Life Insurance Guaranteed Values Are a Big Fat Idiot
Posted at Advisors4Advisors.com on August 7, 2010
One of my pet peeves is that sales illustrations for life insurance policies show the guaranteed cash values and death benefits on the same page, side by side, using the same formatting, as the non-guaranteed values. This leads many life insurance buyers to think that the guaranteed values are an important factor in choosing a policy. In the worst case, it can lead a buyer to make a really dumb decision.
Insurance regulators are responsible for this problem. The Life Insurance Illustrations Model Regulation, adopted by the National Association of Insurance Commissioners in 1995, serves as the model for most state regulations. It states: “Guaranteed death benefits and values available upon surrender, if any, for the illustrated premium outlay or contract premium shall be shown and clearly labeled guaranteed...The guaranteed elements, if any, shall be shown before corresponding non-guaranteed elements and shall be specifically referred to on any page of an illustration that shows or describes only the non-guaranteed elements.”
The Financial Industry Regulatory Authority (FINRA) issued IM-2210-2 (Communications with the Public About Variable Life Insurance and Variable Annuities) in 1993. It states: “The illustrations must reflect the maximum (guaranteed) mortality and expense charges associated with the policy for each assumed rate of return. Current charges may be illustrated in addition to the maximum charges.”
In October 2009, FINRA proposed to replace IM-2210-2 with Rule 2211 (Communications with the Public About Variable Insurance Products), pending approval by the Securities and Exchange Commission. The proposed rule continues the mandatory use of “maximum guaranteed charges for each assumed gross annual rate of return,” and it extends this requirement to illustrations generated by “investment analysis tools,” such as simulation software.
Here’s an example of guaranteed and non-guaranteed cash values, using a $1 million whole life policy with a $73,770 annual premium and the current dividend scale:
Year 20
Guaranteed: $642,290
Non-guaranteed $1,873,342
What does the guaranteed cash value represent?
It represents the amount that you will have if (1) the insurance company never pays a dividend after you buy the policy; and (2) you keep the policy in force despite its terrible performance. To state it differently, it represents the amount that you will have if, as soon as you buy the policy, interest rates plummet, mortality rates skyrocket, and you become uninsurable.
What is the chance that this will happen?
Note that these bad events have to happen immediately, not later. With each passing year, the dividends that you receive effectively become vested. If the company becomes insolvent, you do not receive only the guaranteed values that were shown at issue. The current (non-guaranteed) values at the time of insolvency become the starting point for determining what you will receive going forward.
Paying only the guaranteed values shown at issue would clearly penalize longtime policyholders the most, because the difference between current and guaranteed values increases each year. So this is not how insolvencies actually work. You can imagine the lawsuits that would occur if an insolvency were handled that way.
And an insurance company cannot decide to seize the accumulated excess of the current values over the guaranteed values due to future bad performance. That is not how life insurance policies work. Insurers can adjust the non-guaranteed elements (dividends, interest rates, insurance and expense charges) going forward, but they cannot take away what you already have.
So in effect, a new schedule of guaranteed values is generated each year, using the current values as the starting point for the projection. The guaranteed values in the sales illustration do not reflect the vesting of future performance; they implicitly assume that disaster occurs right now, not later.
For all types of cash value life insurance except no-lapse universal life (which is purchased for the no-lapse guarantee), guaranteed values are useless in choosing one policy versus another, or in deciding how much money to put into a policy each year. If you think that the illustrated guaranteed values have any chance of occurring, you shouldn’t buy the policy. (Fun thing to do: Ask the insurance company’s chief actuary about the probability, rounded to ten decimal places, that you will get only the guaranteed values shown in the illustration.)
And that brings us to situations where the guaranteed values are worse than useless, because they can lead people to make dumb decisions.
Here are the cash values for the same whole life policy as above, but using a minimum-commission blend of whole life, term and paid-up additions.
Year 20
Guaranteed: $77,930
Non-guaranteed $2,262,981
Compare the guaranteed cash values for the maximum-commission and minimum-commission versions of the same policy.
Maximum-commission version (all whole life): $642,290
Minimum-commission version (blended policy): $77,930
Oh my goodness, look how risky the minimum-commission version is: you might get only $77,930, instead of $642,290 with the maximum-commission version!
I’ve lost track of how many clients have expressed this concern, forwarded from their agents (whose income, of course, depends on how the policy is configured).
In this example, the huge difference in guaranteed values has this primary cause: the illustration for the minimum-commission version does not include the guaranteed values of the paid-up additions rider.
And that’s why life insurance guaranteed values are a big fat idiot.