An allegation of bad faith in claims handling can have far-reaching effects, including drawn-out legal battles resulting in potentially sizable settlements and damage to the organization’s reputation. But bad-faith claims are not always the result of an organization’s deliberate attempt to avoid paying a claim. Rather, they’re often the result of an oversight or miscommunication.
It’s this latter category that claims professionals should focus on. If an insurer is intentionally underpaying its customers or denying claims without valid reason, best practices are not going to improve the situation. But taking a step back and looking at the claims process at an organizational level is an effective way to identify gaps in knowledge or processes that can and do lead to bad-faith claims.
1. Exercise due diligence when investigating claims.
Claims representatives and their insurers’ special investigative units have a lot of experience detecting and investigating fraudulent claims and are trained to watch for specific triggers and red flags. However, a suspicious claim is not always a fraudulent one, and claims representatives must still conduct a fair and balanced investigation. Although this may be difficult, waiting until a definite determination is made is the most prudent way to go.
Even if a claim appears to be fraudulent, it still requires the same level of due diligence throughout the investigation–interviewing witnesses, inspecting property damage, reviewing medical records, etc. Proper documentation goes hand in hand with proper investigation techniques. Claims professionals should encourage the claimant to submit all relevant documentation or evidence, even if the claim seems fraudulent. This documentation may help clear up any uncertainties. And the investigation must be timely as well as thorough. Often, the timeline for an investigation is mandated by regulations or the specific terms and conditions of the policy. Sticking to this schedule is crucial to meeting requirements and maintaining your reputation with the insured. More and more, claimants expect timely updates with faster resolutions. It’s hard to blame them–people want payment for their medical bills or repairs to their homes. Insurers need to stick to the timeline they promised.
2. Rely on a solid claims system.
A good claims system that documents a claim’s progress is one of the best ways to protect your organization should bad-faith claims allegations arise. Claims representatives usually have a lot on their plates; a formal yet easy-to-use framework makes it easier to comply with regulations and the specifics of individual policies.
A robust claims system also helps maintain consistency. A lot of different people may access a claim or contribute to it, such as supervisors, auditors, underwriters and attorneys. Online systems that prevent anyone from changing information once it’s been entered help guarantee that everyone who touches the claim is up to date and on the same page.
3. Make use of experts and mentors to stay informed.
Having a strong support network is essential to anchoring the claims process. Any time a claims representative is unsure of how to proceed when processing a claim, she should know exactly where to go to get an answer and get the claim moving again. That includes an up-to-date claims manual with set procedures and a chain of command with decision makers who can resolve uncertainties during the claims process. Sharing this information should be a top priority during onboarding for claims professionals.
Continuing education is also key. Webinars, designations and state-specific resources detailing evolving regulations and case law are essential. Individual claims representatives should work to expand their knowledge in areas they frequently handle. If you primarily adjust residential claims, become an expert in that field, then use that knowledge to mentor other employees or act as the go-to source of knowledge on that topic.
The National Association of Insurance Commissioners, your state’s insurance department and insurance commissioner, your insurer’s legal and training departments and your direct supervisor are all good sources of information on regulatory standards. States have different laws and court rulings regarding bad-faith claims, and insurers have their own company-specific standards, as well. For larger organizations or individuals in the field who cover a large territory, it may be necessary to keep up with several states’ standards. One possible source: Unity Policyholders, which provided a survey and an overview of bad-faith laws and remedies for all 50 states in 2014.
Claims representatives can often facilitate the claims process simply by listening. Never lose sight of the fact that you may talk to people on some of the worst days of their lives. Sometimes, a person will call, upset and frustrated, and start talking about legal representation. It may be best to listen; it doesn’t mean that you’ll pay the claim or agree to everything they want, but you can offer some compassion and avoid becoming aggressive in turn.
Rarely will all parties agree during the claims process. The key is finding a balance between established procedures that rely on best practices while also leaving enough room in the process to treat each claim uniquely and provide a personal touch for customers.
Interested in learning more about good-faith claims handling? Take a look at The Institutes’ Good-Faith Claims Handling course. For broader claims knowledge, learn about The Institutes’ AIC and Associate in Claims Management (AIC-M) designation programs.
