Comparing Costs and Policy Illustrations

Transcription

1 Comparing Costs and Policy Illustrations 6 Learning Objectives An understanding of the material in this chapter should enable you to 6-1. List and explain the methods of comparing life insurance policies, and some strengths and weaknesses of each Describe the importance of interest adjustments in analyzing policy illustrations and determining the cost of a life insurance policy Explain the guidelines and regulations that effect the life insurance policy illustration Identify the issues that led to regulation of policy illustration content and organization Discuss the factors that affect the illustrated performance of a life insurance policy Discuss the important elements of developing and presenting the life insurance plan. Chapter Outline METHODS OF COMPARING LIFE INSURANCE POLICY COSTS 6.2 Net Cost Method 6.3 Interest-Adjusted Method 6.4 Cash-Accumulation Comparison Method 6.1 Equal-Outlay Method 6.1 Comparisons That Isolate Interest Rates 6.11 LIFE INSURANCE ILLUSTRATIONS 6.13 Types of Policy Illustrations 6.15 Sample Illustrations 6.16 Presenting Illustrations 6.25 NAIC Life Insurance Illustrations Model Regulation

2 6.2 Essentials of Life Insurance Products DEVELOPING AND PRESENTING THE PLAN 6.33 Product Solutions 6.33 Designing the Solution 6.34 Preparing for the Presentation 6.36 Elements of the Presentation 6.36 CHAPTER SIX REVIEW 6.4 Chapter 6 investigates the meaning and methods of evaluating the costs of life insurance policies, especially based on comparing one against another. Tables showing examples of these methods are provided at the end of the chapter. The chapter also looks at policy illustrations, the most common technique for explaining an abstract and intangible financial product to a prospect. The chapter will examine illustrations in depth for the following important reasons: They are widely used by financial advisors in working with prospects. Misrepresentations and other problems have been associated with their use over the last few decades. Advisors need to understand the fine technical points of constructing illustrations in order to avoid the associated problems. METHODS OF COMPARING LIFE INSURANCE POLICY COSTS Many studies of the American public have indicated that life insurance consumers do not have a good understanding of life insurance products. They do not understand pricing and the features of life insurance policies. They have a hard time understanding and explaining the differences between whole life and term insurance. Many have not heard of variable life, universal life, or variable universal life, let alone know how they differ. The process of buying life insurance intimidates consumers. Consumers are interested in the rate of return of cash value life insurance and what return is accruing for their benefit and their family s. They want to know what the capital in their life insurance is doing and to what costs it is exposed. Over the years, a number of systems have been developed to help consumers with the financial analysis of life insurance policies. These systems can be divided into two types: those that are predictive and use numbers from life insurance illustrations, and those that analyze policies using current policy data. As we will see in the discussion of life insurance illustrations, a predictive analysis based on life insurance illustrations is

3 Chapter 6 Comparing Costs and Policy Illustrations 6.3 doomed to fail, because illustrations are based on assumptions that are not known to the public and are not comparable from company to company. If a consumer is trying to select a policy based on an illustration, the process will be flawed and more and more unreliable as they project farther into the future. Using historical data may be productive because it uses actual results, but it may not be helpful in selecting policies. Life insurance products are complex and extremely difficult to evaluate and compare. Several analysis methods exist for this purpose. While cost comparison methods yield precise figures, this precision can lead to an unwarranted feeling of authenticity and credibility. No single method can take into account all of the factors that should be considered when making a life insurance purchasing decision. All methods have limitations and must make some arbitrary assumptions to derive costs. The most important limitation is that no cost comparison method can take into account the quality and integrity of the advisor and the insurer. Many of the existing comparison methods were developed in simpler times, when policies were based more on guaranteed values, general portfolio interest rates, fixed-premium policies, and less complex policy designs. What had been illustrations of past performance have increasingly become projections of future results based on assumptions. The following is a brief summary of these methods. net cost method Net Cost Method Historically, the traditional net cost method has been widely used. Its procedure is quite simple, easy to calculate, understand, and explain. The starting point is to specify the duration of coverage to be evaluated. Typically this is either 1 or 2 years, or to a specified age, such as 65. The steps of the evaluation simply involve totaling all of the premiums paid under the policy, then subtracting the cash surrender value and all dividends paid over that interval. One reason this method is so easy to understand is that it does not take into account the time value of money. In other words, it ignores interest, which can be a significant factor in the cost of an investment over time. The time-value-of-money concept focuses on the timing of money paid or received and the role of interest in determining comparable financial costs and value. Without considering the time value of money, the results of this method are misleading. The total cash value available to the policyowner on the date chosen is subtracted from the sum of premiums paid to that date to determine the policyowners net cost. The final cost obtained under the net cost method is considered the cost of the insurance to the client. The main criticism of this analysis is that after 2 years the net cost is usually negative. This means the cash value and dividends paid over the interval exceed the aggregate premiums paid. The implication is that the policy owner has received

