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Life insurance due care.

Most CPAs who advise clients on business and estate planning find themselves reviewing existing or proposed life insurance coverage. It is common for CPAs to be asked for advice on transactions such as making gifts to pay life insurance premiums, placing life insurance in irrevocable trusts or using life insurance to facilitate business succession. While life insurance plays an indispensable role in these and many other arrangements, stories of policies--and even insurance companies--that did not perform as expected abound. Clients may then turn to their CPAs and ask: "What went wrong?"

To avoid such problems, due care must be taken to evaluate life insurance companies and policies using all available information. When clients plan to use life insurance to solve business, estate or investment problems, understanding the due care process will help CPAs be a more effective part of a client's team of advisers.


For many years, life insurance got cheaper and cheaper. Mortality rates were decreasing; interest rates were stable or slowly increasing. Historically, it seemed conservative to use sales illustrations showing how a policy would perform if the company's current dividend scale or interest rates continued. Consumers became accustomed to policies that always performed as well as, or usually better than, initial illustrations.

The sharp increase in interest rates that peaked in 1980 changed the situation. The practice of illustrating policy performance using current results continued through most of the 1980s--few companies considered showing what would happen if high interest rates didn't continue indefinitely. As market rates declined, some companies sought continued high yields by making riskier investments. Others tried to make illustrations appear better by finding more nonguaranteed ways to reduce apparent premium requirements, not disclosing the assumptions underlying some of those results or the increased risk built into the underlying product structure.


It's relatively easy to choose a life insurance policy that illustrates the best current performance. It's also easy to ignore illustrations and choose an insurance company with the highest safety ratings. Due care involves balancing these countervailing safety and performance objectives in a way that suits a specific client's needs, funding abilities and risk tolerance. After these factors have been identified, the due care process begins with learning the overall financial security of the insurers being considered. The next step is to assess the credibility of an insurer's policy illustrations, which determines how they are used to effectively set a range of expectations for coverage costs and benefits.

Can applying due care to a life insurance purchase impose certainty on the uncertain world of life insurance? It's impossible to make absolute predictions of future policy results. But due care can enable CPAs and their clients to make informed choices. The process can strengthen a CPA's trust in both the insurance professional and the company he or she recommends.


In reviewing any life insurance purchase, the most basic question is whether the insurer will remain strong over the long term. There is no guarantee a stable and well-managed insurer will remain so. But a review of current financial factors and published qualitative evaluations of a company's operations lets CPAs make informed recommendations to their clients.

Making effective use of published rating service reports is the first step. Four rating services--A.M. Best, Duff & Phelps, Moody's and S&P Claims-Paying Ability rating service--routinely publish comprehensive life insurer reviews using management interviews as well as evaluations of published and supplemental financial information. Reports include letter ratings, statistical information and a narrative evaluation and conclusion. The services differ in the number of companies rated, the scale of letter ratings used and the types of reports produced. (See the exhibit at left for a listing of services, the number of rated companies and rating scales.

It is essential to know not just a company's letter rating, but also the service that provided the rating. For example, an A+ rating from A.M. Best is that service's second-highest rating. An A+ from S&P, on the other hand, is the fifth-highest rating on its scale.

All four services rate insurers at the insurer's request. Two other ratings-S&P's Qualified Solvency Ratings and Weiss Personal Safety Reports--rate all life insurers based almost entirely on statistical formulas applied to published annual financial statement data. These ratings are considered by some to be more objective because of the lack of any possibility of insurance company influence over the results. By the same token, they do not contain any qualitative analysis of the underlying company strategy or the factors behind particular financial results.

Most larger insurers are rated by more than one service, although few are rated by all. CPAs should know the available letter ratings of all of the insurance companies being considered. There are definite advantages to going beyond this and reading at least one of the full rating reports from a comprehensive service. These reports will give additional insight into a company's key strengths and risk factors, reasons for differences in ratings among services and details more relevant to the particular purchase being contemplated. (The sidebar below discusses the fundamental factors on which rating assessments are based.


Life insurance is unique in that companies provide detailed sales illustrations of future results that are not guaranteed. These nonguaranteed results incorporate dividends, excess interest rates or other elements subject to change at the insurer's discretion. Used properly, they can be effective tools in planning an insurance purchase. If illustrations are used without understanding their true nature, they can lead to poor policy choices, unrealistic expectations and incomplete financial plans. For example, the section below on policy selection and planning demonstrates how a typical "vanishing" premium illustration may mislead clients who do not understand that nonguaranteed elements drive the illustrated out-of-pocket payments.

Why do insurers illustrate nonguaranteed results? Life insurance contracts all contain minimum guarantees an insurance company feels it can provide over the 50 or more years the policy may remain in force. Currently, however, insurers can earn higher interest rates and experience lower mortality rates than the levels used in the permanent policy guarantees. Insurers pass part of those better results through to policyholders on a nonguaranteed basis. Dividends or other nonguaranteed performance elements can be used to provide extra benefits or reduce out-of-pocket premiums. While companies bear the risk of providing contractual guarantees, most of the risk of failing to meet the better nonguaranteed results shown in an illustration is passed on to policyholders.

