Understanding Life Insurance Illustrations
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UPDATED: Oct 28, 2020
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Understanding Life Insurance Illustrations
Here in my left hand is a mirror, in my right hand… Smoke.
A life insurance policy “illustration” is a set of projections, prepared by the actuarial department of the insurance company. It shows how your policy will perform over your lifetime. It includes financial projections for each year. If it’s a term policy, the projections extend to when the policy ends. If you chose permanent life insurance, the projections show data that stretches well beyond your 100th birthday.
For term insurance, a policy illustration usually shows at least three things: current and maximum premiums for each year; total premiums paid up to that year; and each year’s death benefits. If your policy has “re-entry” provisions for certain years — requiring you to qualify for the benefits through a physical exam, for example, there are columns telling you the premiums if you passed (“re-entered”) or failed the company’s medical requirements.
Sounds easy, doesn’t it? If you are stopping at term insurance, you are in luck. If not, be prepared for a shocker when you take a look at your first permanent life insurance illustration.
An Illustrative Jungle
Permanent insurance illustrations are complicated enough to make you want to give up the buying process altogether. Obviously, that’s a bad idea because you’ll end up with no insurance at all. The typical term insurance illustration runs two or three pages and contains 100 or so numbers. By comparison, the typical permanent life insurance illustration can run 10 pages with 1,000 numbers. Further complicating this numerical morass: Except for the numbers listed in the “guaranteed” columns, the actual pay out for virtually every number you see is bound to be higher or lower than projected.
Why are permanent life insurance illustrations so unreliable? Obviously, the company has to project years into the future, therefore making long-term estimates of its investment success, its expenses, and its mortality charges. These are the numbers that you often don’t see. The numbers that you do see on the illustration, apart from the guaranteed premiums, cash value, and death benefits, are pie-in-the-sky figures.
Many reputable insurance professionals tell their clients to forget the non-guaranteed numbers altogether and to consider them as icing on the cake (the cake being the guaranteed part). The problem is that many other insurance professionals don’t, and they brandish the life insurance illustration as their primary sales weapon in the battle to get your business.
The Phantom Interest Rate
Did you know the illustration software that insurance professionals use allow the insurance professional to change the interest rates? This means they can put any interest rate they want into the projections?
Life insurance professionals often sell particular products by touting the company’s “current interest rates” and “current dividend rates.” It is tempting to just buy the policy with the highest current rate, just to get the buying process over with. The problem is that current rates are usually only guaranteed for three-to-12 months, and some of the life insurance companies with the highest current rates have the most expensive policies in the long run. They have to show potentially high payoffs to attract buyers.
All of the non-guaranteed numbers are based on the company’s best guess about future performance. That task is even harder than trying to estimate an investment’s future performance. The insurance company estimates how well it will invest its portfolio, and also projects its expenses and mortality costs dozens of years into the future.
Making Illustrations Work for You
First and foremost…..compare apples with apples! If, for example, you are receiving illustrations for interest sensitive policies (universal life), make sure the insurance professional sets the interest rate at the same rate for all life carriers. By the way, set the interest rate at conservative levels!
Second…Ask for Option 1 for level death benefit and maximum cash value accumulation, or Option 2 for increasing death benefits and use the same “Options” with all illustrations with the different carriers.
Third…If your goal is maximum death benefit at the end of say, year 30, compare the death benefit with each carrier who has the highest? If the goal is maximum cash accumulation and not maximum death benefit compare the surrender values at year 30 for all of the carriers using Option 1 variable.
Ask for the Payoff Projections
When comparing illustrations, you should always ask for projections that show the payoff if current interest rates continue into the future. Then you should ask for a second illustration that shows the payment if the rates drop by two percentage points. It is surprising how much the numbers differ when the scenarios change. This is especially important when comparing policies from two different companies. Go for the policy that looks better at the lower rate. That is probably the more conservative company, and therefore has a better chance of meeting its projections.
Finally, remember that clothes may make the man but illustrations don’t make the company. Illustrations offer only a glimpse into how well a company thinks (or wants you to think) its policy will perform for decades to come. By knowing what illustrations to ask for, how to compare them, and what your insurance professional should do, you will maximize your chances of picking the right one.