[Editor's Note: This is a guest post from Brian Fechtel, CFA, founder of Breadwinners’ Insurance. It is unusual to see a CFA selling insurance, and he provides a very unique perspective on the industry. His website is full of all kinds of great data about life insurance policies, both good and bad. He was one of the contributing authors to the NAIC’s White Paper on the State of Life Insurance Industry, having written a section advocating the importance of drastically improved policy disclosures. Last September the Journal of Financial Planning published his article, “Bringing Real Clarity and Understanding of Cash-Value Life Insurance to the Marketplace.” We have no financial relationship.]
Cash value life insurance illustrations and disclosures
One needs good information in order to make savvy financial decisions. When it comes to the life insurance industry’s products, good information is hard to come by. There are major changes coming from The Dodd Frank Reform for the financial services industry. Yet the life insurance industry still has draconian policy disclosures and regulation.
Cash value life insurance products are sold with illustrations. Policies are reviewed and compared with sales or in-force illustrations. Yet policy illustrations are not financial projections. And one cannot compare a policy from insurer A to insurer B, on the basis of two illustrations side by side. This is because there are no disclosures on illustrations, and because the underlying assumptions for the life insurer’s financial performance may be very different.
The Society of Actuaries declared illustrations cannot to be used to compare policies over 20 years ago. Illustrations are not even required to be financially sustainable. An illustration is nothing more than hypothetical future scenario. And the assumptions used generally are current dividend rates. One insurer declared dividends of 7%, and its illustrations may use that dividend rate assumption. Can one really assume that they will receive a 7% dividend for the duration of policy being in-force? That does not seem realistic, yet the industry allows such.
Mutual Funds Can't Do It, So Why Can Insurance Policies?
Mutual funds with track records tend to report past performance as a measurement to compare similar fund strategies and managers or to the performance of an index. Past returns are by no means an accurate predictor for future performance. No financial advisor would illustrate how a mutual fund would grow using a current rate of return. That is essentially what cash value life insurance illustrations do. Illustrations use current dividend rate assumptions to show a hypothetical future scenario. No one can predict the future and an illustration is worth nothing more than the piece of paper it is on.
Bad Information Leads To Insurance Misconceptions
To make good decisions, one needs genuine, appropriate information. Without appropriate information, basic misconceptions may persist with real, harmful consequences. For example, many individuals think there are two types of life insurance, term and permanent; and that term is akin to renting and permanent akin to owning. This conceptualization contains the very seeds of poor decisions and costly mistakes. All life insurance is comprised of term insurance. To assert that a term policy is the least costly form of life insurance is both to overlook this basic fact and to fail to consider the after-tax costs of different policies. Similarly, the presumption that a permanent policy bought long ago probably provides good value today because it allegedly locked-in a cost based on a much younger age is pure financial foolishness.
The solution, of course, is to understand the life insurance industry’s products the same way one understands any financial product: by obtaining good, appropriate information from an expert who can explain such. For instance, the value a policyholder receives from a cash-value policy depends ultimately upon the financial performance of the insurer. This fact is true even of guaranteed, no lapse policies, given that a guarantee is only as good as the guarantor.
Delving Into Life Insurance Products
To understand life insurance products one should work with an experienced agent who will share good, appropriate information and be able to explain such. Here are five questions that come as a natural starting place for anyone considering cash value life insurance policies:
- What is the life insurer’s rate of return earned from its investments, and credited on its policies?
- How efficient are the life insurer’s home office and agent operations?
- Of the life insurer’s block of cash value policies a) what share was underwritten during the past five years, and b) remains on the books even ten years after being issued?
- How competitive are the life insurer’s average mortality costs, and what are the implications of uncompetitive costs for you?
- How fairly does the life insurer distribute its earnings?
Financial decision-making may actually begin with risk management, and good decisions cannot be made without appropriate information. Only by learning the answers to the above mentioned questions, and obtaining proper product disclosures, will one be able to make an informed buying decision.