The definition of “illustrate” is to “explain or make (something) clear by using examples, charts, pictures, etc.”
Any non-life insurance person who has ever tried to decipher a life insurance illustration can attest that the definition does not really fit. For example, a life insurance illustration generally does not reveal what the insurer will charge the owner for policy expenses, cost of insurance charges, premium loads and other expenses. How is that a clear explanation?
Would you do business with your money manager if they would not tell you what they would charge to manage your money?
Increased attention has been brought to this issue with rules like the CFP fiduciary standard and New York State Regulation 187 requiring the “care, skill, prudence and diligence of a prudent person.” In fact, the State of New York Reg. 187 FAQ states that while compliant illustrations can be used as part of a sales process, a recommendation cannot be based solely on “illustrated or projected values, particularly when the product contains non-guaranteed elements.”
The good news is that these requirements are likely to lead to better outcomes for clients.
On the flip side, these requirements might pose a risk for fiduciaries such as CPAs, investment advisors and attorneys. Many life insurance producers may not be able to provide illustrations that would allow these advisors to comply with their fiduciary responsibility when life insurance company illustrations are challenging to understand, and some insurers will not disclose their costs. This can create fiduciary liability for the fiduciary if the fiduciary discusses life insurance with a client based on non-compliant decision support material.
Let’s try to decipher how illustrations work so clients and their advisors will know what to look for when presented one.
How to Separate Costs and Performance in an Illustration
I go to great measures to not become too technical in these monthly blog posts and do not want that to change this month. By way of a few screen shots, I am hopeful a life insurance novice coming across this piece can gain a sense of what to look for in an illustration when trying to understand costs and performance.
For this example, I chose a 60-year-old male in excellent health to be the insured for a $8 million universal life policy sold in South Dakota. The actual policy is available in every state.
Keep in mind how universal life works: the insurance company invests the premium and earns “X” and then credits the policy with “X-Y”, with “Y” being the spread the insurance company keeps to cover overhead and profitability.
The premium is $187,360 for 12 years and the hypothetical illustration reflects a conservative 4.85% rate of return.
Let’s go to the 25th policy year. The cash value is $2,258,082, representing a rate of return on the death benefit of 6.59%.
Okay, so far, I think we are all on the same page. What next? Well, if we apply the fiduciary duties required of a financial advisor to this life insurance transaction, we need to examine the cost, performance and risk – just like would be done for a client’s investments. This is rarely completed in the life insurance industry because a life insurance illustration comingles these elements.
Next, I asked the insurance company for more information on cost, performance and risk and this is exactly what producers need to do for their clients.
Back to that 25th year on the illustration. Remember, the illustrated rate of return is 4.95% and the cash value is $2,258,082. Now look at the “interest credited” and the “policy value credits”. Those figures are $170,649 and $144,402, respectively, and total $315,051.
Hmmm…on a cash value of $2,258,082, that $315,051 comes to a 13.9% yield and not 4.85%.
If we jump to the 30th policy year when the insured is age 90, the combined “interest credited” and “policy value credits” is $534,820. Given a cash value of $2,658,096, this means a 20.1% yield.
So What?
The goal of this example is to not demand that the insurance company give more of the investment spread to the policy. In other words, whether 13% or 20.1% can be credited is contractually up to the insurance company. I want those considering life insurance to realize that when they believe they are purchasing a policy with a conservative 4.85% crediting rate, that they are actually purchasing a more aggressive policy earning a higher yield.
In other words, to keep a client’s estate, retirement or business continuity plan on track, the life insurance policy they are relying upon needs to credit 20.1%. I am not saying the insurer can or cannot credit 20.1%, I am saying is that this product has nondisclosed risk that can only be discovered when using care, skill prudence and diligence. Armed with this strategy, a prospective policyholder and their life insurance producer can make an informed decision when analyzing and selecting a suitable product.
Independent and Unbiased
Life Insurance Strategies Group, LLC is a fee-based life insurance consultancy providing affluent individuals and their advisors with independent and unbiased support in making decisions involving complex life insurance transitions. We do not sell products.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.