Looking at results based only on guarantees significantly understates benefits that probably will be available (or overstates the cost of the benefits). Such conservative planning may be acceptable for clients who want only security, are not concerned about price and will plan to pay the guaranteed premium rates for a policy's life. But for clients with more concern about current cash flow, the proper use of current, nonguaranteed illustrations can help establish more realistic expectations.

Illustrations are based on assumptions about an insurer's future financial results in investment earnings, mortality experience, policy persistency and expense levels. A credible illustration should first be grounded in reality by using assumptions in each of those areas consistent with the company's current experience. Although current experience is bound to change, this starting point at least gives a common frame of reference. (See the sidebar on page 52 for guidelines on deciding if an illustration matches a company's current experience. To show how a policy will react to changes, illustrations also should be provided of results with assumptions worse than current experience.

Other factors not directly part of an illustration also are relevant to how well a policy can be expected to perform after purchase. How have a company's existing policyholders been treated in the past? Have changes in interest rates, for example, been reasonable in relation to changes in new money market yields? If bonuses are illustrated for new policies, is the company setting up reserves for such bonuses or have similar bonuses been paid on any existing contracts? Has a company previously offered update programs to existing policyholders, offering to add features or benefits developed for new policies?

Another relevant question is whether the policy being illustrated is part of a line of business fundamental to the insurer's overall corporate strategy. A company that has consistently received a substantial part of its revenue and profit from individual life policies, for example, is more likely to have an ongoing commitment to and an expertise in such policies.


Life insurance illustrations are most useful in showing how a policy works, demonstrating how results can be expected to change as nonguaranteed performance elements change after a policy is issued and portraying a reasonable range of performance expectations. For example, typical "vanishing premium" illustrations generally show insurance coverage extending for the insured's life, while he or she pays premiums for only a limited number of years. (The premium is shown to "vanish" because of growing dividend payments or excess interest credits.

Since vanishing premiums are not guaranteed, how should they be evaluated? The first step is to look at the guaranteed portion of the illustration. Depending on the type of policy, this will either show that the policy lapses at some time after premiums stop or that premiums must continue for life for benefits to be guaranteed for life. In some cases, guaranteed premiums may even increase after a certain point.

To better understand the nonguaranteed portion of an illustration, CPAs can review results under a variety of interest rate assumptions; for example, at both current rates and at rates 1% or 2% lower. These alternatives will set up a somewhat more realistic range of expectations for premium outlays. (Interest rate changes are used as a readily available proxy for general analysis of performance risks. However, be aware that actual results also may vary because of changes in expense, persistency or mortality experience.

Illustrations run at lower than current rates often assume a single fixed level of performance from the time the policy is issued. They will show that additional premiums will be required from the policy outset, or show a longer continuous premium period. It also is important to know what will happen if interest rates drop after premium payments stop. Monitoring a policy's current status compared to initial expectations and reevaluating the future range of performance expectations must continue after policies are issued. The initial policy review should establish how these reevaluations will be performed, who will perform them and the range of post-issue flexibility the policy offers to adjust to changes in actual experience. The sidebar on page 52 discusses how to keep policies on-track.


Some CPAs assume full responsibility for due care review of clients' life insurance purchases. If so, a thorough understanding of the questions raised in this article, and how to interpret the answers, is essential. Other CPAs may prefer to make sure a qualified life insurance professional is part of the clients' team of advisors. He or she can ask the right questions and translate the answers into appropriate recommendations. Even in those situations, the more CPAs understand about the role of life insurance due care, the better they can serve clients and preserve future client relationships.

RELATED ARTICLE: Life insurance rating services

A.M. Best Company, Ambest Road, Oldwick, New Jersey 08858 Number of companies rated (% with highest rating): 881 (7%) Rating scale *: A++, A+, A, A-, B, C, D, E

Duff & Phelps Credit Rating Company, 55 East Monroe Street, Chicago, Illinois 60603 Number of companies rated (% with highest rating): 176 (30%) Rating scale *: AAA, AA+, AA, AA-, A, BBB, BB, B, CCC, CC C

Moody's investors Service, 99 Church Street, New York, New York 10007 Number of companies rated (% with highest rating): 123 (9%) Rating scale *: Aaa, Aa1, Aa2, Aa3, A, Baa, Ba, B, Caa, Ca, C

Standard & Poor's Insurance Rating Services, 25 Broadway, New York, New York 10004 (a) Claims-Paying Ability ratings Number of companies rated (% with highest rating): 267 (22%) Rating scale *: AAA, AA+, AA, AA-, A, BBB, BB, B, CCC, CC, C (b) Qualified Solvency ratings (only life insurers that do not have an S&P Claims-Paying Ability rating) Number of companies rated (% with highest rating): 862 (48%) Rating scale: BBBq, BBq, Bq

Weiss Research, Inc., P.O. Box 2923, West Palm Beach, Florida 33402 Number of companies rated (% with highest rating): 1,436 (4%) Rating scale *: A+, A, A-, B, C, D, E, F

* + or - (or, for Moody's, 1, 2, or 3) also may be appended to ratings of A and lower


Any review of an insurance company should cover the areas described below. CPAs should be careful, however, about relying on simplistic comparisons of a few financial ratios for several companies. Valid comparisons can't be made unless a consistent basis for calculating each company's ratios has been used. Even more important, no single ratio or simple set of ratios can adequately take into account or balance all of the risk factors of a company's operations. A thorough presentation of insurer quality starts with quantitative results in each of these areas but also should contain a description of the basis, significance and other considerations surrounding these results.

