Journal of Financial Planning - February 1996

Claims of life insurance illustration abuse have now come under attack by plaintiff attorneys. What began as a spinkle has turned into a torrential downpour of litigation activity.

Detecting Illustration / Policy Performance Abuses

by Peter Katt, CFP, LIC

In an earlier Journal column (July 1995), I wrote about vanishing premiums that won¯t vanish. I pointed out that a vanish-premium design is rarely ideal, but that the life insurance industry fell in love with vanishing premiums because of the availability of powerful personal computers on every agent¯s desk to produce such illustrations, an era of historically high life insurance company investment yields that made the illustrations look great, and the human desire for certainty ì the false certainty that after paying premiums for, say, seven years the policy would be forever adequately funded.

My January 1994 column also was about life insurance illustrations. Some illustrations produce exaggerated and unrealistic promises in order to slay the competition, but all illustrations are based on pricing assumptions that change constantly.

Claims of illustration abuse have now come under attack by plaintiff attorneys. What began as a sprinkle has turned into a torrential downpour of litigation activity. It is my hope that through the precedent-setting system of case law, some rational ground rules will be established regarding illustration and projected policy performance abuse issues. A subsequent column will deal with other possible life insurance litigation issues.

Some plaintiff attorneys have grabbed onto vanish-premium cases as if they have found a new honey pot, treating all of them the same. If a company and agents sold policies with a vanish-premium design that now appear to require a greater number of premium payments, file a lawsuit. Nearly all life insurance companies in the 1980¯s and the 1990¯s sold policies on a vanish-premium basis that now appear to require additional premiums. If case law sets the standard of care so high that all companies, regardless of whether their projections had been legitimate at the time prepared, will be required to provide all these policyholders a paid-up policy, the American life insurance industry will face serious financial strains. We need a rational interpretation of vanish-premium cases in order to establish reasonable standards because there is nothing inherently wrong with vanish-premium designs. But there is no doubt that some companies and agents have left themselves very vulnerable in this area. I believe three po tential problems exist for companies and agents.

First, if the company¯s pricing assumptions used in its illustration software was or is producing exaggerated projected policy values, the company may have a difficult time defending such a practice. While a number of methods can be applied to test whether the illustrated projections were exaggerated, ultimately the proof of such exaggerations may be to compare illustrated pricing assumptions with the pricing formulas used by that company for existing policies.

Exaggerated illustrations should not be confused with pricing assumptions that can be justified in the year the illustration was produced. For example, if a vanish-premium policy sold in 1987 was projecting adequate funding with the payment of 10 premiums, using illustrated pricing assumptions consistent with the pricing formula being used for existing policies, these illustrations should be considered legitimate for the year they were presented (forgetting the fact that the 1980¯s produced historically high investment yields for life insurance companies). However, if another company was projecting the same premiums, death benefits, and long-term cash values with premium payments for only seven years, a detailed analysis of the illustration would probably disclose that this second company was hyping their pricing assumptions, illustrating better results than their current pricing formula for existing policies would justify, in order for their projections to look better than companies using legitimate p ricing assumptions.

I believe that case law will establish the distinction between companies using reasonable pricing assumptions for the year presented, even if the then-current investment yields were historically high. With companies that used (and use) pricing assumptions that could not be justified in order to exaggerate their illustrations to beat the illustrations of their competitors. But it is also possible that case law will not establish a clear distinction, in which case companies may become more prudent during times of historically high investment yields by using pricing assumptions consistent with historical average.

Second, companies who imprudently trained their agents to believe that vanish-premium policy illustrations were reliable during the period of the aforementioned historically high insurance company investment yields are a problem. Such imprudent training led agents to incorrectly promise their customers such things as, "With the payment of these seven premiums, Mr. Smith, you will have this policy for life." Home-office marketing documents demonstrating this imprudent training, agents putting such promises in writing, or repeatedly saying them to many customers will make such behavior very difficult to justify. This kind of case is tremendously enhanced if the company also appeared to be hyping its illustrations.