4 6.4 Essentials of Life Insurance Products insurance free of charge, and in fact made a profit on the premiums. In this sense, the policyowner is being paid to keep the insurance. One shortcoming of this method is that it gives equal weight to payment amounts that may be separated by 1 or 2 years. Another is that it does not consider opportunity cost, the simple fact that the money spent on the life insurance could have been spent or invested elsewhere (see Table 6 1 at the end of this chapter for an example using this method). The net cost method is not appropriate for comparing policies, whether they are of the same type or different. It is unacceptable under state statutes and regulations for purposes of making replacement evaluations. In fact, under some state statutes, insurance advisors are prohibited from using the net cost method. Policy illustrations and comparisons that do not take into account the effects of interest are by default assuming that the interest rate is zero and inflation is zero. Dollar amounts from different periods are comparable only if money can be borrowed without cost (no interest charged) and if prices remain unchanged over time (no inflation). This is obviously unrealistic and distorts the cost of a financial product. Illustrations that include interest-adjusted figures are preferable, due to their increased accuracy and adjustments for the real world. interest-adjusted method National Association of Insurance Commissioners (NAIC) Interest-Adjusted Method The interest-adjusted indices are similar to the traditional net cost approach except that the interest-adjusted indices take into account the time value of money. The National Association of Insurance Commissioners (NAIC) developed the interest-adjusted cost indices and model laws regarding their use. The NAIC is a voluntary association of state insurance regulatory officials that issues model insurance laws and regulations for state adoption to promote uniformity in the separate states. The interest-adjusted index statutes were drafted and adopted during the 197s, prior to the high interest and inflation rates experienced in the late 197s and early 198s. The NAIC developed a model regulation to give consumers a way to compare the relative costs of different policies and to improve the quality of the cost information given to consumers. The policy summary on illustrations is required to contain two cost indices of the issued policy. These indices reflect the time value of money (interest) by recognizing that money is paid and received at different times and that policy costs can be better compared by using a specified interest assumption. Almost every state mandates that a 5 percent annual interest rate be used. The concern of these state regulations is not the accuracy of the interest rate in representing the actual future interest earned, but rather a need for the comparability of indices for different policies and different companies. Indices based on different interest rates are not easily comparable. By

5 Chapter 6 Comparing Costs and Policy Illustrations 6.5 prescribing one interest rate, results in comparison indices can be used without further adjustments. Premiums alone do not always reflect the true cost of a life insurance policy. This is particularly true in permanent insurance, especially the flexible premium universal designs. Naturally, the public perception is that the premium is the price of the contract, so the higher the premium, the higher the perceived cost of the insurance within the policy. However, this is not always true. Additionally, the cost indices are based on illustrations that are themselves suspect, as we will see. Actual results will vary from the nonguaranteed projections in those illustrations. Actually, several factors (policy premiums, cash values, expenses, and possible dividends) determine the ultimate cost of a policy. We say ultimate because until we know how long a policy will stay in force, we cannot know with certainty what the final, true cost will be. The actual cost cannot be determined until the policy ends, through a death claim, lapse, or surrender, and we can look at what actually occurred. Although you cannot tell prospects the exact cost of a policy they will buy today, you can estimate what a policy will cost in different situations. The purpose of cost disclosure is to show the annual cost per $1, of insurance if the insured died or surrendered the policy after 1 or 2 years. surrender cost index Surrender Cost Index The surrender cost index represents the annual cost per $1, of life insurance if a policy is surrendered for its cash value. Unlike the net payment index, this index includes the policy cash value. It is most useful in comparing costs when cash accumulation is a primary concern. The surrender cost method takes all premium payments, when actually paid, and treats them as if they were put into an interest-bearing account to accumulate interest until the end of the interval for evaluation. In a similar manner, all dividend payments are carried as if they are deposited in an interest-bearing account when they are projected to be paid, and that account balance is calculated for the end of the interval under evaluation. After all premium and dividend payments have been adjusted to the end of the comparison interval, the policy cash value and accumulation dividends are subtracted from the accumulated value of all the premiums paid. The next step is to take that future net cost and divide it by the future value of an annuity due, based on the specified interest rate (5 percent) and the period of time being evaluated, either 1 or 2 years. An annuity due is a series of payments of equal amounts made at the beginning of each of a number of consecutive periods, like premiums. This step adjusts for premiums, dividends, and cash value being paid annually and having an interest adjustment based on the year that they are paid. At 5 percent interest,

