Journal of Financial Planning - October 1997
Peter Katt looks at cash value life insurance illustration abuse and the attempts of the National Association of Insurance Commissioners to curb it through new regulation.
Deciphering Cash Value Life Insurance Illustrations
by Peter Katt, CFP, LIC
Cash value life insurance illustrations are critical to the life insurance planning process because they serve as roadmaps for consumers considering the purchase of life insurance. However, life insurance policy pricing is inherently complicated, making it easy for life insurance companies to manipulate illustrations in ways that give them an apparent advantage over other companies, yet leave policy buyers vulnerable to exaggerated claims that may not materialize. In this game of illustration liar’s poker, the most frequent pricing manipulations are
- Cost-of-insurance (COI) rates that are below current experience in the out years Nonguaranteed crediting of bonus interest at various intervals, typically in the 10th and 20th policy years with no apparent justification The use of lapse-supported pricing, which withholds some of a policy’s asset share if the policy is surrendered during a given period of time, usually 10 to 20 years, and using these losses to pump up the cash values of policyholders who remain
Illustration games gained the attention of regulators, and in 1995, after nearly a ten-year saga, the National Association of Insurance Commissioners (NAIC) completed model regulations intended to correct life insurance illustration abuses. This effort was announced as a success and interested persons and organizations that worry about such things happily went on to solve other problems.
In the fall of 1995, financial columnist Jane Bryant Quinn asked me to review the NAIC’s model life insurance illustration regulations that had recently been issued. Upon reviewing these regulations, I concluded that it was impossible, for me at least, to evaluate the model regulations’ words (the model regulations run 16 pages, of which 3 pages are devoted to definitions) without being able to evaluate how companies would interpret these regulations in their illustrations. Therefore, I told Ms. Quinn I wanted to wait until I could evaluate post-model regulation illustrations before reaching any conclusions. Recently, two illustrations—ones that the companies who produced them claim are in compliance with the new regulations—have come across my desk. They make a mockery of the intended purposes of the model illustration regulations.
One illustration is for a $5 million survivorship policy (insureds’ joint equal age is 55) with annual premiums of $50,000 that are projected to be paid for ten years. This illustration’s pricing patterns produce projected policy values that are heavily lapse-supported. The surrender value for this policy is zero for four years (after having paid $200,000 in combined premiums for four years!) and the surrender value is far below its apparent asset share for more than 15 years (for example, the surrender value in the tenth year is calculated using my
asset share pricing model). Further, my analysis confirms that the long-term projected values are higher than I would expect them to be without lapse-supported pricing, giving this company an illustration advantage over companies who don’t resort to this kind of pricing. This policy, like all policies with lapse-supported pricing, subjects unsuspecting policy buyers to the risk of surrendering their policies during the period when the surrender values are far below what policyowners would be entitled to. Regardless of the actuarial technicalities that define a policy with lapse-supported pricing policy in the model regulations (how many angels can dance on the point of a pin), at the very least, the spirit of the regulations is being ignored by this company.
The other illustration that I recently reviewed, also claiming to be in compliance with the new illustration regulations, shows the same unjustified exaggerated projected policy values that the regulations were supposed to have cleared up. A policyowner was presented with this exaggerated illustration by an agent trying to replace a policy he had sold in 1987. The agent claimed that the 1987 universal life policy had become less competitive and that the recommended replacement policy was far more competitive as demonstrated by comparing the 1987 policy’s 1997 in-force illustration with the recommended replacement policy’s point-of-sale illustration. My evaluation of the 1987 policy’s 1997 in-force illustration suggested that its COI rates were reasonable and interest crediting was only slightly below market. My evaluation of the recommended replacement policy exposed either ridiculously low COI rates, or undisclosed bonus interest rates being credited to the illustrated values. Regardless of what is ca using it, the recommended replacement policy’s illustration created the illusion of a much better-priced policy than the in-force illustration for the existing policy.
My tentative conclusion is that the NAIC’s attempt to eliminate illustration abuses is producing underwhelming results. First, the regulations appear to be inadequate for protecting unsuspecting consumers from the potential losses they may incur with lapse-supported pricing. Second, the regulations apparently can be interpreted to allow companies to continue the game of illustration liar’s poker by making unsupported exaggerated policy values promises. If predator companies continue to prey on life insurance consumers by using creative illustrations unaffected by the new regulations, pressure builds on more ethical companies to follow suit in order to compete in the marketplace, and we could go back to the worse abuses of the 1980s.
This attempt by regulators to rein in predator life insurance companies’ illustration abuses reminds me of my dog Ginger’s occasional frantic efforts to catch her tail. Chasing her tail produces great purposeful effort, and when the whirling activity concludes, apparent satisfaction. But her tail is still firmly attached to her butt and, except for momentary dizziness, nothing much has changed.
Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Vol. 10 No. 5, October 1997.