As is often the case, I recently found myself drafting a letter of explanation to a professional advisor explaining something a life insurance agent was attempting to relate. Assuming that the advisor I am working with is likely not the only one in the market with the same lack of understanding, it seems worthwhile to share excerpts of the letter in a generic format. The point of the exercise was to help the advisor make sense of an agent’s recommendation to pull the trigger on a transaction because the insured individual was “changing age” for insurance purposes and the premium was going to increase.
I believe you understand the point of “backdating to save age” is to have lower pricing on a policy for the duration of the contract. It is important to remember that with some insurance companies you turn a year older on your birthday (‘age last’ pricing) and with others you turn a year older on your half birthday (‘nearest age’ pricing). Either way, you can generally backdate to save age up to six months. There is nothing inherently better or worse regarding either methodology though one or the other may have a pricing advantage depending on what point of the year one is at relative to the insured’s birthday. Most insurance carriers, however, are ‘nearest age’.
Let’s look at Company A, a company which is ‘age last birthday’ versus ‘nearest age’. My birthday is on May 20. If I am applying with Company A and my policy is approved and ready to be issued on June 1, it would clearly make sense to backdate to May 19 to make myself a year younger and to have a reduced premium for the balance of the contract. However, if it is October or November and I would have to backdate 5 or 6 months to save age, it may or may not make sense. If it was November and I did backdate to May 19 to save age I need to remember that my second annual premium is due on May 19 of the next year which is only six months away so I have effectively “wasted” six months of premium in the first year in order to save premium every year thereafter. It may still make sense but I would have to run the numbers to see if my annual savings more than made up for my wasted first year premium in a reasonable time frame. To calculate this appropriately I might also incorporate a time value of money. Generally speaking, the more months I backdate the longer it will take to break even.
Say, for example, backdating would save me $1,000 a year in premiums. If my annual premium is $10,000 and I “wasted” $5,000 in first year premium by backdating six months, you can see that my break even is in 5 years (not accounting for time value of money). This could be worth it. However, if the annual premium was $30,000 and backdating saved me $1,000 a year, then I “wasted” $15,000 in first year premium and my break even would be much further out and it probably would not be worthwhile to me. A number of factors would play into the decision, including time value of money, cash flow, the number of years I had planned on paying the premiums, etc. A five pay or ten pay premium scenario will likely result in a different outcome than a full pay scenario. Single pay transactions generally will always be backdated as the cost is lower or the death benefit attainable for a given deposit would be greater and there is no second premium due. I even had a client recently choose not to backdate because the backdated policy date would have been in December when he already is buried with end of year expenses and Christmas costs and donation requests.
Let’s flip to our client’s situation, if they pull the trigger now on the policy at hand, they would have been backdating a full 6 months. If the annual 10-pay premium is $100,000 then they would have “wasted” $50,000 in first year premium to lower the annual premium for the balance of the contract because the next $100,000 premium is due in only six months. This could make sense if the savings were great enough. However, the $4,000 annual savings over the 10 years of premium requirements would be only $40,000. There is clearly no “break even” here as they would have been behind the ball coming out of the gate. Therefore, if our numbers are accurate, it does not make sense to backdate because the cumulative increase in annual premium is less than the first year wasted premium.
Admittedly, the numbers in this situation came out a bit differently than I normally see but it goes to show the importance of crunching the numbers in order to make the right decisions. If the annual premium savings by backdating were $10,000 or more annually there may very well have been an argument to backdate to save age. In any given situation the agent might be making the call based on experience and assumed it would be better or maybe it is a sales tactic to apply pressure to get the case closed. I don’t know that but I do know the client was better served in this situation, maybe counter-intuitively, by issuing the policy at a higher age. The point is, if you have objective information and help understanding the numbers, you can make an informed decision and be comfortable with it.