6 6.6 Essentials of Life Insurance Products the annuity due factor for a 1-year period is , and for a 2-year period is The result represents the level annual cost for the policy. This is an aggregate policy amount that must be converted to a per-thousand amount, by dividing the level annual cost amount by the number of thousands of dollars in the policy death benefit. For example, the aggregate level annual cost for a $5, policy is 5 times greater than it would be for a $1, policy. We would therefore divide the level annual policy cost by 5 to determine the level annual cost per thousand dollars of coverage. These future values appear on sales presentation materials so there is usually no need to calculate them independently. Calculations can be done by hand using compound interest tables, but they are easier and quicker when done on a computer or financial calculator (see Table 6-2 at the end of this chapter for an example of a surrender cost index calculation). net payment index Net Payment Index The net payment index represents the annual cost per $1, of insurance if the policy remains in force over a given period. It considers the amount of premiums paid, minus dividends received, if any, but it disregards the cash value. This is to take into account the fact that if an insured with a permanent insurance policy dies, the cash value will be included in the face amount. This index is useful in comparing costs when the death benefit is emphasized. Determining the net payment index is similar to calculating the surrender cost index, except that there is no recognition of the end-of-period cash value. Under this calculation, dividends payable over the interval and terminal dividends at the end of period are the only items subtracted from the accumulated premium amounts. This gives a future value of net premiums that is then divided by the annuity due factor for the appropriate period and interest rate. Future values contained in advisors sales materials are based on a 1- and 2-year interval and a 5 percent annual interest rate (see Table 6 3 at the end of this chapter for an example). Net Payment Index Computation 1. Accumulate the premiums at the desired interest rate (5 percent). 2. Accumulate the dividends (if applicable) at the desired interest rate (5 percent). 3. Subtract step 2 from step Divide step 3 by the amount to which $1 paid each year will accumulate for the period selected (2 years) at the desired interest rate (5 percent). This amount is the future value of an annuity due factor for 2 years at 5 percent (the factor is ). The result represents the estimated level annual cost of the policy. 5. Reduce the result of step 4 to a cost per $1, of coverage by dividing it by the number of thousands of dollars in the policy s death benefit. The result is the estimated level annual cost per $1, of coverage.

7 Chapter 6 Comparing Costs and Policy Illustrations 6.7 Sample Comparison A simple example of a fictitious policy is presented in Table 6-4 at the end of this chapter. In the example there is a premium of $15 per year over a 1-year interval and a dividend of $. the first year and $1. the second year, increasing by $1. each year until it reaches $9. in the 1th policy year. The accumulation at 5 percent of all premiums paid is $198.1; the accumulation of all dividends is $ Subtracting the accumulated value of dividends from the accumulated value of premiums yields a future value of net premiums equal to $ Subtracting the cash value at the end of 1 years ($12) from that amount yields a future value of net cost equal to $ This future net cost is then divided by the future value of an annuity due for 1 years, or , which yields a surrender cost index of $1.81. In the same table we can see that by ignoring the cash value, the payment cost index is $1.9 per thousand. These cost indices are a way of comparing similar policies. The policy with the smaller numerical values for surrender cost and payment cost indices is preferable to policies with higher index values. The method is not acceptable, however, for comparing dissimilar policies for example, a term policy with a whole life policy. It is also not well suited for evaluating policy replacements. As pointed out earlier, the indices are derived from illustration data and are suspect for previously mentioned reasons. Surrender Cost Index Computation 1. Accumulate the premiums at the desired interest rate (5 percent). 2. Accumulate the dividends (if applicable) at the desired interest rate (5 percent). 3. Subtract step 2 from step Subtract the cash value at the end of the period from step 3 and divide by the amount to which $1 paid each year will accumulate for the period (2 years) selected at the desired interest rate (5 percent). This amount is the future value of an annuity due factor for 2 years at 5 percent (the factor is ). The result represents the estimated level annual cost of the policy. 5. Reduce the result of step 4 to a cost per $1, of coverage by dividing it by the number of thousands of dollars in the policy s death benefit. The result is the estimated level annual cost per $1, of coverage. Notice that the steps are the same for the net payment and the surrender cost indices, except that there is no subtraction of the 2th year cash value in the net payment cost index. Calculation Example. In most cases, you can easily find a policy s interest-adjusted indices on its policy summary or in commercial publications. However, the calculation procedure is illustrated here to help