Is surplus adequate? Healthy surplus indicates current safety, a history of earnings and an ability to support growth from new sales. Meaningful measures compare surplus to benchmark levels of capital commensurate with the risk level inherent in a specific company's assets and product mix.

Are assets of good quality and well diversified? Insurers' investments must balance competitive yield potential and safety considerations. The level of high-risk assets should not exceed 150% of the company's adjusted surplus. Good diversification of the investment portfolio also reduces the risk of sharp drops in yield or value.

Are total company and individual life earnings stable? Consistent good earnings indicate stable blocks of profitable business and a well-managed company.

Does the company have qualified management and a clear direction? A company cannot excel in the above areas without stable management that can set direction and focus resources effectively.


The answers to four important questions can help CPAs decide if the insurance proposal being evaluated is consistent with the company's actual current experience. 1. Do the current illustrations depend on an assumption of future mortality improvements? If so, how would the policy perform without such improvements? 2. Are current investment earnings sufficient to cover the illustrated dividend rate or credited interest rates? If yields achieved on new investments continue at their present levels, what will future interest rates be for this policy? 3. Are the lapse assumptions underlying the illustration consistent with current experience? Will policy performance be significantly worsened if lapses differ from assumptions? 4. Are the total expense margin assumptions underlying the illustration large enough to cover actual aggregate expenses being incurred by the company?


Learning the answers to these four questions when a policy is selected will help ensure a life insurance policy is likely to continue to meet the client's needs. 1. Can premium payments be resumed at any time at the insured's discretion? If so, are there restrictions on the new premium amount? Might a payment much larger than a typical premium be required to restart premiums? 2. How much warning will be provided before the policy lapses for insufficient premiums or value? Will that warning be early enough to permit the client to keep the policy in force by paying a reasonable premium? 3. If experience is better than expected, will the client be advised it's possible to pay lower premiums? 4. What kind of periodic reprojections of policy results will be provided after the policy begins? Ask to see actual current samples of such analyses.


As director of personal financial advisory services for M.R. Weiser & Co., with offices in New York City and Iselin, New Jersey, Lisa Osofsky's typical client is a closely held business owner. Many of the client problems she works on relate to estate and succession planning, which means life insurance frequently is part of the solution.

Osofsky believes one of the best life insurance services CPAs can provide is "an objective view." CPAs can help clients understand why they need a certain dollar amount of insurance by actually working through the numbers with them, reviewing the type of policy an agent recommends to make sure it's the right one and does what the client thinks it does and also explaining to the client how that policy works.

"Part of the planning we do for our clients is to analyze their life insurance, both group and individual, to see if the coverage is sufficient." Osofsky says the process reassures clients because they are working with a professional who doesn't have a vested interest in recommending more life insurance.

Osofsky frequently works with a client's own insurance agent. "If a client has an agent with whom he or she is comfortable, I may ask that agent for an in-force illustration of existing policies so I can help the client decide about additional coverage." For clients who don't have an agent, she generally turns to agents her firm has worked with before. "We introduce our clients to more than one agent so they can decide who is a better match."

The reception Osofsky gets from clients' insurance agents usually is good because of how she approaches them. "I tell them we'd like to work as a team to provide the client with maximum planning services. Most are pleased because any life insurance recommendation comes from us, not them."

Osofsky cites several instances in which her firm's involvement in a client's insurance affairs improved the situation. "We recommended an agent who helped a client get the best possible rates and then we explained to the client--in English--how the policy worked. The client walked away appreciating the agent's work and thanked us for making the introduction and working with the agent."

More recently Osofsky had a client who thought he was buying an annuity and a life insurance policy. In fact, it was just a split-dollar insurance policy; the agent's projection showed the client borrowing the cash value at retirement, thereby creating an "annuity" but also decreasing the death benefit. "We had to explain that it was just life insurance--not an annuity and death protection." The situation remains unresolved and Osofsky expects she will get involved directly with the agent to ensure the client understands the coverage and it meets his needs.

CATHERINE TURNER, FSA, is an actuarial consultant to the M Financial Group, a Portland, Oregon-based firm with offices nationwide specializing in wealth transfer and executive benefit planning. She is coauthor of Life Insurance Due Care: Carriers, Products, and Illustrations, published by the American, Bar Association.
COPYRIGHT 1995 American Institute of CPA's
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Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:CPAs and Life Insurance; includes related article on life insurance as a part of Lisa Osofsky's practice
Author:Turner, Catherine R.
Publication:Journal of Accountancy
Date:Mar 1, 1995
Previous Article:What to look for in an insurance professional.
Next Article:The question of derivatives.

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