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Journal of Financial Planning - April 1999 Planners need to identify underpriced life insurance policies early and recommend defensive strategies to help protect insureds. Detecting Exaggerated Policy Performance by Peter Katt, CFP, LIC One of my most common tasks is to review existing life insurance policies for clients. Two of the steps needed to review a permanent life insurance policy are (1) obtain the point-of-sale illustration (not always available) and a current in-force illustration, and (2) independently evaluate the pricing assumptions inherent within the illustrations. There are several ways to perform such an evaluation: profit test, Litton Yield and asset share are the most common. In my practice I use an asset share pricing model (described in an April 1993 Journal of Financial Planning article) that helps me detect whether projected illustrated values may appear to be (1) exaggerated (underpriced), (2) below what might be expected (overpriced), or (3) reasonable. I also test for various pricing anomalies. It is not uncommon to discover that a policy's projected policy values appear to be exaggerated. Two Major Reasons There are two major reasons why projected values may appear exaggerated. One cause is lapse-supported pricing, which usually is a false positive in that the apparent exaggerated values may in fact be legitimate. A lapse-supported policy has a lower cash surrender value than its asset share for an extended period of time, usually around ten years. Therefore, if an asset share pricing test is done while the policy's surrender value is below its asset share, the projected increases in surrender values will appear to be too great. However, if the policy's asset share can be estimated (the best way is to test the point-of-sale illustration when available), the projected policy values can appear reasonable. (This pricing is referred to as lapse-supported because policy owners who lapse their policies during this period of low cash-surrender value receive less from the insurance company than they are entitled to. By withholding asset share from policy owners who cancel their policies, the insurance company can reward policy owners who persist. Unfortunately, insurance companies don't tell buyers about lapse-supported pricing.) The other cause for policy values appearing exaggerated is pricing assumptions that are overly optimistic. Either (1) an insurance company is using bonus-interest crediting or dividend interest that is little more than wishful thinking, (2) it is using mortality costs that are better than experience, or (3) a combination of the two. When overly optimistic pricing is used, the likely practical effect is that the amount of premiums the policy owner expects to pay in order to meet some predetermined goal (such as endowment at policy maturity) will be too low for current pricing conditions. Unless the company exaggerating future policy performance is willing to support policies that are underfunded (thereby losing money), the premiums will soar. (Of course, investment yields could unexpectedly increase substantially or mortality could decrease substantially, but this would be mere luck). Recommendations Exaggerating policy performance can be severe. I recently completed a review for a client who was being told by the insurance company, via an in-force illustration, that he should expect to pay annual premiums of $35,000 to meet his predetermined goal for the policy. But my testing produced expected annual premiums of $70,000, twice the amount the insurance company is projecting. If you suspect an insurance company is exaggerating the projected performance of an existing policy-thereby leading a policy owner to believe the projected necessary premiums are much lower than they may actually be-this has to be dealt with. I would not recommend that the client begin paying a larger premium based on my calculations, but they should be informed that their policy's premiums could soar in the future if or when the insurance company's pricing assumptions come into line with reality, causing much higher premiums to be paid. Alternative planning should be established for this contingency. If the client has the resources, he or she should begin a side fund in anticipation of spiking premiums. If paying much higher potential premiums in the future isn't an option, then the client may need to adjust his expectation regarding the amount of life insurance the client can support long term. That is, if greater premiums can't be paid, a reduction in death benefits while paying the current premium may be the only alternative. I also would consider contacting the insurance company, on behalf of the client, requesting an explanation of their pricing and asking them to specify what future conditions would cause a significant deterioration in projected policy values. Although my experience hasn't been good in actually receiving useful information from insurance companies, limited assurances or even silence may be beneficial in the event the premiums do spike and the client wishes to consider benefit-of-the-bargain litigation if it can be shown that the pricing never could have been justified. In any event, an in-force policy that appears to have exaggerated projected values should be monitored carefully with adjustments either to the target premiums or death benefits as necessary. Exaggerating policy performance in order to look better than the competition at the time of sale can persist, leaving a policy owner unaware of the lurking danger of policy underfunding until the insured has reached an age at which making up for the shortfall is very expensive. As a financial planner, you should develop the skills to evaluate life insurance pricing so you can detect possible exaggerated policy projections and inform your clients of this potential danger and make alternative plans. Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 12, Issue 4, April 1999.
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