8 6.8 Essentials of Life Insurance Products you understand how it is derived, and in case you wish to make the calculations yourself. You should understand how the cost indices are calculated, so that you can explain it to clients and help them understand what the indices mean. Following are the calculations and, for this example, the assumptions used. Example: Calculation Assumptions: Accumulated value of $1 per year for 2 years at 5 percent (future value of an annuity due)... $34.72 per $1, values Annual premium... $21. 2th year accumulation of cash value... $37. 2th year accumulation of dividends at 5 percent... $211. Calculation: 1. Accumulation of premiums $21. x $ $ Accumulation of dividends* $ $ Net payment index: $ $14.92 $34.72 = 4. Surrender cost index: $ $37 $34.72 = $4.27 *Omit this step for policies that do not pay dividends. A simple way to explain these indices to your prospect or client is to treat the policy s premium as being split into three parts: the dividend, the cash value, and the company s share. Even though the premium remains level throughout the life of the policy, the size of these three parts varies through the years. In the early years, dividends and cash value accumulations are small and the company s share large, but as time passes, dividends and cash values increase and the company s share decreases.

9 Chapter 6 Comparing Costs and Policy Illustrations 6.9 $6.8 Average Dividend $21. Premium $14.92 Net Payment Index = Assume that the annual premium in our example of $21 per thousand can be broken down into the average dividend of $6.8, the average cash value increment of $1.65 (coming directly from the premium, not from earned interest), and the average company share of $4.27. These averages take into consideration the time value of money. Subtracting the average dividend from the premium leaves the net payment index of $ This is the policyholder s average yearly cost, assuming the policy is still in force 2 years from date of issue. $6.8 Average Dividend $21. Premium $1.65 Average Cash Value Increment = $4.27 Surrender Cost Index Subtracting the average dividend and the average cash value increase from the premium leaves the surrender cost index of $4.27. This is the yearly cost of $1, of life insurance that portion of the premium the policyowner does not get back assuming that the policy is surrendered for its cash value in the 2th year. Equivalent Level Annual Dividend A third index that might appear on the policy summary is the equivalent level annual dividend. This measures the role that dividends play in the cost of a participating policy. This index, which is labeled the average dividend in the diagram we just illustrated, is an average of the total dividends with interest over the 2 years. It is found by dividing the 2th year accumulation of dividends by the appropriate accumulation of $1 per year factor. Referring to our previous calculation, this index would be $6.8, found by dividing $211 by $34.72.

10 6.1 Essentials of Life Insurance Products cash-accumulation comparison method equal-outlay method Cash-Accumulation Comparison Method The cash-accumulation comparison method is much more complex than either the net cost method or the interest-adjusted methods and requires a computer to make the calculations. A significant amount of data must be entered into the computer program to calculate the results accurately. One of the strengths of this method is that it can be used to compare permanent insurance policies with term policies and for evaluation of replacement proposals. The technique is simply to accumulate the premium differences between the policies being compared, while holding the death benefits of both policies constant and equal. For example, to compare a whole life contract with a term contract, set the death benefits equal at the beginning of the period, and use the yearly premium differences between the whole life policy and the term policy as the amount to deposit into a side fund to accumulate at interest. The calculation is essentially a buy-term-and-invest-the-difference approach to comparing the policies. At the end of the interval being evaluated, the side fund accumulation can be compared to the cash value in the whole life or other form of cash value insurance policy. All other things being equal, the policy with the greater accumulation at the end of the comparison interval is the preferable one Caution must be taken with the validity and accuracy of any illustration, based on the assumptions made in the illustration. Additionally, any side fund, if in fact it were accumulated, would not have the same tax advantages as a life insurance policy in terms of tax deferred accumulations, and income tax-free death benefits. The side fund may also be subject to death taxes and probate fees, from which life insurance proceeds are normally exempt. This method also does not account for value of the creditor protection afforded to life insurance under state laws, but not amounts held in most other types of investments (see Tables 6-5 to 6-9). Equal-Outlay Method The equal-outlay method is similar to the cash-accumulation method. The same amount of premium dollars is expended for a cash value contract and a term policy. The amount by which the cash value policy premiums exceed the term premiums is deposited into a side fund, and the difference in premium amounts is accumulated at specified interest rates. Then the death benefit of the term insurance, plus the accumulated side fund amounts is compared with the death benefit under the cash value contract. Any dividends are used to purchase paid-up additions and the value of the paid-up additions is included in the death-benefit cash value policy. Under this type of comparison, the policy producing the greater death benefit is considered the preferable contract (see Tables 6-1 to 6-14).

