Understanding Life Insurance Illustrations: How to Make Sense of It All
CPAs who are new to insurance may find they are sometimes confused by policy illustrations. In truth it's not easy to digest the complex information they present without some training. Insurance illustrations are what the industry gives clients to help them understand a policy. They are simply hypothetical representations that reflect the critical assumptions the company used to compute policy results. Insurance illustrations often contain 20 pages of densely packed numbers and legal disclaimers. Here are some tips for CPAs on how to read them and what to look for. HOW TO DISSECT THE ILLUSTRATION Insurance policies have four moving parts: Inflows from premiums and interest credits both increase cash value; mortality charges and expenses both decrease it. An illustration typically has two key components: * The guaranteed illustration. This is the legally required disclosure of a worst-case scenario. It outlines policy performance based on the carrier's minimum filed credit rates for a particular policy and the maximum mortality charges based on the 1980 commissioner's standard mortality table. * The current illustration. This is the insurer's representations of policy performance based on credit rates and mortality charges currently in effect. The exhibit on page 71 shows the guaranteed and nonguaranteed values and other policy information for a female nonsmoker age 65 purchasing $1 million of universal life insurance. When a Client asks them to look at an insurance illustration, CPAs should look first at the basic assumptions the company used to compute it, including the age, sex and underwriting health status of the prospective insured. An illustration involves three variables: the premium, cash surrender value and death benefits. The insurer's software will compute one variable based on selected assumptions for the other two. Illustrations must contain at least the guaranteed and current/nonguaranteed rates. The former reflect the minimum interest filed for this policy type and the maximum mortality charges permitted by law. When a client purchases a policy, the results indicated in the nonguaranteed columns are guaranteed for the first year only. When looking at an illustration, CPAs should understand the only true guarantee is that the policy's actual financial results will be different from those shown in either the guaranteed or nonguaranteed columns. TEST AN ILLUSTRATION'S VALIDITY CPAs should test the assumptions in an illustration using the so-called 80% test. Here's how. Use a program that calculates the future value of a stream of payments to compute the compound payment value if the client pays the policy premiums into an investment fund yielding 5% from now until the end of the life expectancy used in the illustration. This value should be at least 80% of the illustration's death benefit. If not, it means the illustration uses a rate of return or other assumptions that may be unreasonable. Using the premium information from the sample illustration in the exhibit, the future value of annual payments of $19,110 for 30 years at 5% is nearly $1,270,000. This amount clearly passes the 80% test, based on the $1 million death benefit that the illustration shows. When evaluating an illustration, accountants also should get a Vital Signs report (www.lifelinkpro.com) on the insurance carrier. This service provides summaries of all insurance companies filing with the North American Association of Insurance Commissioners. It includes the ratings of all companies by the major rating services plus selected financial information. When advising clients, CPAs should look to see whether results from operations and returns from the company's investment portfolio are positive. If an insurer is losing money in both areas, this is a warning sign about the illustration's value in predicting future policy performance. GUARANTEED AND NONGUARANTEED VALUES The guaranteed column in an insurance illustration assumes the worst case--that from policy inception, the carrier will credit the minimum interest and charge the maximum amount based on the standard mortality tables. …