A short time ago, in Jenkintown, PA
Post-issue service is the most critical aspect of the life insurance policy process. The work to design, underwrite and implement coverage happens over a relatively short period of time. (“Relatively” being the key word here, as we’ll explore in a future post about the joys of the medical and financial qualification process.) Ongoing policy management is a multi-decade task.
Like any other financial instrument, insurance policies require routine analysis and, when appropriate, adjustments to the game plan. Permanent, cash value-based policies are dynamic and the “performance” – the likelihood to achieve the original desired outcome – is certain to change over time.
The vast majority of policy designs are dependent upon non-guaranteed assumptions at inception, most notably:
1. The assumed prospective hypothetical rate of return;
2. Current, non-guaranteed insurance charges and;
3. The amount and timing of future premium payments.
The inforce illustration is the primary tool to identify these changes, and the starting point to evaluate what adjustments may need to be made to have the policy achieve the ultimate goal.
Comparing to the “As Sold”
“So, what I told you was true, from a certain point of view”
-Obi Wan Kenobi
As I mentioned in Write from Home #2 “Lies, Damn Lies and Illustrations”, the “As Sold” illustration is the centerpiece of the insurance proposal. The As Sold outcome is based on a hypothetical, non-guaranteed prospective rate of return and current, non-guaranteed cost of insurance charges.
After any period of time, we expect to see some variation between the original outcome and what a current inforce illustration projects going forward. The amount of drift between the As Sold and the “As Is” caused by a change in one of the underlying factors of return, expenses and funding.
The change that is easiest to identify from the As Sold is a missed, late, or increase/decrease in the planned premium and/or policy loans or withdrawals off-schedule. These changes are owner driven and not necessarily a reflection of a change in underlying policy performance.
Assuming the cash flow has remained constant, the most common cause for policy performance variation is the actual return on the policy. Variable Universal Life policies, where the cash value is mark-to-market, will generally exhibit the most year-to-year change vs. the original assumptions due to nearly infinite possible fluctuations and widest range of outcomes. Current Assumption Universal Life and Whole Life policies tend to have smaller deviations in performance in short periods as dividends and interest crediting rates generally move in smaller bands and have contractual minimums (unlike Variable Universal Life, where the policy can have negative returns).
Adjusting for the Future
“Difficult to see. Always in motion is the future”
- Jedi Master Yoda
If the As Sold illustration tells us the “How” questions (https://www.1847pcg.com/single-post/lies-damn-lies-and-illustrations), the As Is answers the “Why” question: “Why is my policy performance different than originally illustrated?”
Once we’ve established how we got to this point, analyzing multiple inforce scenarios provides the client and advisor a greater understanding of how to manage the policy going forward.
Along with the As Is illustration, a best practice is to evaluate what changes need to be made in order to get the policy back on the proper track. Since funding is the component of performance under the most control, increasing (or decreasing in the event of better-than-illustrated performance) the amount or duration of premiums to reach the original objectives - either death benefit amount, policy duration, or desired distributions - provides an indication of the cost impact to performance drift compared to the As Sold.
The engine of policy performance is the relationship between the earnings credited and the cost of insurance charges. Cash Value = Premiums + Earnings – Charges/Fees. While we expect the rate of return to vary based on ambient market conditions, the issuing company has near total control of the underlying mortality and expense charges. Changes to the Cost of Insurance (COI) can have a dramatic impact to the performance of the policy, particularly in later years when the per unit cost of net amount of risk (difference between cash value and death benefit, or what the insurance company is on the hook for) is at its greatest. Pricing changes to inforce policies – as opposed to new product versions for new sales – tend to take place when the issuing company is either in financial difficulty or when a larger insurer assumes a block of business from a struggling carrier. Measuring and evaluating the impact of these cost changes – and looking if replacement options are more favorable – is a critical part of the ongoing policy supervision.
As policy performance will change over time, so to can objectives. Inforce illustrations are the proxy for establishing a new baseline or “Current Game Plan” as the need for the policy evolves. For example, before taking a withdrawal or loan from the contract, an inforce illustration will provide guidance on how the loan will impact overall performance, and perhaps impair the ability for the policy to reach mortality. Additionally, depending upon changes to the health of the insured, an inforce illustration can be used to reduce or extend the planned death benefit duration to meet the expected need.
“In my experience, there’s no such thing as luck”
-Obi Wan Kenobi
Using inforce illustrations to understand actual experience and model prospective performance is essential for a life insurance design to reach its intended purposes. The inforce process should be iterative, using one illustrated scenario to prompt a series of “what if” questions to test and retest the projected future performance under various return and funding scenarios. Developing a process for routine inforce reviews should be established between the advisor and policy owner at implementation. Understanding the likelihood and severity of actual results versus the assumed environment will help to set expectations on the need for adjustments to achieve success.
Each practitioner / client should agree on how often adjustments should be made to a policy based on performance. This can vary from small year-over-year changes to developing a threshold on performance (e.g., the lapse year drops below expected mortality) to determine when changes should be made. The frequency of changes can vary depending upon the type of policy and the crediting mechanism driving performance.
One would assume Guaranteed Universal Life policies are exempt from the need for inforce illustrations – there’s no moving parts so what can change? It is still advisable to run an inforce illustration routinely to confirm the all premiums have been paid in full and on time. The timing of premiums is especially important to the calculation of the shadow account that supports the contractual guaranteed; a premium 60-90 days later than due can reduce the duration of the death benefit guarantee.
Indexed Universal Life (IUL) policies provide their own challenges when it comes to evaluating the performance of the strategy based on the inforce illustration. First, interest above the guaranteed floor is credited once the segment (usually one year) is complete. For policies where an annual premium is submitted after the policy effective date, the funds are kept in a holding account until the next ‘monthiversary’, starting a segment that runs from Year 1, Month 2 to Year 2, Month 2. If an illustration is run on Year 1, Month 1, the segment return is incomplete and will only show 11/12ths of the guaranteed interest rate reflected on the cash value.
For IUL policies, changes in the non-guaranteed interest credit cap may limit the illustrated maximum amount for inforce policies. As an example, if the cap at inception for a policy was 11.50% the illustrated maximum prospective return may be 6.50%. Should the cap reduce to 9.00% in future, the future illustrated maximum rate may reduce to 6.00%. This could lead to a situation where the actual realized performance – the cash value as of a certain date – is greater than originally illustrated, however the future performance is less favorable than the As Sold due to the constraints on what can be illustrated going forward over (compounding less over a period of many years).
The expectation is that the performance of permanent life insurance policies will change over time. The inforce illustration provides us with a way to measure past results, anticipate future outcomes and stress test our assumptions to determine what needs be done to keep the strategy aligned with the original intent. Including multiple inforce illustrations as a part of a routine policy review provides a track record for the advisor and client to monitor and explain what has happened, why it happened, and what was done about it.
“He’s quite clever, you know … for a human being”