11 Chapter 6 Comparing Costs and Policy Illustrations 6.11 Both this method and the cash-accumulation method are very sensitive to the interest rate chosen for purposes of the side fund accumulation. Manipulating the interest rate can skew the comparison results. The higher the interest rate used, the more the equal-outlay method will favor the term policy with the side fund. This method can be used to compare two flexible or fixed-premium policies, a flexible and fixed-premium policy, and is popular for comparing a cash value and term/side-fund plan, testing the results of a buy-term-invest-the-difference scenario. Comparisons That Isolate Interest Rates There are three comparison methods that use an assumed cost of coverage to isolate an interest rate for comparison purposes. One of the problems of comparing any life insurance policies is that there is variability in the many factors that influence the illustration. We cannot make a singlefactor comparison without choosing assumptions for the other factors, and doing this in a way that holds those factors constant. For example, if we want to calculate a policy s internal cost of insurance, we have to make some assumptions about interest rates; if we want to calculate interest rates, we have to make some assumptions about the cost of insurance. Further complicating the comparison is the fact that different companies create different policies, and the assumptions and cost allocations can differ significantly. These assumptions are proprietary company information and they are reluctant to share them with competitors and the public. comparative-interestrate method Linton yield method Comparative-Interest-Rate Method The comparative-interest-rate method is a modification of the cashaccumulation method, where we calculate the interest rate that would make a term insurance policy/side fund exactly equal to the cash value policy s surrender value at the end of the evaluation period. The comparative-interestrate method looks for the interest rate that would make the buy-term-andinvest-the-difference comparison exactly equivalent in the death benefits provided. To make this calculation, both the outlays for premiums and side funds and the death-benefit levels must be held equal. This method is often referred to as the Linton yield method, named for actuary Albert Linton, who first published the approach in the early 19s (see Table 6-15). Its primary drawback is the complexity of the calculation, which requires a computer to calculate the interest rate desired, and a large amount of policy information that must be entered into the program before it can be calculated. A word of caution when using software for comparisons of this type: Each comparison should use the same assumed term premium rates to derive the interest rate. Otherwise, there will be manipulation of the interest rates

12 6.12 Essentials of Life Insurance Products derived by the calculations. The policy generating the highest comparative interest rate is considered the preferable policy. Belth yearly rate-ofreturn method Belth yearly price-ofprotection method Belth Yearly Rate-of-Return Method Joseph Belth, a retired professor of insurance and publisher of the Insurance Forum newsletter, developed several cost comparison approaches (see Table 6-16). He points out that there is no perfect comparison method, because the wide range of objectives that insurance policies address requires different levels of priority to be placed on the death benefits and cash values in different situations. Each method puts its primary emphasis on the elements considered to be the highest priorities for that particular approach. Under the Belth yearly rate-of-return method, only one year of the policy is considered in making an individual calculation. Such a calculation can be made for each year of coverage over the given interval. The objective is to identify the benefits provided by the policy during that year (the end-of-year cash value plus the dividends paid during the year, and the net death benefit for the policy year), and the investments in the policy necessary to create those benefits (a combination of the beginning-of-the-year cash value and the premium paid for that year). The yearly rate-of-return formula divides the sum of the benefits by the sum of the investments and then subtracts the number one from that amount. This process is repeated for each year over the comparison interval. The policy with the highest rates of yearly return in the largest number of years over the observation interval is considered the preferable policy. The calculation under the Belth yearly rate-of-return method depends on a realistic assumed term rate, not a manipulated rate that is so high or low that it skews the results. This method does not necessarily make it easy to identify a predominant policy. The highest yearly rate of return may change back and forth among the policies being compared. Belth Yearly Price-of-Protection Method Under the Belth yearly price-of-protection method, we assume an interest rate and thereby calculate the cost of protection. The calculations are made one year at a time for each of the years in the comparison interval (usually 1 or 2 years as in most other comparison methods). Using this method, the beginning cash value and the current premium are accumulated at the assumed rate of interest to derive a theoretical year-end surrender value. After computing the theoretical end-of-year value from the beginning cash value and the premium plus interest, we subtract the actual end-of-year cash value plus dividends paid during the year. This is the difference assumed to have been available to pay mortality charges.

13 Chapter 6 Comparing Costs and Policy Illustrations 6.13 The next step is to divide the difference between theoretical year-end values and actual year-end values plus dividends by the amount at risk per $1, of coverage. The actual formula looks quite formidable, but when its terms are defined, it is really quite simple and straightforward. P + CVP) x (1 + i) (CSV+D) Cost per $1, = (F CSV) x (.1) P = Premium CVP = Cash surrender value previous year i = Net after-tax interest rate CSV = Cash surrender value current year D = Dividend current year F = Face amount of coverage After making a yearly price-of-protection calculation for each policy being compared for each year in the comparison interval, it is then a matter of identifying the policy with the lowest cost of protection for the largest number of years over that interval. In most cases, that policy will be the preferable one of those under consideration. Both Belth methods of policy comparison are appropriately used for comparing similar and dissimilar policies. With some modification, these methods are suitable for conducting replacement evaluations. Part of their attractiveness is their simplicity and their ability to be calculated without the need of a computer. LIFE INSURANCE ILLUSTRATIONS Life insurance illustrations are typically used in the sales/planning process to show the prospective client how a life insurance policy works and how it might perform under various conditions. They display key policy values: the premium, guaranteed cash values, and guaranteed death benefits. Illustrations may also show hypothetical values based on certain performance assumptions such as interest rates, mortality charges, or dividend scales. This undertaking can be especially complex when the cash value accumulation is based on variable interest rates or the value of underlying investments, or when alternative premium payment arrangements are being proposed. An illustration is not part of the policy and is not a contract between the insurance company and the policyowner. Prospects do not always understand the differences between guaranteed, illustrative, and current (nonguaranteed) values typically found in life insurance policy illustrations. If the differences are not clearly explained, a prospect can easily be misled into believing that the policy promises