In spring 2016, PwC investigated the current state and future direction of stress testing. We surveyed 55 insurers operating in the US about their stress testing framework and the specific stresses that they test. We also engaged in more detailed dialogue with a number of insurers in the US and globally, as well as with some North American insurance regulators. Our principal conclusion is that stress testing, though well established, would benefit significantly from a modest amount of additional effort. Borrowing terminology from the Pareto principle, we think less than 20 percent more effort would yield 80 percent more value.
A brief history
Thanks to the requirements of the Dodd Frank Act of 2010, we expect that stress testing is the most widely recognized and understood risk management tool. The basic concept is relatively simple and most people in business and government readily accept the notion that if a specified future unfolded –say a repeat of the last economic crisis –it would be good to know ahead of time if banks would remain financially viable. After its initial introduction, stress testing continues to maintain a high level of attention via the ongoing publication of results from the Federal Reserve Board’s Comprehensive Capital Analysis and Review (CCAR) which the media, financial commentators, and the banks themselves eagerly anticipate.
It is easy to see how stress testing concepts in the Dodd Frank Act could apply to insurers. And, indeed the insurance industry (more specifically, its actuaries) has widely used stress testing and scenario analysis for decades.
More recently, 2013 was especially noteworthy for insurance stress testing, with publications on the subject by the North American CRO Council, the CRO Forum and the International Actuarial Association. From a regulatory perspective, the National Association of Insurance Commissioner’s (NAIC’s) Own Risk and Solvency Assessment (ORSA) calls for a prospective solvency assessment to ascertain that the insurer has the necessary available capital to meet current and projected risk capital requirements under both normal and stressed environments. In Canada, the Office of the Superintendent of Financial Institutions (OSFI) has provided clear direction on stress testing governance and methodology in its 2009 publication on Sound Business and Financial Practices (Guideline E-18). It also is noteworthy that, in Europe, despite all of the attention lavished on Solvency II and internal capital models, the European Insurance and Occupational Pensions Authority (EIOPA) launched a Europe-wide stress test for the insurance sector in May 2016.
Equally as important as the regulatory initiatives are the business applications and benefits of stress testing. As we address in more detail below, survey results show that insurers make good use of this risk management tool and are looking to expand its application even further.
A little more effort
We see three areas where only a little more effort can yield substantial benefit: 1) a clearer definition of stress testing, 2) more thoughtful stress construction, and 3) a more robust stress testing platform.
As a start, it will be useful to clarify what we mean by stress testing. As we use the term here, we mean a projection of income statements, balance sheets and –most importantly –projected available and required capital over a multiyear business planning timeframe (including new business over the planning timeframe). Typically the test is done for the entire enterprise and includes a base case and a number of stressed future states. This definition of stress testing is consistent with how both insurance (ORSA Guidance Manual) and banking (FRB CCAR) regulators use the term. It contrasts with risk-specific stress testing. Risk-specific stress testing typically looks at a single risk, often only for the part of the enterprise susceptible to that risk. And, it frequently assesses the impact over a range of stochastically determined scenarios. Distinguishing between stress testing and risk-specific stress testing needs little effort but can help companies avoid considerable confusion as they enhance and apply stress testing capabilities. Only with clear definitions can an insurer evaluate whether or not it has deployed the tool effectively. A vague notion of stress testing taking place somewhere in the organization typically means that there is unawareness of potential gaps in the enterprise risk management (ERM) framework.
Another area where we believe a little more attention would pay major benefits is the development of comprehensive stress scenarios. When describing future states, insurers have many factors to consider in order to articulate the risks that can impact their business. As an indication of the range of these factors, the section of our survey that addressed stresses had 32 questions, many with sub-parts, each covering a different risk. However, rather than starting with an effort to combine all of these risks, stress testing benefits from starting instead with a narrative that articulates a potential future and then addresses how that future would impact the insurer through various risk factors. For example, a stress narrative could be based on a prognosis of an ongoing steady decline in the price of oil and other commodities, then a postulation of the resulting impact on economic growth, interest rates, equity valuation, employment rate, etc. The narrative then could move to an analysis of the impact of these factors on the insurer’s risks, leading to a projection of how the company’s income statement, balance sheet, available and required capital would fare if this future, in fact, unfolded.
