Lack of Transparency Regarding Fees
Consumers need to understand the type and size of the fees that must be paid to maintain their LIIS policies, but consumers are rarely given meaningful disclosure of those fees. That will continue to be the case unless disclosure requirements are adopted. A federal court recently ruled that disclosure of fees was not required by existing law governing life insurance policy illustrations. See Joyce Walker, et al. v. Life Insurance Company of the Southwest, U.S. District Court No. CV 10-09198-JVS (C.D. Cal. December 22, 2017 Order at 14-16) (addressing California’s version of the NAIC Illustration Regulation).
Not only did the court in the Walker case rule that the NAIC Illustration Regulation did not require disclosure of fees, but the court also rejected a claim under California’s Unfair Competition Law (California Business and Professions Code Section 17200) that the illustration’s treatment of fees was likely to mislead consumers. See April 14, 2015 Order at 67-70. The illustration in the Walker case stated in bold, italicized type that there was “One Policy Fee,” and the illustration then showed only one fee, which is called the “Monthly Administrative Charge.” But in fact the policy was subject to four other fees besides the Monthly Administrative Charge (specifically, the Premium Expense Charge, the Monthly Policy Fee, the Monthly Cost of Insurance Charge, and the Monthly Percentage of Accumulated Value Charge). See LSW Policy. None of these fees was disclosed in the illustration, yet the court found that consumers were not likely to be misled.
Legislation is needed to require that insurers disclose fees in illustrations so that the consumer can readily see the type and amount of fees that would be charged in the scenario shown in the illustrations. Such disclosures are easy for insurers to prepare using their illustration software, and many insurers already enable their agents to run a report, often called a “Policy Charges Report” or a “Policy Expenses Report,” that itemizes each fee related to the illustrated scenario on a year-by-year basis. But most insurers do not require agents to provide this report to prospective policyholders, and agents, who earn sizable commissions, are financially incentivized not to provide the optional report.
The Policy Charges Report: As shown in the exemplar Policy Charges Report, the report shows the amount of policy charges (i.e., fees) that would be deducted from the policy in the scenario shown in the illustration. By “scenario” we mean the set of variables that are assumed by the illustration and that affect the determination of the policy’s cash value (e.g., the assumed charge levels and the assumed interest crediting rates). Such disclosure is necessary for the consumer to understand the cash values (including both “Accumulated Values” and “Cash Surrender Values”) shown in the illustration. But this disclosure is rarely given to consumers because most insurers make providing such disclosure optional to the agent. Agents understand that it is against their self-interest to give fee disclosures that they are not required to give. For this reason, agents generally do not provide the “optional” report to prospective policyholders even though it can be provided simply by checking a box in the input screen of the illustration software.
Insurers may argue that they indirectly disclose fees in illustrations in the sense that the accumulated cash values and cash surrender values shown in the illustration are presented net of charges. That is not good enough. Accumulated cash values and cash surrender values (collectively, “policy values” or “cash values”) are determined by both credits earned and charges deducted. Credits may be based on a straightforward interest calculation (e.g., crediting 5% per year), or credits may be based on an index such as the S&P 500 (e.g., crediting the percentage of 1-year S&P 500 gains, subject to an annual cap of 10% and a floor of 0%). Regardless of how determined, the credits used in calculating the illustrated nonguaranteed cash values are not guaranteed and may never be realized, yet most charges will continue to be charged to the policy regardless of whether credits are earned. There is no way for a consumer to understand how the credits and debits operate over the life of a policy unless they are broken out separately; blending charges together with assumed credits only obscures the charges.
Potential Public Policy Approaches:
The type of Policy Charges Report described above should be required as part of all illustrations presented to consumers. Agents who show consumers illustrations on screens must show not only the “ledger pages” showing policy values but also the Policy Charges Report. The Policy Charges Report should be initialed, in the same medium as the illustration was presented, by the prospective policyholder.