14 6.14 Essentials of Life Insurance Products significantly greater values than those guaranteed. Allowing this misconception to exist, or actually fostering it, is a serious form of misrepresentation. The illustration shown or given to the prospect should have no highlighting, underlining, or any other marks on it, so as not to emphasize, or detract attention, from certain illustrated values. In recent years, insurance regulators and insurers have placed emphasis on proper formats of illustrations and clearly explaining what is and is not guaranteed in the contract. Because of the NAIC Life Insurance Illustrations Model Regulations (discussed later), insurers and state insurance departments require a full illustration, including all footnotes and explanation pages, of a product purchased by an individual to be signed by the client. The signature indicates that the client has read and understands the guaranteed and nonguaranteed elements in the illustration. The full explanation of the illustration is especially important when focusing on the projected cash values, dividends, or interest accumulations in the future. It is critical to show the client that the premium will still be required if the illustrated values are not achieved. Lower credited interest rates or dividends, and increases in administrative expense or mortality charges can all negatively affect the illustrated cash values. The life insurance policy illustration is a tool designed to assist the advisor in explaining an intangible, abstract, and in many cases highly complex and sophisticated financial product. In the past few decades, with the advent of the personal computer and financial software, many advisors have turned to illustration selling. This involves selling the appealing numerical values on the printed illustration, rather than conducting a fundamental financial planning process, uncovering the client s needs based on sound fact-finding, and designing real solutions to real financial problems and concerns. The temptation to leave these preferred procedures behind and dwell on the columns of numbers must be avoided. Policy illustrations are based on a variety of assumptions about the future. It is an estimate of what may happen in the future, based on projections of past performance and assumptions about the future. Although some projections may be accurate some of the time, the chance that all of these factors will occur as proposed is almost impossible. In fact, the only assumption we can make about a policy illustration regarding the nonguaranteed elements is that what is projected will not happen. It is easy to believe that there is some connection between these illustrations and reality. However, it is more likely that neither the advisor nor the prospect know the underlying assumptions in the illustration. Companies do not disclose pricing assumptions. You can be confident that the assumptions used in illustrations vary from company to company and that the illustrations are not comparable. When you focus on policy values 1, 2 or more years into the future, you are focusing on the results of compounding errors, and any

15 Chapter 6 Comparing Costs and Policy Illustrations 6.15 resemblance between these numbers and reality is purely coincidental. The bottom line is you cannot depend on illustrations to compare policies. Types of Policy Illustrations There is almost an unlimited number of types and variations of policy illustrations. The simplest types show how much will have to be paid out-ofpocket to keep the policy in force. These illustrations show premiums due, dividends projected, guaranteed cash value, and death-benefit values. Policy illustrations may show increasing death benefits based on the application of policy dividends to purchase paid-up, additional insurance. The use of dividends to purchase one-year term insurance is another type of illustration an advisor can use that increases the policy death benefit without altering the policy or increasing the premium. These simple illustrations can increase in sophistication to include complex combinations of term and permanent coverage using policy cash values or dividends as funding. Policy comparisons, especially of term and whole life insurance, using the techniques discussed earlier in this chapter, such as the cashaccumulation method, compare a large amount of information regarding the costs of different policies. The cash-accumulation method compares illustrated cash values and death benefits of whole life insurance with term insurance with a side fund investing the difference of premium at some assumed interest rate. Universal and variable life show performance under several different assumptions concerning mortality and expense charges, investment or interest earnings, and guaranteed and nonguaranteed values, which creates many columns and variations to consider. Illustrations have become an important part of the life insurance sales process, yet many policyowners have been dissatisfied with products that have not performed as projected by policy illustrations. Over the past two decades, there has been an especially large gap between actual and projected performance, as interest rates and investment performance declined from high points, due to falling interest rates and equity markets. As a result, state regulators and company compliance departments instituted numerous requirements for illustrations that have expanded the policy illustration into a lengthy document. Explanations, caveats, definitions and page after page of numeric tables are now required on illustrations. The policy owner must also sign to indicate receipt of the illustration. These issues will be discussed later in this chapter.

