Avoid the insurance illustration trap

By Ginger Applegarth

A life-insurance-policy illustration is a set of projections, prepared by the actuarial department of the insurance company, that 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 the date that the policy ends. If you chose permanent life insurance, the projections stretch 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 policy illustration for permanent life insurance.

An illustrative nightmare

Permanent insurance illustrations are complicated enough to make you want to give up the buying process altogether. The typical term insurance illustration runs two or three pages and contains perhaps 100 numbers. For permanent life insurance, the 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 payout 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 dozens of years into the future, estimating how well it will invest its portfolio and what its expenses and mortality costs will be. So, except for guaranteed premiums, cash value and death benefits, the future payouts you see in the illustration are pie-in-the-sky figures.

Many reputable agents tell their clients to forget the nonguaranteed numbers altogether and to consider them as icing on the cake (the cake being the guaranteed part). But some agents don't, and they brandish the illustration as their primary sales weapon in the battle to get your business.

The interest rate 'sting'

Life insurance agents 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.

The problem is that current rates are usually guaranteed for only 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.

Making illustrations work for you

If you keep all of these factors in mind, there are ways to make illustrations work for you.

First, agents are required to give you all of the pages of the life insurance illustration, including the one with the Interest Adjusted Net Cost (IANC) indexes. These "box scores" for each policy take into account the premiums paid as well as the time value of money. They give you the cost per $1,000 for both guaranteed and projected death benefits (for term and permanent policies) and for the policy's cash value (for permanent policies).

You can use these indexes to compare different policy illustrations in an apples-to-apples way.

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 2 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 it has a better chance of meeting its projections.

Ask your agent for an illustration questionnaire from The American College for all companies you are considering, and then ask the agent to explain the information to you.

If your agent doesn't know what the IQ is or can't explain what's on it, you should buy from someone else. If an agent talks to you about variable life insurance, he or she must have a National Association of Securities Dealers license, because that's considered an investment product. Sometimes unlicensed agents discuss the product with prospective clients and then have a licensed agent actually sign the application and submit it.

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 agent should do, you will maximize your chances of picking the right one.

Updated June 25, 2007