But this reform alone would be inadequate because the type of Policy Charges Report that most insurers currently make available shows the amounts of charges that will paid only in a scenario where the nonguaranteed credits are realized. That report does not show the charges that will need to be paid if the nonguaranteed credits are not earned. For many policies, the cost of insurance charges that will need to be paid will be much higher if crediting rates turn out to be lower than illustrated because the cost of insurance charges are based on the difference between the death benefit of the policy and the cash surrender value (the so-called “net amount at risk”).
For example, if a policy has a so-called “level death benefit” of $1,000,000, and the policy’s cash value after thirty years grows to $800,000, then the insurance company will charge a cost of insurance charge based on the $200,000 difference between the death benefit and the cash value (the “net amount at risk”) because upon the death of the insured, the insurance company will pay a $1,000,000 death benefit that includes $800,000 of the policyholder’s own money and only $200,000 that the insurance company must pay to make a total pay out of $1,000,000.
But now assume that the crediting rates paid by the insurance company turn out to be significantly lower than in the above example so that the policy’s accumulated cash value after thirty years is only $300,000. Then the net amount at risk will be $700,000 because the insurance company will still have to pay $1,000,000 upon the death of the insured, but there is only $300,000 in accumulated cash value to contribute to the $1,000,000 that is due. To calculate the cost of insurance charge for any given month, the insurance company will multiply the net amount at risk times the cost of insurance rate (which is based on the risk that the insured will die during the month and is expressed as a certain dollar amount per thousand dollars of net amount at risk). Let’s assume that the monthly cost of insurance rate is $1.50 per thousand dollars of net amount at risk. In that case, the monthly cost of insurance charge would be $300 if the crediting rates were high and the policy’s cash value grew to $800,000 (because $200,000 net amount at risk times $1.50 per thousand dollars of net amount at risk = $300), but the monthly cost of insurance charge would be $1,050 if the crediting rates were lower (because $700,000 net amount at risk times $1.50 per thousand dollars of net amount at risk = $1,050). In the second example, where the crediting rates were lower than in the first example, the annual cost of insurance charges are $12,600, which further reduce the policy’s accumulated cash value, thus increasing the net amount at risk and leading to even higher cost of insurance charges in the future. The result can be a spiral of higher cost of insurance charges leading to lower accumulated cash values and higher net amounts at risk, leading to ever higher cost of insurance charges until the policy’s accumulated cash value is used up and the policy lapses.
Many thousands, if not millions, of people who bought universal life policies when interest rates were high have discovered the sad reality that while the high interest rates assumed in their illustrations have not been realized, charges such as cost of insurance charges must be paid regardless. The lower interest credits turn out to be insufficient to offset charges, and the polices lapse.
Case in Point:
Bob B. of Berkeley, California bought a universal life policy from First Colony Life Insurance Company, a predecessor of Genworth, in 1991, when he was 52 years old. The policy had a death benefit of $500,000 payable to Bob’s wife upon his death. The nonguaranteed values columns in the policy illustration showed Bob paying a planned premium of $4,793 every year, maintaining the death benefit in force and maintaining cash value into Bob’s 90’s. That sounded good to Bob, so he bought the policy. See First Colony Illustration.
Fast forward to 2018. Bob was 79. He had faithfully paid $4,793 in premiums every year since 1991. But then Genworth told him the cash value of Bob’s policy had declined to nearly zero, and in order to keep the policy alive until age 95, Bob would have to start paying premiums of $28,000 per year! These premiums were the result of the high cost of insurance rates applicable to him as he got older, so that by the time he neared 80 years old, the policy became unaffordable. (For example, when Bob bought the policy at age 52, his cost of insurance rate was $0.27583 per $1,000 of net amount at risk, but the rate increased by approximately 1,000 percent to $2.7325 at age 80 and was scheduled to increase further to $8.24917 at 95.) Because Bob’s policy illustration assumed a higher crediting rate (9.25%) than the rates the insurer actually paid (which fell over time to the guaranteed rate of 5%), the high cost of the policy was not apparent to Bob. Bob decided that he had no choice but to abandon the policy and let it lapse because he could not afford to pay enough to keep the policy in effect.
