently stipulates the maximum per diem benefit payable is $320 per day, or $116,800 per year.
The Terminal Illness Rider is usually offered on all policies, whereas the Chronic and Critical Illness Riders are offered on standard or better risks. Often, a supplemental questionnaire is required to assess the additional risk.
In the more common form of the issuance of these riders, the discounted or no-charge method, the riders are added to the base life policy at no additional charge. This "no-charge" rider design has experienced success in marketing to the middle market. The applicant sees this as a way to receive added benefits for no additional cost. This is the case unless the insured files a claim for the benefit.
Some recent statistics show that less than half of the policyholders eligible for the rider benefit claim it. The reasons behind the low claim figures could be the insured's reluctance to reduce the death benefit of the policy or he or she feels the discounted amount offered is unacceptable.
This is where a potential problem can arise. The original sales illustration presented to the applicant describes that filing a claim for the living benefit would reduce the death benefit in a greater proportion than the amount requested; in reality, however, this fact can be overlooked or misinterpreted. In an instance where the insured disagrees with the discounted offer made by the company, either due to the assessment of the severity of the impairment or the final offer, the dispute could potentially lead to a lawsuit.
In the lien approach, interest is added annually to the amount of lien, which over time could cause this amount to exceed the policy's death benefit and result in a lapse of coverage.
The additional premium variation of these riders avoids some of the potential problems. The change in policyholder behavior can impact the base policy. It also presents a sales challenge due to the increased cost.
Living benefit riders are one option for life insurance providers to increase sales, either in existing markets or in the ever-elusive middle markets. These extremely popular riders have various potential risks associated with them—making pricing, underwriting controls and additional analysis necessary to assess the living benefits. These riders have a great potential to successfully serve a broad market, but the risk should carefully be weighed.
For more articles in this publication, view the Table of Contents.