Police Your Policy NowAmey Stone
Wayne Bohrer, a 55-year-old federal employee, bought a $50,000 whole-life insurance policy eight years ago, thinking it would be paid up by this year, when he qualified for retirement. But last September, Bohrer's annual premium notice called for a ninth payment of $1,218. When he requested more information, he got a shock: His policy had not been accumulating value at nearly the rate he expected, and it would take at least five more years of $1,218 payments--or 60% more cash than he planned on spending--to keep the policy in force. Bohrer is canceling his policy instead.
Bohrer is one of thousands of the 120 million cash-value life insurance policyholders who discovered just how wrong estimates for a policy's future value could be. Thousands more who haven't checked their policies are in for the same sad surprise.
LITTLE ACTION. The shortfall is the result of the downward spiral in interest rates over the past seven years. Lower rates undermined insurance-company estimates for how long it would take premiums to vanish--in other words, for a policy's cash value to become large enough for dividends and interest to cover the payments. Not only are premiums on many policies issued in the 1980s still unexpectedly due but some policies are so severely underfunded that they are about to lapse.
The insurance industry and regulators have been scrambling to improve disclosure since the crisis surfaced last year. Their focus has been to change the way pricing information is provided to customers at the point of sale. So far, there has been much study but little action.
When life-insurance agents make a pitch, they usually generate a sales "illustration" on their computers. These documents, which run several pages in length, include several columns of numbers listing the customer's age, the annual premium, the projected cash value, the guaranteed policy value, and the death benefit for every year the policy is held up to about age 95.
EDUCATED GUESS? But illustrations are fraught with problems. Columns of numbers are boring and confusing, so people don't read the material carefully and miss important disclaimers. Insurance agents are free to manipulate the numbers via computer programs, making illustrations easy to abuse. Information on the strength and size of the company, cancellation charges, and the agent's commission structure is left out.
But the biggest problem is that the insurer is only guessing. Illustrations are always based on the dividend scale companies are currently paying to policyholders. They demonstrate the increase in value of a policy over time if all the conditions that go into determining the scale--including mortality rates, return on investments, lapse rates, and expenses--remain the same over the next 30 or 40 years. Fat chance. "There are far too many people who think that because an illustration is generated by a computer and has a lot of numbers, the price has got to be guaranteed," notes Burke Christensen, general counsel to the American Society of Certified Life Underwriters & Chartered Financial Consultants.
Historically, insurance companies have made money handily, passing the profits off to policyholders at a greater rate than the illustrations had indicated. No one complained when premiums were paid up and cash value was accumulating more quickly than had been anticipated. "We all got seduced by this," says Fred Stitt, a Chicago insurance agent and chairman of an American Society task force studying the illustration issue. "Then all of a sudden, interest rates started coming down. None of us had ever dealt with that."
The decline in interest rates affected the companies' return on investments, forcing them to lower the dividend scale paid to policyholders--most drastically since 1990. Signs are that insurers will reduce nonguaranteed rates again this year.
"VAGUE STATEMENT." Any policy that has a provision for reduced premium payments is vulnerable to becoming underfunded. Although a good agent will send customers current illustrations every few years, they are not required to keep clients up-to-date.
All illustrations must include the caveat that the values represented are not guaranteed. Bohrer remembers reading this disclaimer--"the possibility exists that cash premium payments may be required for more or fewer years than the period illustrated"--on his Prudential illustration. "I was left with the idea that eight years should take care of it," he says. "I thought that could be off by a couple of years in either direction. Not five years more." Testifying before a Senate subcommittee at a May 25 hearing on life-insurance disclosure, he told Senator Howard Metzenbaum (D-Ohio): "I don't believe such a vague statement is enough to warn people their retirement is at risk."
Metzenbaum is expected to introduce legislation to create a federal insurance commission that would set guidelines for illustrations. A similar bill never made it out of committee last year.
Industry groups are also trying to improve disclosure without limiting their ability to sell. The American Society has created an "IQ," or illustration questionnaire, for agents to garner enough information from the insurance company to inform policyholders if the illustrations are based on reasonable assumptions. Various industry groups suggest the use of signed disclosure statements and more description of the vanishing premium concept.
Insurance companies are also trying to improve illustrations. Companies are tightening disclosure language, showing cash accumulation under scenarios other than just current dividend rates. Some companies are also considering rounding off numbers so that premium payments and nonguaranteed values would not be shown to the exact dollar.
But consumers must be vigilant. The commission structure for agents does little to encourage ongoing monitoring of an account. Most agents get the bulk of their commission the first year--typically, more than half the initial premium--and small residuals each year the policy is in force. It's a good practice to review any policies you own, especially if purchased in the early to mid 1980s, when interest rates were higher. Request an "in-force" illustration every few years and compare the difference in cash value with the original illustration. Contact the policyholder-services department or your agent with any questions you might have.
If possible, try to make sure the assumptions used in the illustration are reasonable before you buy. Unrealistic illustrations, of course, make policies seem cheaper than they are and allow for easier sales. For example, agents will usually show the lowest premiums for "preferred" policyholders in excellent health. But some companies give very few of its healthy customers this rating. Also, some insurers will assume mortality rates will continue to improve in the future as a way to increase their projected dividends.
REPLACEMENT RUSE. Your agent should be able to answer questions about the assumptions used in illustrations, but if not, you can get help for a fee. Beacon Co. in West Bloomfield, Mich. (800 824-1274), will evaluate an illustration for $108, and actuary James Hunt can tell you the true rate of return on a policy for $35. For Hunt's service, send your illustration and a self-addressed stamped envelope to the National Insurance Consumer Organization, 121 N. Payne St., Alexandria, Va., 22314.
Illustrations seem to provide a great way to compare policies but are actually based on such different assumptions that fair comparisons are impossible. Unscrupulous agents may try to generate new sales off existing customers using illustrations that look more favorable than the one for an old policy. Replacing a policy generates big commissions for the agent but rarely benefits the consumer.
If illustrations are so problematic, why doesn't the industry stop using them? The truth is, they are excellent tools for agents to demonstrate how complicated life-insurance policies work. Also, says Beacon President Peter Katt, if insurers could not utilize "current assumption pricing," they would be more conservative and premiums might be higher. Policyholders must find an insurance agent they can trust in addition to doing their homework. "This isn't something you buy and then throw in a safe-deposit box and forget about," says Judy Faucett, an actuary at Coopers & Lybrand. If you do, you could be in for a big shock just when you think your insurance policy is finally paid off.
QUESTIONS FOR YOUR LIFE-INSURANCE AGENT -- Is the insurance company in sound financial health, and how large is it? -- How highly is it rated? -- Are individual-life policies part of its core business? -- What rates does the policy guarantee? -- Are there cancellation charges, and what are they? -- How difficult is it to qualify for the 'preferred' underwriting class, meaning you would be entitled to the cheapest rates? -- What kind of assumptions does the company use to predict future premium payments? -- Has the agent received the company's response to the 'I Q,'an industry questionnaire about how investment returns, mortality charges, and expenses were predicted? -- Can you see premium payments required for several scenarios that would produce different rates of return? -- Can the agent run the numbers every year or two to make sure your policy is up-to-date? DATA: BUSINESS WEEK