16 6.16 Essentials of Life Insurance Products Sample Illustrations The Participating (Dividend-Paying) Policy The following is an example of a simple illustration showing only the policy year, gross annual premium, dividends, and net premium after dividends. This illustration uses dividends to reduce premiums. Table 6-17 shows an illustration for a $5, graded-premium-paid-up-at-age-95 policy. It can be seen that it does not even present the cash values for the policy. Today these types of illustrations are known as supplemental illustrations, and must be shown with a complete illustration following the NAIC Model Illustration regulations adopted by state laws and company regulations. TABLE 6-17 Policy Illustration 1 Year Gross Annual Premium Dividend Used to Reduce Premiums Premium Due $ $ $ , , , , $5, $1, $3,757 NOTE: $5, graded premium paid-up-at-age-95 policy for a female, aged 32, with an initial annual premium of $17. Dividends shown are not guarantees of future dividends. They are merely based on the current level of dividends, which may change in the future.

17 Chapter 6 Comparing Costs and Policy Illustrations 6.17 There are some shortcomings, even with this simple type of illustration. The summation of premium payments from the different years is improper, unless the values are adjusted by an interest factor to make them comparable, as discussed earlier in this chapter. In fact, it is inaccurate to combine any dollar amounts from different periods, unless they are adjusted for interest. It is correct to add or subtract values from the same period. In the example, dividends are deducted from the gross premium due in the same period to determine the net premium due. These net premium due values can all be adjusted for interest to determine what the beginning balance would need to be in an interest-bearing account to pay all of the net-premium-due amounts as they become payable. This adjusted amount is the present value of all 2 net-premium payments. When a 5 percent interest rate is used, the present value of the net premiums due is $2,273. In other words, an account with a present balance of $2,273, earning 5 percent interest, would be sufficient to pay all 2 premiums, because the interest earnings of $1,484, plus the starting fund balance would cover the aggregate payments of $3,757. Another way of adjusting payments from different periods is to calculate the accumulated values, adjusting all payments to the end of the selected period, as was done earlier in this chapter with the interest-adjusted indices. The same result is obtained by depositing each net premium due into an interest-bearing account and accumulating interest in the account. The balance in the account at the end of the period is the accumulated value for the specified interest rate, time-period, and payments. This accumulated value for the example in policy illustration 1, based on 5 percent interest for the full 2 years, is $6,32. This value is the opportunity cost of the premium payments. The policyowner is giving up the equivalent of the accumulated value that could have been invested had it not been used for life insurance premiums. Obviously, the particular interest rate used has a strong influence on the adjusted present values and accumulated values. There is an inverse relationship between the interest rate and the resulting present values. Higher interest rates result in lower present values, and lower interest rates produce higher present value amounts. To illustrate this point, reconsider the present value given above. The value was $2,273 when based on 5 percent interest. The calculated present value of the same premiums was $1,524 based on 1 percent interest. Similarly, the accumulated value of those 2 net premiums was $6,32 when based on 5 percent interest, but would have had an accumulated value of $1,252 if it had been based on 1 percent interest. This demonstrates the direct relationship between interest rates and accumulated values. Higher interest rates produce higher accumulated values and lower interest rates produce lower accumulated values. The choice of the proper interest rate is both important and difficult. The difficulty arises from the fact that the rate chosen should represent actual

18 6.18 Essentials of Life Insurance Products after-tax investment rates of return for the policyowner over the selected future period. Any attempt to represent unknown future interest rates is necessarily an estimate or a guess. It is important to select an interest rate that is a relatively accurate representation of actual rates over the period, because slight changes in the interest rate result in significant changes to the present values and accumulated values being calculated and compared. Combination Coverage Whole Life and Term Policy illustration 2 shown in Table 6-18 is an example showing policy dividends used to purchase additional coverage. The basic policy is for $18, of whole life insurance, supplemented with additional term insurance and paid-up coverage purchased with dividends. The term insurance decreases each year as the paid-up insurance increases. The amount of term insurance equals the net amount at risk between the target face amount of $25, and the base whole life policy. Eventually the term insurance is totally replaced by paid-up additions. There are no figures in the illustration to indicate the level of the policy dividends, but there is a footnote indicating that the dividend levels assumed for the calculation are not guaranteed. The first column lists the policy year. The second column shows the gross annual level premium. The third column is labeled total paid-up value. This label is ambiguous, because it does not indicate whether the paid-up value is for the dividend additions only or for both coverages, as a result of applying the cash values of both coverages. Study of the illustration reveals that a paid-up value occurs in the second policy year before there is any cash value associated with the coverage purchased with dividends. Thus, it can be deduced that the total paid-up value is the amount of fully paid-up coverage if the total cash value is applied to the purchase. This illustration is based on the assumption that the policy owner will not exercise any policy loans during the 2 years displayed. The next column, titled guaranteed cash value end of year, indicates that this is the scheduled cash value for the base whole life policy. Values for the supplemental coverage cannot be guaranteed, because the dividends used to purchase the additional coverage are not guaranteed. The enhancement reserve fund column shows the cash value for the paid-up supplemental insurance purchased with policy dividends. The total cash value end of year column lists the sum of the guaranteed cash value and the enhancement reserve fund. The last two columns in illustration 2 show the relationship between the premium paid and the annual increase in the policy cash value. During the first eight policy years, the policy premium exceeds the annual increase in cash value. The cash value increases exceed the policy premium in the ninth and subsequent policy years.

