John R. Skar, FSA, served as the Chief Actuary with four different life insurance companies, including MassMutual Financial Group, from 1986 to 2007. He was one of the principal authors of the Final Report of the Task Force for Research on Life Insurance Sales Illustrations, published by the Society of Actuaries in 1992.
I asked Mr. Skar for his thoughts about how consumers should buy life insurance and what role sales illustrations should play in the decision process.
1. How should people choose between term and cash value life insurance?
Basically, term is more suitable where the need for insurance is high relative to cash available for premiums. Anyone with substantial income or liquid investments who is trying to save money for longer range financial goals should look at cash value life insurance. One significant caveat here is inflation. Many people are predicting that we may be heading toward a period of very high inflation when the value of all dollar-denominated assets, such as bonds and life insurance, will take a huge hit. You can purchase variable life to partially cover this risk, if you believe that the stock market will keep up with inflation.
2. Do some types of cash value policies have inherent pricing advantages?
No product type is inherently a better deal than another. You should buy the type of insurance that best meets your personal financial needs for protection and estate preservation.
3. How should people use sales illustrations when evaluating life insurance policies?
Essentially, illustrations are used for two purposes in the marketplace:
(A) to show how the contract performs under a specified set of premium and interest rate combinations. This is a mechanical calculation based on the policy's contractual terms.
(B) to compare potential future performance between policies from different companies; i.e., which policy is the “best” deal.
(A) is appropriate, and (B) is inappropriate. Unfortunately, most agents and consumers use illustrations inappropriately.
No amount of regulation or disclosure will ever make (B) usage appropriate, for the simple reason that no one can predict the future. The future will undoubtedly impact different companies differently, and there is no way to forecast that.
Think about if your stockbroker came to you with performance projections for Apple and Microsoft stock based on current dividends and price movements. How well would you expect those projections to hold up over 5, 10, 20 or 30 years? Yet a process that is patently ridiculous for common stocks gets used in the insurance marketplace all the time.
I believe that the most important pages to look at in an illustration are the pages that show the rates of return on death and surrender. You should examine how the rates of return change over time to get a good feel for how your investment in the policy may pay off.
Don’t make the mistake of focusing on a particular point in time, such as which contract has the highest cash value in the 20th year. What you should really look at is the flow of values over the potential lifetime of the contract. And always remember that using illustrations for comparative performance purposes is inappropriate.
You could potentially perform all kinds of studies about which companies have come closest to meeting their illustrations, or exceeding them. But all this tells you is perhaps how conservative they have been in the past — it tells you nothing about the future, because a conservative company could have a change in management which could then take advantage of the conservative past performance in touting their latest and greatest products.
Using illustrations to predict future nonguaranteed performance is the holy grail for policyholders and agents, but it is just that, a holy grail, a concept that doesn't exist.
4. How can people find the best cash value policy?
I believe that the single most important thing for rating agencies and other insurance company analysts to get a grip on is the strength and orientation of the senior management team. What is the culture? How steady is their performance over time? Do they have solid company fundamentals at their disposal?
Life insurance pricing is a function of the company’s investment return, its expense structure and how well they do underwriting; i.e., risk evaluation. Companies that do a good job on all three will have a good product. Unfortunately, there are ways of cutting corners or making optimistic assumptions in order to gain market share. The consequences of aggressive pricing usually only show up five to 10 years down the road, which is why it may look advantageous to a management team worried about next year’s sales numbers. So, again, you should look for a company with a stable pattern of long-term, steady growth.
Pricing assumptions relative to lapse, reserving and profit margins tend to be of secondary importance in most cases.
Most consumers will not be able to evaluate life company financial statements by themselves but may want to restrict their selection to companies with consistently high financial strength ratings, if they want to be conservative in their choice of policy. As a consumer, you should have a trusted life insurance professional who has good historical knowledge of at least a few companies. It is generally a bad idea to buy from the company which has recently come from nowhere to the top of the charts.
5. What can you learn from publicly available information about a company’s pricing fundamentals?
I don't believe you could ever glean much from comparing statutory financial data with illustrations, unless the company was incredibly homogeneous in its product line.
For example, general expense information may not correlate with any particular policy form, especially if the company has many different lines of business and individual policy forms. A similar comment applies to mortality information, which depends heavily on the amount and type of underwriting performed across different lines of business.
Investment return data is also far too generalized to be of value to anyone, even insiders trying to compare their company’s performance to other companies. There are just too many extraneous variables.
Statutory statements can be valuable in pointing out any sharp trends up or down. In life insurance, long-term stability is what you should be interested in. You should question any sharp changes in direction.
6. How important are cash surrender values?
For someone with substantial income or net worth, cash value life insurance is a valuable financial tool. There are many ways to use life insurance effectively as an estate and financial planning vehicle. No investment plan is complete without considering what could be done by adding cash value life insurance to the mix.