Making Insurance Illustrations Easier to Understand

Two organizations are trying to improve both the quantity and the quality of information a client receives when considering the purchase of a life insurance policy. The National Association of Insurance Commissioners (NAIC) has adopted the Life Insurance Illustrations Model Regulation, which mandates what must be included in an insurance illustration and how insurance agents can use illustrations in the sales process. The American Council of Life Insurance (ACLI) has formed the Insurance Marketplace Standards Association (IMSA), a self-regulatory organization to promote the ACLIs principles of ethical market conduct. These steps, which are intended to curb the abuses of the past, should make it easier for CPAs to answer client questions about proposed coverage.

THE NEED FOR REFORM
These changes are in response to a life insurance sales process that relied too heavily on using a single illustration to demonstrate product performance and not enough on the features and benefits that meet the clients needs. Clients, CPAs and even some agents tended to confuse policy illustrations with the products contractual provisions, so that an illustration demonstrating attractive values became synonymous with a “good” insurance product. The most common illustration demonstrated the “vanish” premium concept. It showed the death benefit and cash value continuing after the out-of-pocket premiums stopped (vanished) and was based on unguaranteed assumptions.

As prospective policyholders focused their evaluations on the amounts and numbers of annual premiums shown on the illustration, to remain competitive, insurance companies responded by producing more attractive vanish illustrations. This made accurate comparisons between illustrations almost impossible, since some companies used unrealistic assumptions to produce attractive illustrations. For example, some companies assumed their operating expenses would fall as reorganization plans took effect. Others assumed a significant number of purchasers of policies would surrender them before death. CPAs could not always tell which illustrations were based on credible assumptions. Many relied on the technical expertise of the insurance agent selling the policy, but agents usually did not have access to the actuarial assumptions underlying the products and often lacked the resources to thoroughly evaluate what they were selling. Clients became disenchanted when they had to continue paying premiums when these assumptions were not met.

Even policies with a sound actuarial footing often disappointed clients. Many clients never understood that the year in which they were to stop paying premiums (the vanish year) was only a projection. As interest rates as a whole declined, the rate the companies credited to cash value fell below the projected rate used in sales illustrations. With less value from interest income, a policy required more value created by premiums to provide the same projected death benefit. Clients and their CPAs felt betrayed when they saw increases in the amounts of annual premiums or the number of years to pay and learned that the original premium schedules, which they had perceived as sure things, actually were rough guesses.

In addition to hurting policy performance, the revised premium schedules disrupted estate planning strategies. Policies owned by irrevocable trusts sometimes required new premiums in excess of the annual gift tax exclusion. Worse yet, policies owned by generation-skipping trusts might require total premiums in excess of the generation-skipping tax exclusion. A policy funded through split-dollar arrangements—when a sponsor and beneficiary (typically employer and employee) share policy costs and benefits—could no longer disburse the targeted amount to repay the sponsor and terminate the arrangement because of higher premiums.

NAIC MODEL REGULATION

The NAIC regulation addresses the above issues with a two-part approach, which stiffens actuarial requirements for the nonguaranteed values shown in insurance illustrations and mandates showing specific information to any prospect. Insurance companies are required to follow the regulation when conducting business in the states that have adopted it, but many companies are voluntarily complying in all states.

Part 1. To comply with the first part, an insurance company must annually certify to the state insurance commissioner that each set of assumptions used in calculating an illustration, such as interest rates, expense charges or mortality costs, is based on the companys actual recent experience, defined by the Actuarial Standards Board as “current, determinable and credible.” The company also must certify that it will break even on the product after 15 years, reducing the likelihood that—to remain profitable—it will increase charges to policyholders. Finally, the company must certify that it will break even after 15 years even if everyone who buys a policy keeps it. This last requirement is intended to prevent companies from simply assuming they will not have to pay death benefit claims to a large number of policyholders. (About 10% of policies per year are discontinued because they have no cash value.) With limited exemptions, all of the illustrations shown to clients must meet these requirements.

The reliability of these certifications is open to question. Some insurance industry critics contend the tests will limit only the worst abuses because of gaping loopholes.

• The myriad factors involved in the interpretation and actual application of the break-even tests will create opportunities for aggressive actuaries to obfuscate unrealistic assumptions.
• A product can honestly pass the break-even test and still fail to meet the profitability goals set by the company. A product passes the break-even test if the company does not lose money on it. However, insurance companies intend to make money on their products and generally establish profitability goals for each one.
• The tests must be passed only in the aggregate for all ages of insureds. This means insurance companies can still favor particular ages with aggressive assumptions. More likely sales scenarios, such as paying annual premiums for 10 years, also can be favored, with these assumptions offset at other ages or scenarios.

Part 2. Agents must comply with the second major part of the NAIC regulation by giving clients a basic illustration, which includes the narrative summary, the tabular detail and the numeric summary. The pages of the basic illustration must be numbered (1 of 12, 2 of 12, etc.), ensuring that the client receives all pages. The client must sign a disclaimer acknowledging that he or she has received a copy of the policy illustration and understands that any nonguaranteed elements are subject to change. Although the purpose of this disclaimer is to avoid any misrepresentation by the agent, the current environment of skepticism regarding life insurance may cause clients to solicit opinions from outside advisers before signing anything.

The pages of boilerplate text that make up the narrative summary contain a description of the type of life insurance policy being considered. Definitions of key policy terms, which often were coined by marketing departments with a focus on originality, also are found here, giving the CPA a better understanding of the benefits provided by the policy.

