Understanding life insurance illustrations: how to make sense of it all.

CPAs who are new to insurance may find they are sometimes confused by policy illustrations. In truth it's not easy to digest the complex information they present without some training. Insurance illustrations are what the industry gives clients to help them understand a policy. They are simply hypothetical representations that reflect the critical assumptions the company used to compute policy results. Insurance illustrations often contain 20 pages of densely packed numbers and legal disclaimers. Here are some tips for CPAs on how to read them and what to look for.

HOW TO DISSECT THE ILLUSTRATION

Insurance policies have four moving parts: Inflows from premiums and interest credits both increase cash value; mortality charges and expenses both decrease it. An illustration typically has two key components:

* The guaranteed illustration. This is the legally required disclosure of a worst-case scenario. It outlines policy performance based on the carrier's minimum filed credit rates for a particular policy and the maximum mortality charges based on the 1980 commissioner's standard mortality table.

* The current illustration. This is the insurer's representations of policy performance based on credit rates and mortality charges currently in effect.

The exhibit on page 71 shows the guaranteed and nonguaranteed values and other policy information for a female nonsmoker age 65 purchasing $1 million of universal life insurance.

When a Client asks them to look at an insurance illustration, CPAs should look first at the basic assumptions the company used to compute it, including the age, sex and underwriting health status of the prospective insured. An illustration involves three variables: the premium, cash surrender value and death benefits. The insurer's software will compute one variable based on selected assumptions for the other two. Illustrations must contain at least the guaranteed and current/nonguaranteed rates. The former reflect the minimum interest filed for this policy type and the maximum mortality charges permitted by law.

When a client purchases a policy, the results indicated in the nonguaranteed columns are guaranteed for the first year only. When looking at an illustration, CPAs should understand the only true guarantee is that the policy's actual financial results will be different from those shown in either the guaranteed or nonguaranteed columns.

TEST AN ILLUSTRATION'S VALIDITY

CPAs should test the assumptions in an illustration using the so-called 80% test. Here's how. Use a program that calculates the future value of a stream of payments to compute the compound payment value if the client pays the policy premiums into an investment fund yielding 5% from now until the end of the life expectancy used in the illustration. This value should be at least 80% of the illustration's death benefit. If not, it means the illustration uses a rate of return or other assumptions that may be unreasonable.

Using the premium information from the sample illustration in the exhibit, the future value of annual payments of $19,110 for 30 years at 5% is nearly $1,270,000. This amount clearly passes the 80% test, based on the $1 million death benefit that the illustration shows.

When evaluating an illustration, accountants also should get a Vital Signs report (www.lifelinkpro.com) on the insurance carrier. This service provides summaries of all insurance companies filing with the North American Association of Insurance Commissioners. It includes the ratings of all companies by the major rating services plus selected financial information. When advising clients, CPAs should look to see whether results from operations and returns from the company's investment portfolio are positive. If an insurer is losing money in both areas, this is a warning sign about the illustration's value in predicting future policy performance.

GUARANTEED AND NONGUARANTEED VALUES

The guaranteed column in an insurance illustration assumes the worst case--that from policy inception, the carrier will credit the minimum interest and charge the maximum amount based on the standard mortality tables. CPAs studying insurance policy illustrations can assume the benefits, cash surrender value and accumulated values will never be lower than those the insurer guarantees.

Actual policy performance is subject to change at the insurer's discretion within the limits imposed by contractual provisions. The moment the client buys the policy, the illustration no longer predicts future results with the exception of the worst-case scenario and the first policy year using current assumptions, both of which are guaranteed.

Some carriers provide illustrations that offer an additional "nonguaranteed" column. (The one in the exhibit does not.) This second column reflects changes in the interest credits that are halfway between the guaranteed and nonguaranteed assumptions. Don't make the mistake of thinking the midpoint is the most likely scenario for interest credits. It's simply a random point halfway in the interest rate projections. The mortality charges do not change for either illustration.