Lastly, we note that despite the considerable attention and utilization of stress testing as a management tool, it appears that, for many insurers, the infrastructure that produces results is ad hoc and likely inefficient. Our survey indicates that only 10% of respondents have built a bespoke platform for stress testing. 78% of them use spreadsheets alone or spreadsheets combined with actuarial/projection software. In terms of how long it takes to conduct stress tests, 42% of respondents indicate the process takes between one and two months. A further 35% report that it takes more than two months, and sometimes longer than three months.
While systems infrastructure updates do not normally result in major improvements from little effort, many insurers, particularly in the life sector, have already embarked on a process of modernization. As they are looking to address their risk, actuarial, and financial reporting needs in a comprehensive manner, we recommend that stress testing capabilities receive high priority. With a modest amount of extra effort, insurers should be able to incorporate significant enhancement to their stress testing platform as part of this modernization. This in turn will yield the benefit of more timely, accurate and insightful stress testing results.
A lot more value
Insurers already use their stress testing for many purposes. Survey results show that respondents currently utilize their stress testing for an average of almost five different uses. Additionally, respondents indicated they each had plans to add almost four new uses in the future. More than half of the respondents reported using their stress testing work for strategic planning, calibrating their risk tolerances and limits, assisting with dividend, share-repurchase and similar capital planning, and regulatory impact assessments. These are critical business decisions and further highlight the value of stress testing.
Furthermore, stress testing usage has had a positive impact at a significant majority of respondents’ companies. 36% reported instances where key decisions have been made very differently compared to the process prior to stress testing. An additional 29% reported that the results of stress testing has a measureable influence on decision making, though no specific decisions were cited.
We see a few additional areas where better articulated stress testing processes and procedures could result in significant benefits.
Recognize that stress testing is a separate tool in the risk manager’s tool kit–Frequently, publications and discussions on insurance stress testing describe it as something that supplements other risk management tools. We believe that relegating stress testing to supplementary status undervalues its benefits and contribution. It would be more productive to recognize stress testing for what it truly is: a separate tool with different strengths and applicability compared to VAR-based economic capital.
Some risks –for example, liquidity risk –can be addressed only via a stress test. Adding more required capital does not effectively address the problem; liquidity risk needs to be addressed by developing a preplanned course of action, including accessing prearranged liquid funds. Likewise, reputational risk –and in particular the reputational impact of a cyber event –is better addressed via the stress test tool than via the economic capital route (and the potential addition of more required capital).
Similarly, for some risks where economic capital looks like a satisfactory tool, it can give misleading information. Often pertinent risks only reveal themselves fully via stress testing. New business is a good example. Economic capital can include one or more years of new business, typically by assuming new business premium, claims, expenses, etc. are a replica of previous years’ values. But this fails to provide a platform to study how external factors could impact the insurer’s fundamental business model, leading to little or no sales of any new business that resembles prior years’ business.
Lastly, we note that most other measures, especially traditional economic capital, concern themselves primarily with very extreme, “in the tail” events. Stress testing is useful not only for high impact, low probability events. More likely events warrant attention –in fact, they may warrant more attention because they often represent more tangible and practical problems that management needs to address immediately.
Use stress testing to “war game” management action and prepare in advance for risk crises –In our survey, we asked insurers if stress testing incorporates management actions. In other words, as stress events unfold, presumably management would take some form of corrective action in response, and that corrective action would impact future financial results. Almost half said they do not incorporate management actions. We believe this is a significant oversight.
Stress testing provides a ready platform to prepare in advance for risk crises. Insurers can use the tool to test different responses and select the one that yields the most effective resolution. They then can put in place a contingency plan and pre-event corrections appropriate to the event.