The tabular detail (see the exhibit for a sample page) must show the premium outlay and payment mode (annual, quarterly or monthly), the guaranteed death benefit and the guaranteed cash surrender value that will result from those premiums. Nonguaranteed values that have been certified under the first part of the regulation can be included in the tabular detail. They must be clearly identified as nonguaranteed and must be preceded by the guaranteed values. Some illustrations show the tabular details of the guaranteed values on a separate page, while others include columns for guaranteed and nonguaranteed on the same page. In either case, CPAs should exercise care in selecting the appropriate set of figures when evaluating a policy illustration.

Agents are allowed to show the nonguaranteed values on a supplemental illustration to increase readability and comprehension or to demonstrate specific formats, such as the ownership interests under a split-dollar agreement. Because of its relative simplicity, the supplemental illustration will likely become the focal point of the insurance sales presentation. It must be accompanied by a basic illustration, and must refer to that illustration, as in the following example:

“This illustration depicts elements that are not guaranteed and is considered a supplemental illustration. Guaranteed elements are shown in your basic illustration, along with important information regarding the difference between guaranteed and nonguaranteed elements of the policy. Please refer to your basic illustration when comparing guaranteed and nonguaranteed values.”

Another element of the basic illustration is the numeric summary, which includes the client signature line. It shows policy values for years 5, 10, 20 and (if applicable) age 70, based on the anticipated premium outlay and three scenarios: the guaranteed values, the nonguaranteed values and the midpoint values. The midpoint values are those produced using policy charges and crediting rates, which are the average of the illustrated and the guaranteed rates, that is, halfway between the two rates. For example, if the illustrated cost of insurance (COI) charge is $2.35 per thousand and the guaranteed COI charge is $9.47, the midpoint values would be based on a COI charge of $5.91. For participating (dividend eligible) policies that rely on dividends rather than crediting rates, the dividends are reduced by 50%. For each of these scenarios, the summary must include the premium outlay, the policy cash and surrender values and the death benefit. Each scenario also must disclose when the policy will lapse if that occurs before maturity or age 100.

The use of midpoint values is intended to provide the client with a range of performance expectations. While most insurance companies do not expect to ever charge or credit the guaranteed rates in their cash value policies, it is just as unrealistic to assume that none of the charges or credits will ever deviate from the current rates. The midpoint values provide a glimpse of the performance of the contract under reduced assumptions, but they should not be the only look at reduced scenarios. CPAs should advise their clients to request complete illustrations based on crediting rates of 100 or 150 basis points below the current rate when evaluating coverage. These reduced rate illustrations should demonstrate the additional years of funding required to achieve the original policy goals or show performance based on the original premium schedule.

It is equally important for CPAs to temper any evaluation of midpoint values with a review of the insurance companys financial condition and, if possible, the degree of conservatism built into the companys actuarial testing process. A company in a strong financial position, or one using more conservative assumptions, may be less likely to move toward the midpoint values than a company experiencing financial difficulty. The major ratings agencies—A. M. Best, Standard & Poors, Moodys and Duff & Phelps—can be consulted by CPAs seeking information on a companys position. Reviewing publications such as the American Society of CLU and ChFC Life Insurance Illustration Questionnaire or conducting a more in-depth policy-specific analysis may be necessary in order for CPAs to evaluate the level of conservatism in underlying assumptions.

The regulation also addresses the need for continuing client communication after the policy has been issued. Insurance companies will be required to provide annual reports to any policyholder who was issued a policy covered by the regulation. The report must show the policy cash value as of the last annual report and as of the end of the current period as well as the surrender value and death benefit as of the end of the current period. An in-force illustration is not required, but the report must advise the policyholder that an illustration is available and recommend that the policyholder request one before considering replacing or changing the contract. The insurance company is required to provide a “prominently displayed” notice of any adverse change in the nonguaranteed elements of the policy. The policyholder also must be advised if the current cash value, plus any scheduled premiums, will not support the policy to the next reporting period, based on guaranteed values. However, if CPAs and their clients use the annual reports to compare the actual values to the projected values shown on the basic illustration, they will be aware of any impending policy lapse long before this notice appears.

IMSA REQUIREMENTS

If the NAIC model regulation is a micro approach to reform, the IMSA requirements are the macro equivalent. The goal of this self-regulatory organization is to establish membership in the association as an insurance industry “Good Housekeeping Seal of Approval.” The strategy is to use competition to drive all insurance companies into compliance. Companies can comply voluntarily with these broader standards and advertise their membership beginning in January 1998.

The standards are codified in six sweeping principles to which no one could seemingly object, including a 1990s version of the golden rule that says companies will treat others the way they would like to be treated. The principles commit member companies to ideals such as “competent and customer-focused sales and service,” “active and fair competition” and producing “sales materials that are clear as to purpose and honest and fair as to content.” The member companies also agree to maintain a system of oversight and review designed to achieve these standards.

As with any broad ethical statement, specific situations are proving troublesome. It is important to outline exactly what activities will comply with the standards because IMSA evaluators will examine company practices and award the membership designation. What is reasonable for one company may be unreasonable for another. The IMSA faces the challenge of developing guidelines that are stringent enough to be meaningful yet broad enough to encompass a diverse industry.

IMPORTANT STEPS FOR THE FUTURE

While the insurance industry will change as a result of these reform initiatives, CPAs cannot rely on these changes alone to make understanding life insurance proposals easier. A basic illustration still does not provide all the information necessary to make a recommendation regarding coverage. At a minimum, additional illustrations demonstrating reduced rate scenarios are necessary. Nor is membership in the IMSA a panacea. At best, these developments represent important steps in improving the information delivered to CPAs and their clients. CPAs should continue to press insurance agents to go beyond these standards in order to best serve their clients.