What happened to Bob demonstrates why insurers must disclose the charges that will be paid not just under the assumption that the nonguaranteed crediting rate underlying the illustrated policy values will be provided, but also under the assumption that it will not be provided. Under a policy like Bob’s, the cost of insurance is based on the “net amount at risk” (meaning the death benefit minus the cash surrender value). An illustration that assumes a high crediting rate will show high cash values and thus a lower net amount at risk and consequently lower cost of insurance charges; such an illustration, as with the first policy in our example above, might show that after thirty years the policy’s cash value would be $800,000 and the monthly cost of insurance charge would be $300. The problem is that the crediting rates used in the illustration are not guaranteed and may not be realized. If crediting rates turn out to be lower than the rates assumed in the illustration, then cost of insurance charges will be higher than the amounts assumed in the illustration. This is the case with the second policy in our example above, where the policy’s cash value was only $300,000 after thirty years and the monthly cost of insurance charge was therefore $1,050.That is what happened to Bob – interest crediting rates turned out to be significantly lower than was assumed in his illustration, and that led to lower policy cash values and higher cost of insurance charges that eventually consumed all of the policy’s cash value. Consumers need to understand how much the policy will cost if the illustrated nonguaranteed crediting rates are not realized.
For a traditional universal life policy, like Bob’s, we believe the alternate assumption should be the guaranteed minimum interest rate (5% in Bob’s case). For an indexed universal life policy, we believe that a more appropriate alternate crediting rate would be the mid-point of the guaranteed minimum rate and the non-guaranteed rate that is used to calculate the policy values. For both traditional and indexed universal life, the charges should be shown at the guaranteed maximum levels as well as at the nonguaranteed levels currently planned by the insurer (the so-called “current scale” of charges). Thus, the disclosure that we propose would include the level of fees in each of four permutations: nonguaranteed credits/current charges, alternate credits/current charges, nonguaranteed credits/guaranteed maximum charges, and alternate credits/guaranteed maximum charges.
Fee Disclosure in the Policy Itself Is Not a Substitute for the Policy Charges Report:
Insurers may argue that our proposed disclosure is not necessary because all fees are disclosed in the policy itself. This argument is wrong for several reasons.
First, many, if not most, consumers do not read their policies because they make their purchase decisions based on the illustration. Consumers typically do not see a policy until the very end of the sales process, after reviewing the illustration, applying for the policy, and going through medical underwriting. Consumers can reject the policy after it is delivered under “free look” laws, but for many if not most consumers the decision to purchase has already been made by the time the policy is delivered.
Second, fee disclosure in policies typically consists of the mathematical formulas for calculating fees and will not convey a meaningful sense of a policy’s likely costs over time. For example, a policy may disclose fees in the form of a particular amount or formula (for example, $1.05 per thousand dollars of face amount or per thousand dollars of net amount at risk). But it is difficult for consumers to understand how charges work in the context of their plan for the policy. Illustrations provide the consumer with a sense of how the policy will perform under a specific plan for the policy, chiefly consisting of an assumed premium funding plan, an assumed crediting rate, and assumed but not identified policy charges. A Policy Charges Report is needed to show the prospective policyholder the amount of fees that will be deducted if the policyholder pursues the funding plan shown in his or her illustration.
Third, policies disclose the maximum charges that can be charged, but they generally do not disclose the typically lower, so-called “current,” list or “scale” of charges that the insurer expects to charge in the future, as reflected in the “current” rates that it has used in the actuarial analyses underlying the policy. For example, policies disclose only the guaranteed cost of insurance rates, meaning the maximum that the insurer may charge, but they do not disclose the rates that it expects to charge and on which the nonguaranteed policy values in the illustration are based. The maximum rates may be several times higher than the current rates. This means that the consumer cannot get any realistic idea of the cost of the policy by reading the policy. Disclosure of maximum charges in policies is necessary, but it is not sufficient. The Policy Charges Report described above is needed to educate consumers about the types and magnitude of the fees that will be charged to the consumer.