The third potential problem is the failure to properly inform policyholders who inquired of their agent, or directly of the company, about their vanish-premium policy¯s progress. I have reviewed situations where agents ignorantly or intentionally failed to alert policyholders to the probability that the number of expected premiums was increasing as insurance company investment yields fell. I have even seen several examples of agents falsifying in-force illustrations in order to misinform the policyholder about the probable need for additional premiums.

Vanish-premium designs are legitimate, although rarely a good policy design. When recommended, the ideal procedures are:

• Agent took steps to verify the illustration was reasonable when presented.

• Agent indicated to the client that the actual results would be different than illustrated, including the probability that more premiums would become necessary when vanish premiums policies were purchased during times of historically high investment yields for life insurance companies.

• Agent monitored the policy regularly to adjust the client¯s expectations about the number of premiums that may be needed.

However, when projected values were purposely exaggerated, companies and agents imprudently made promises about future policy performance, or agents misled policyholders about their policy¯s progress, agents and companies will have problems defending such behavior.

Some companies present information in their illustrations about their policy¯s cash value that is misleading or wrong. For example, some companies refer to a policy account value as well as a policy surrender value. This so-called account value may be fictional. For example, a 55-year old male purchasing a $500,000 full-load policy with an annual premium of $10,000 is shown an illustration with a first-year account value of $8,000 and a surrender value of zero. A full-load policy would have combined first-year selling and other expenses of more than the first year¯s premium of $10,000, so the claim that the policy has an account value of $8,000 is misleading at best, and an outright deception at its worst interpretation.

My test for the accumulation account is whether is can be borrowed, surrendered for, or used to pay subsequent policy costs. If none of these can be done with the account value, it is my judgement that its only purpose is to mislead the customer into believing the policy has more value than it actually does in order to hide the very high first-year selling expenses. Typically, this account value will be greater than the surrender value column on the illustration for as long as 20 years. Policyholders who made their purchase decision based on this apparent distorted information, especially those that canceled their policies within several years of buying, may have legitimate claims.

Some companies use pricing formulas that cause policyholders to suffer losses in order to justify higher long-term cash values for other policyholders, without disclosing this information to consumers. This is a pricing strategy known as "lapse support". It features the deliberate withholding of the policy¯s true asset share for a period of time. Policyholders who cancel their policies during this lapse-support period receive less than their contribution of premiums would entitle them to. This allows the insurance company to profit from these losses suffered by policyholders who cancel their policies early. Theoretically, these lapse-support profits can be divided among policyholders who retain their policies. This allows for the legitimate projection of higher policy values in later years than would be possible if lapse-support wasn¯t being used. Lapse-supported illustration projections depend on the percentage of policies that are lapsed, or canceled during the lapse-support period. As such, pr ojections of lapse-supported illustrations are far more tenuous.

I believe lapse-support is done to justify better-illustrated long-term values in order to beat the competition. While lapse-support pricing is an interesting pricing concept and, in the right circumstances, I might even recommend it, it should only be done with full disclosure to consumers that it is being used and about the possible risks, which are (a) the losses they would incur if they cancel early and (b) lower actual values for policyholders who retain their percentage of cancellations are less than estimated.

Lapse-support pricing is frequently accompanied by the apparently fictional account value columns described above in order to hide the very low surrender values during an extended period. Companies that use lapse-support pricing without informing customers, especially when accompanied with fictional account value columns, may find these practices difficult to defend.

Life insurance¯s compensation system features high first-year commissions, permanent life insurance being priced-to-the-market (producing unpredictable results), many companies¯ and agents¯ apparent disinterest and inability to properly monitor and manage life insurance policies they have sold, complicated planning issues and policy pricing analysis that are beyond the reach of many selling-oriented agents, a Wild West approach to policy performance promises, and few effective disclosure requirements. All of these areas combine to create one of the most fertile litigation areas currently available to plaintiff attorneys. Over the next several years, the results of the many claimed illustration abuse cases should establish new standards of care for agents and companies. This litigation solution to the horrendous behavior of some agents and companies regarding life insurance illustrations is a welcome relief from the failed attempts at regulatory solutions, which in the past have been more than a facade than a reality.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, February 1996.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).