Clients regularly ask for “How much will my investment become in 22 years?” Really, I have no answer…so this is how I have decided to react.

Do you want a policy illustration or a knock on the head?    Now that I have to show you an illustration, I will.

However that will have to be read along with this note. Normally to most people neither the article nor the illustration makes any sense, so please join the gang. I am the leader! Here is the note, read on………..

In analyzing the possible rate of return of either a new or existing life insurance policy, and comparing it to possible alternatives, it is first important to understand how inherently unreliable, difficult to understand and completely misleading is the most common method of analysis — the policy illustration prepared by the company.

Sellers of life insurance policies, especially products with an investment component, are forced to do that which is illegal for the seller of other investments – to project into the future the likely rate of return of a particular policy and to represent that the illustration is sensible!

For e.g. the Institute of Chartered Accountants does not allow its members signing a projection forecast – for say even 6 months! The fund manager (paid far, far more than the agent) cannot tell you what the NAV (net asset value of the fund will be the following day) are just a couple of examples. To even pretend that the illustration shows how the policy will perform is more misleading than if similar sales materials were allowed to be used in the sale of mutual funds. This is because the life insurance policy is more complicated than a mutual fund, and its future rate of return is therefore more difficult to predict. While the mutual fund’s performance depends only on the gross rate of return of the investment and money management expenses, the life insurance policy’s return is tied to four factors — investments, mortality experience, expense charges, and lapse rates of policies (how long they stay on the books).

Does it make sense that projecting the future performance of the relatively uncomplicated product (the mutual fund) is illegal, while doing the same thing for the more complex product (the life insurance policy) is not only legal but is the primary basis upon which agents sell and consumers choose among competing products?

Obviously not.

Indeed, the practice defies logic and invites deception. How well a policy performs and how close it comes to meeting or exceeding its illustrated rate of return depends on the company and policy in all of the areas affecting rate of return, and the current results do not always justify the manner in which these factors are shown to play out in the future. In other words, the future forecast may look much brighter than the past.

What this means, is life insurance illustrations are almost certain to be a hopelessly flawed basis for choosing the company and policy that will likely perform most competitively in the future.

Misleading assumptions of life expectancy:

The widespread problems with life insurance policy illustrations result, from overly optimistic projections of life expectancy. Moreover, these mortality rates are also only a projection, and sometimes not a guaranteed rate! The fund management charges again, are not guaranteed. That the performance of a life insurance policy fluctuates with changes in the insurer’s investment experience would seem obvious. But its dependence on other factors, especially a company’s mortality charges, may not be easy to understand.

Did you notice that a change in the asset management fees from 0.8% to 1.25% – is a 50% increase in costs for you? That has a big impact over the life of a policy. The compounded effect of this over a 25 year tenor of the policy can well be imagined!

Or even the basic fact that an illustration is just meant to demonstrate how the expenses (mortality, asset management charges, etc.) actually bring down the yield (return for the client) of the investment product. And that if you have 2 illustrations in a policy with cash value – the one that shows higher ending corpus is actually lower because its charges (not binding, they can change it later on) are lower.

While it is possible for the sophisticated consumer or professional advisor to judge whether the investment expectations underlying the projected performance of a life insurance policy are realistic, there is no ready ability to determine the mortality assumptions.

For e.g. in India it may be still ok for an agent to say “Equities will give a return, of say 18% over the long term”, in the USA this would be a gross mis-sale! Nor does the agent have any control over the assumptions used. Unlike the investment assumption, which can be changed by the agent in different illustrations, the mortality and expense assumptions are embedded in the illustration and cannot be altered.

The inscrutability and immutability of life insurance mortality and expense charges masks the most disturbing fact about policy illustrations – the hidden and widespread use of low mortality charges in the later years of a policy to make it look much better than it otherwise would. This practice allows insurers to play the “illustration game,” showing either more death benefit for a given premium or a lower premium for a given death benefit.

Illustrations are a completely unreliable basis for predicting policy performance and for choosing one insurance company over another.

These practices have drawn public criticism in a Forum of Actuaries! Imagine the fate of the agent who thinks he has understood this!

How can one respond to this state of affairs?

1. Do not base life insurance investment decisions on policy illustrations. To the extent possible based on underwriting results, choose “endowment” life insurance from the company that offers the best combination of strong financial strength ratings and top historic rates of return. Do not select one company over another because the preferred company’s illustration shows a lower premium for the same death benefit or more death benefit for the same premium. That appearance may simply be a function of more aggressive and unrealistic non-guaranteed assumptions with regard to life expectancy and other factors.

2. Look out for under funded “permanent” policies that may lapse (i.e., fall apart).

Much existing insurance has been purchased based on perceptions of lowest price. The combination of lower interest rates (negative returns in equity markets) and higher mortality and expense charges than those assumed in the policy illustration will cause most of these policies to fall apart if the insured (or the survivor of two insureds in the case of survivorship policies) lives a long time. Remember Aids, Bird flu, etc. have to still play out in India.

Possible corrective action includes:

(1) Pay a higher premium, either by “topping -up” or by paying for a longer period

(2) Reduce the death benefit,

(3) Replace the policy, with a new policy that can be expected to offer a better long-term return.

3. How can one detect unreliable and misleading policy illustrations for either new or existing insurance?

Not easily, but it is crucial for both new and existing policies of any size because of the widespread problems discussed above. One must first determine the assumptions behind an illustration compare them to some benchmark rate. This process is called the “reverse engineering” of a life insurance policy illustration.