Both nonguaranteed illustrations--the current and the intermediate--are hypothetical representations of the company's current practices. They reflect a scenario based on rates the insurer declared to be in effect when it issued the policy. For planning purposes CPAs should assume this annual declared rate is in effect through the end of the policy period.

PREMIUM CHANGES

It's always a good idea for CPAs to ask the insurer to provide an inforce reprojection showing any changes in credits or charges the company has declared for the next policy year (an insurer won't issue one unless asked). Review it with the client. Look closely for any unanticipated premium increases. Changes in credits and charges to the policy will be reflected in revised premiums or benefits. The example in the exhibit shows the carrier maintaining a regular annual premium of $19,110 for the 35 years the policy runs. Any change in the projected annual premium or the benefits would result from alterations the insurer made prospectively to the policy's performance assumptions.

CPAs should look closely at illustrations that show "vanishing" premiums. This happens when policy cash value and earnings are projected to cover the premiums. The common presumption is that such policies are "paid up." This is not necessarily so. With the real-world rise and fall of interest rates and expenses, premiums that had vanished may, in future years, suddenly reappear. If this happens, clients who haven't anticipated premiums reappearing are in for a rude surprise. CPAs should recommend clients budget for these premiums annually. If the premium doesn't reappear in a given year, the client can spend his or her "windfall" elsewhere.

NARRATIVE SUMMARY

Beware of any illustration an agent provides that is missing pages in the narrative summary. Just as an audit report is incomplete without all the notes to the financial statements, so is an illustration without the narrative summary. It must include several parts.

* Policy description, terms and features. These give an overview of the main elements. Make sure the policy's premium stream and benefits projections match the client's needs.

* Underwriting discussion. This contains the policy's benefits, premiums and tax information.

* Column definitions and key terms. They define what the carrier intends the terms used in the illustration to mean. Make sure the definitions match your own understanding.

* Disclaimer. It advises readers the illustration is not an estimate of future values and actual results could be more or less favorable.

* Signature page. This shows a numeric summary of the illustration in 5-and 10-year increments. The applicant signs a statement that he or she understands the nonguaranteed elements are subject to change. The insurance agent (also called the producer) signs, saying he or she has explained the nonguaranteed elements are subject to change.

CPAs can look at a sample summary for a typical policy at www.aicpa. org/download/pubs/jofa/Guide_to_Illustration.pdf.

WHAT'S NEXT?

CPAs will increasingly be called on to have a working understanding of insurance illustrations and what they mean. Clients will ask more and more detailed questions they once would have expected insurance agents to answer. Responsibility for informed judgment increasingly will go to a trusted adviser--the CPA. Continuing education programs will help CPAs get a more detailed understanding of insurance illustrations and their limitations.

Sample Life Insurance Illustration
$1,000,000 of Universal Life Insurance--Hypothetical

Female
Age: 65
Preferred nonsmoker

                                 Guaranteed *

                       Accumulation   Surrender       Death
Year   Age   Premium      value         value        benefit

