by Michael C. DeFillipo, CLU®, ChFC®, Partner, 1847 Private Client Group
The backbone of an insurance proposal is the illustration. On the surface it answers the “What” questions:
“What will it cost?”
“What is the death benefit?”
“What is the cash value?”
“What are the distribution amounts?”
After 30-or-so pages of definitions, disclosures and legalese, the illustration opens up to an array of numbers sorted into various columns for each year going forward. There’s multiple assumptions run next to each other, summary pages that try to condense the information into a single slightly-less-confusing table, and pages that are for some reason intentionally left blank.
At its core, an illustration is a mathematical representation of a concept; it is a tool to help make an intangible and unknown future be measured and analyzed based on the provided parameters and assumptions.
Policy Pricing, A (Brief) History
In the past, the process for pricing permanent insurance was fairly simple. The life insurance producer would determine the premium by looking at a book that contained a matrix of amounts per unit of death benefit and match it up with insured’s age. The only product available was Whole Life, which is built with an underlying guaranteed cost and priced such that the policy would “endow” (the cash value equaling the initial face amount) at product maturity. For non-participating Whole Life, where dividends are not applied, this was a very simple, straight-line calculation.
When we add dividends to the mix, a more detailed ledger is required to show how the policy would perform based on a) no dividends (the guaranteed scenario similar to the non-participating version), and b) the current (or alternative) dividend rate. By assuming dividends are applied, we have the ability to look into the future and determine when those dividends would begin to reduce or eliminate the out-of-pocket payments. But pricing was still based on the fact that a fixed premium was due every year – it could be illustrated to be paid with cash, dividends or policy loans.
Sometime later, the Great Universal Life Revolution occurred. (But the term “whole life” is still used in many situations instead of “permanent insurance”.) After that insurance products were not based solely on a contractual premium but were placed on a flexible chassis. Each month, an insurance charge is deducted from the cash value – so as long as there is sufficient cash value to cover the expense, the policy persists. Those charges are not set at the contractual maximum, but instead the insurers have a current rate that is lower than what is filed with the Insurance Commissioner’s office. This means we have an unknown.
With no dividends, the cash value of the policy has to grow by some other means. The dividend’s cousin, a declared interest rate set by the company, was applied to projections – as with charges, it was not the contractual minimum, but an amount the insurance company felt comfortable with given the yield on their investments. Next came Variable Universal Life, where the cash risk shifted to the policy owner – the mechanism for how the cash would grow is dependent upon the performance of underlying mutual fund analogues. And then came Indexed Universal Life, where cash value was credited interest based upon the performance of a widely held index over a stated period of time. Now it was up to the advisor and the consumer to determine the future performance of equity markets for the next 40-50 years and apply that to the pricing of their insurance policy.
This is an overly simplistic summary, but it is meant to illustrate the point that as more variables and flexibility come into play, the less an illustration actually reflects what will happen.
What an Illustration Tells Us
Based on this specific, selected, hypothetical, non-guaranteed, prospective rate of return and current, non-guaranteed cost of insurance charges, this will happen. Any change to these assumptions may impact policy performance.
Putting aside Guaranteed Universal Life, what history (and common sense) has told us is that the future is not a static experience. All the numbers on an illustration are most likely NOT going to be exactly what happens. Interest crediting rates have decreased significantly and continuously over the last two decades – that may turn around in the next few decades.
For Variable and Indexed Universal Life, not only do we not know how equity markets will perform, we are assuming a straight-line rate of return on our already admitted best guess of an average return; in situations where varying rates of return seem to make the illustration more realistic, we have just swapped out a linear unknown for a sequence of unknown events … in an unknown order.
This does not mean illustrations are deceptive or misleading. When positioned appropriately, the illustration helps to understand the “How” questions:
“How does my policy work?”
“How do better or worse assumptions of crediting rates / performance impact the policy?”
“How much risk is there in the insurer changing the underlying pricing”
The Takeaways
Knowing with a high degree of confidence that the illustration is not an exact match to what will happen in the future, here are some key thinking points when analyzing an illustration:
It is all about the inputs. The output of an illustration is entirely dependent upon the selected variables. Are there assumptions of changes in crediting rates or equity returns built into future years? Is there a change in how the death benefit is structured (e.g., changing from a level death benefit to an increasing option)? What kind of flexibility is there to increase, decrease or skip scheduled premiums? If no underwriting has been done, what does a change in risk class do to the underlying insurance costs?
If the policy is designed to have the cash value support the monthly cost of insurance charges (so anything not dependent upon a contractual guarantee, e.g., Guaranteed Universal Life), what cash value “goal” was used to determine the premium outlay? In many situations, the premium is solved for using a calculation to have $X cash value at Y year.
If the policy is designed to have no cash value and lapse at Age 100, this means any decrease in crediting rate or increase in charges may put the policy in danger of lapsing prior to life expectancy. On the other hand, if the premium is funded such that there is more robust cash value at maturity or life expectancy, the plan has built in a cushion to account for potential negative future events.
Stress testing is good, but do not stress about it. Looking at how various rates of return around the benchmark assumption (for example 2% +/- the baseline rate of return in a Variable Universal Life policy) can demonstrate what additional funding may be necessary to support the death benefit and/or the potential for an early policy lapse. However, if the stress testing comes down to the level of illustrating a very low rate of return on a Variable Universal Life policy, that may be a good indication that other products with less equity risk should be evaluated.
Understand what the intent of the “Guaranteed Assumptions” are within the design. With pricing pressure on Guaranteed Universal Life leading to several providers eliminating the product and many others increasing pricing on pure stand-alone Guaranteed Universal Life policies, there has been an increase in the use of limited secondary guarantees on non-guaranteed chassis. In other words, a policy can be designed to have a death benefit guarantee (not subject to return or insurance charge risk) to a certain point, such as expected mortality, while also having a non-guaranteed target of cash value performance.
Similar to the comments around stress testing, if the strategy is constructed based on non-guaranteed assumptions – such as in situations where the policy is being overfunded for cash accumulation purposes – the concept is dependent upon achieving some level of return based on accepting more risk. If the consumer is not confident that the highly rated insurance company is not going to increase the charges to the contractual maximum minutes after they purchase the policy, and at the same time, that equity performance or interest rates are going to fall to historically low levels and persist there forever, then perhaps re-design is in order.
The life insurance illustration is the best tool we have available to demonstrate how the life insurance strategy is supposed to work. By understanding its components and their interaction with each other, the advisor and consumer can evaluate whether the proposed solution fits with the intended goal given the expectations of risk and return.
The decision to implement a strategy should not be based on “the numbers” from the illustration. The discussion around the illustration should be to reinforce and validate the concept that is being presented, making sure the solution is the appropriate approach for solving the problem.
Michael C. DeFillipo, CLU, ChFC, is a Partner of 1847 Private Client Group, in Conshohocken, PA. Michael has nearly 20 years of experience working with high net worth and ultra-high net worth clients and their advisors designing, implementing and monitoring sophisticated life insurance portfolios. 1847 Private Client Group is an owner firm of Lion Street – an exclusive national network of elite financial firms.