19 Chapter 6 Comparing Costs and Policy Illustrations 6.19 TABLE 6-18 Policy Illustration 2 Year GrossAnnual Premium $ TotalPaidup Value $ 285 1,98 1,863 2,577 Guaranteed Cash Value end of year $ ,5 Enhancement Reserve Fund $ Total Cash Value End of Year $ ,5 Total Cash Value Increase End of Year $ CV Increase Less Net Payment $ ,291 3,958 4,583 5,226 5,926 1,324 1,642 1,96 2,296 2, ,324 1,642 1,96 2,33 2, ,57 7,228 7,97 8,569 9,214 2,983 3,334 3,73 4,72 4, ,73 3,48 3,918 4,368 4, $ 6,4 9,846 1,494 11,131 11,755 12,398 4,89 5,194 5,58 5,965 6, ,72 5,37 5,813 6,335 6,87 7, $ 7, $ 1,39 NOTE: Combination of Whole Life and Additional Coverage Purchased with Policy Dividends for female age 4; $18, whole life, $7, additional coverage, $25, death benefit. Annual premium $32. The current dividend scale is expected to continue, and it is now adequate to provide the needed $7, of benefits as term insurance for the first eight policy years, then as whole life additions. The dividends are not guaranteed. The three column totals in illustration 2 have the same flaw as those in the previous illustration; they are only appropriate if both interest rates and inflation rates are zero. The accumulated value of the $32 annual premium after 2 years is $11,11 based on 5 percent interest, or $2,161 if it is based on a 1 percent interest rate. The accumulated value of the last column is only $557 if based on a 5 percent interest rate. This is less than the column sum of $1,39, because of the negative quantities in the first 8 years, which accrued negative balances until they were counterbalanced in subsequent years with positive values. The accumulated value is $1,76 for a 1 percent interest rate.

20 6.2 Essentials of Life Insurance Products The important concept to be understood from this illustration is that the premium is sufficient to create an internal buildup of funds in the policy, which also earns investment income. These internal funds are essential for the level-policy mechanism to work. Advanced Underwriting Illustrations Policy illustrations can become extremely complicated and require expertise and experience to understand. For example, when illustrating splitdollar plans, it is important to use a marginal tax rate in the policy illustration that is the same as the marginal tax rate for the prospective policyowner. Minor variations in the tax rate can result in significant changes in the aftertax costs to the policy owner and other participants. Illustrations based on tax rates that are significantly different from those of the prospect are misleading and could be considered deceptive sales practices. Split dollar, executive bonus, and other applications used primarily for business purposes incorporate the effects of marginal tax rates between the business and the business executives to show the after-tax cost of policies. Knowledge of the federal income tax system, as well as the concept behind the illustration, is necessary to interpret and present these illustrations. The size limitations of standard office stationery tend to limit the amount of information that can be displayed on a single sheet of paper. Consequently, many related and important items are not included in policy illustrations, or are spread out over several pages. It is essential to show both the corporate information and the individual insured information for this type of illustration. Illustrations can include premium-paying techniques using policy loans, such as minimum-deposit, or withdrawing money from the policy for a variety of other purposes. Minimum-deposit illustrations show how policy cash values can be used to pay policy premiums. Policy loans, dividend surrenders, and cash value withdrawals, which are sometimes used for premium financing and funding of other financial objectives, may be forecast. Additional premiums can be shown to serve a number of purposes, such as paying for additional benefits, potentially shortening the premiumpaying period, or accumulating additional funds for future needs. These illustrations will typically include additional columns, showing loan amounts, loan interest, net cash values, and death benefits. Policy illustrations that have more than four columns of values often derive some of their data from information that is not provided in the illustration. The relationship between columns is sometimes defined in the footnotes to the policy illustration, but often the relationships between columns are only partially described, if at all.