 1     65    $19,110        $13,314           $0    $1,000,000
 2     66    $19,110        $27,002           $0    $1,000,000
 3     67    $19,110        $40,689         $689    $1,000,000
 4     68    $19,110        $54,391      $20,092    $1,000,000
 5     69    $19,110        $68,125      $39,525    $1,000,000
 6     70    $19,110        $67,386      $44,587    $1,000,000
 7     71    $19,110        $64,155      $47,055    $1,000,000
 8     72    $19,110        $58,175      $46,776    $1,000,000
 9     73    $19,110        $48,664      $42,965    $1,000,000
 10    74    $19,110        $34,752      $34,752    $1,000,000
 11    75    $19,110         $4,557       $4,557    $1,000,000
 12    76    $19,110             $0           $0            $0
 13    77    $19,110             $0           $0            $0
 14    78    $19,110             $0           $0            $0
 15    79    $19,110             $0           $0            $0
 16    80    $19,110             $0           $0            $0
 17    81    $19,110             $0           $0            $0
 18    82    $19,110             $0           $0            $0
 19    83    $19,110             $0           $0            $0
 20    84    $19,110             $0           $0            $0
 21    85    $19,110             $0           $0            $0
 22    86    $19,110             $0           $0            $0
 23    87    $19,110             $0           $0            $0
 24    88    $19,110             $0           $0            $0
 25    89    $19,110             $0           $0            $0
 26    90    $19,110             $0           $0            $0
 27    91    $19,110             $0           $0            $0
 28    92    $19,110             $0           $0            $0
 29    93    $19,110             $0           $0            $0
 30    94    $19,110             $0           $0            $0
 31    95    $19,110             $0           $0            $0
 32    96    $19,110             $0           $0            $0
 33    97    $19,110             $0           $0            $0
 34    98    $19,110             $0           $0            $0
 35    99    $19,110             $0           $0            $0

                                 Nonguaranteed **

                       Accumulation   Surrender       Death
Year   Age   Premium      value         value        benefit

 1     65    $19,110        $13,587           $0    $1,000,000
 2     66    $19,110        $27,781           $0    $1,000,000
 3     67    $19,110        $42,248       $2,248    $1,000,000
 4     68    $19,110        $57,014      $22,715    $1,000,000
 5     69    $19,110        $72,114      $43,514    $1,000,000
 6     70    $19,110        $91,288      $68,489    $1,000,000
 7     71    $19,110       $110,595      $93,495    $1,000,000
 8     72    $19,110       $130,378     $118,979    $1,000,000
 9     73    $19,110       $150,596     $144,897    $1,000,000
 10    74    $19,110       $171,205     $171,205    $1,000,000
 11    75    $19,110       $192,400     $192,400    $1,000,000
 12    76    $19,110       $214,165     $214,165    $1,000,000
 13    77    $19,110       $236,466     $236,466    $1,000,000
 14    78    $19,110       $258,801     $258,801    $1,000,000
 15    79    $19,110       $281,524     $281,524    $1,000,000
 16    80    $19,110       $304,960     $304,960    $1,000,000
 17    81    $19,110       $329,174     $329,174    $1,000,000
 18    82    $19,110       $353,843     $353,843    $1,000,000
 19    83    $19,110       $378,996     $378,996    $1,000,000
 20    84    $19,110       $404,678     $404,678    $1,000,000
 21    85    $19,110       $430,957     $430,957    $1,000,000
 22    86    $19,110       $457,931     $457,931    $1,000,000
 23    87    $19,110       $485,727     $485,727    $1,000,000
 24    88    $19,110       $514,492     $514,492    $1,000,000
 25    89    $19,110       $544,427     $544,427    $1,000,000
 26    90    $19,110       $575,772     $575,772    $1,000,000
 27    91    $19,110       $608,828     $608,828    $1,000,000
 28    92    $19,110       $643,960     $643,960    $1,000,000
 29    93    $19,110       $681,618     $681,618    $1,000,000
 30    94    $19,110       $722,353     $722,353    $1,000,000
 31    95    $19,110       $766,844     $766,844    $1,000,000
 32    96    $19,110       $815,925     $815,925    $1,000,000
 33    97    $19,110       $870,627     $870,627    $1,000,000
 34    98    $19,110       $932,229     $932,229    $1,000,000
 35    99    $19,110     $1,001,158   $1,001,158    $1,000,000

* Guaranteed values are calculated using the guaranteed maximum
monthly deductions and guaranteed minimum interest rate for the
duration of the policy.

** Nonguaranteed values are based on the current assumptions of
the insurance company, which are certain to change.

NEIL ALEXANDER, CFP, is founder and president of Alexander Capital Consulting, LLC, in Los Angeles. His e-mail address is [e-mail].