Here again stress testing can provide a different perspective than economic capital and similar measures. Economic capital works well as a tool to quantify the impact of taking certain types of action in the present. For example, it can help determine the reduction in required capital if a particular reinsurance treaty were implemented. On the other hand, faced with a multifactor, multiyear stress event (perhaps including changes in interest rates, inflation and equity values, with increases in unemployment and deteriorating buying patterns), stress testing would be a more effective tool in judging if and when to reconfigure the asset portfolio, alter products and prices, and the cost and manner of reconfiguring staffing models.
It is worth noting that, in our discussions with regulators about the merits of including the impact of management actions, their expectations are that, yes, insurers should include them. They recognize the benefit that stress testing can provide as an opportunity for planning ahead. However, they indicated that it would be appropriate to show the stressed result both before and after the application of management action. Showing both results can help promote thoughtfully developed post-management action results, not just a broad assumption that management will take appropriate actions.
Take advantage of the board’s and senior management’s broad business insights to construct more insightful stress narratives –Our survey shows that most boards receive the results of the stress test either directly or via the risk committee of the board. However, only 11% report asking either the board or board risk committee to approve the stresses the company uses. We believe this represents a missed opportunity to gain board members’ insights and benefit from their engagement in the stress testing process. Not all directors will necessarily have detailed knowledge of the range of potential outcomes of all of the risks that can impact an insurer or the potential stochastic distributions of those risks, but directors typically are experienced and knowledgeable, often with a high level of business and economic acumen. Utilizing their individual and collective skills to contribute ideas on the types of stresses that merit study seems like a good fit for their role and an effective complement to managements’ efforts.
Stress testing represents a potential avenue for global capital consistency –As a final potential benefit, we note again that stress testing seems to have a role in all major insurance and other financial services regulatory regimes. At the same time, the global insurance industry is challenged by the task of agreeing to a capital adequacy ratio, presumably based on an economic capital VAR-like foundation. A simpler capital formulation coupled with a robust stress testing regime may hold more promise for a globally agreeable approach.
Based on survey results and various discussions we had with insurers and other stakeholders, stress testing is universally accepted as a useful tool. We suspect that this is a consequence of its being directly related to the common business practice of preparing a financial plan. Including a few more future states or stresses and incorporating a measure of required and available capital in the financial plan are not major steps. Accordingly, the transition from planning to stress testing should be easy to accommodate. We note how sharply this contrasts with the introduction of economic capital, especially in the US insurance industry. Though its usage is growing, economic capital is not a uniformly accepted regulatory and business tool even after two decades. On the other hand, stress testing is already actively and universally used as a management and regulatory tool. With a little more effort, we believe it can yield very substantial benefits for all.
“Do you know where your children are?” That was a popular catchphrase in a TV public service announcement.
Do you know where your reinsurance program is? Many senior executives at insurers can’t say for sure.
Many insurers find it a struggle to document their ceded reinsurance program (the risk they have transferred to a reinsurer) in a way that’s acceptable to regulators—and senior management—because they have not automated management of ceded reinsurance policies, data and claims. According to a recent survey, only 14% of primary carriers have a reinsurance system. Most insurers still use spreadsheets or other manual methods to keep track of their reinsurance contracts and claims.
The NAIC Risk Management and Own Risk and Solvency Assessment Model Act (RMORSA) became effective in January 2015, and many states have adopted this model legislation. RMORSA requires insurers to have a systematic way of identifying, assessing and managing risk, and everything related to reinsurance is certainly part of it. Under it, insurers are required to submit an annual summary report to their primary regulator. A key part of complying with RMORSA, and other regulations, will be documenting reinsurance coverage in detail.
It is possible to comply with RMORSA without a true reinsurance system. But it’s a difficult, time-consuming process that doesn’t guarantee good results. Using a spreadsheet and other manual methods to track contracts and claims doesn’t give you everything you need in one place for regulatory filings. For instance, an insurer might not being able to identify out-of-compliance policies. This can occur when a reinsurer requires one or more exclusions in the policies it reinsures. If the insurer issues the policies without the exclusions, the policies are out of compliance, and the reinsurer may deny liability when there’s a claim.
But complying isn’t just a bureaucratic exercise. The RMORSA process also helps insurers get a clearer picture of their risks—and what could be more important for a company whose business is managing risk?
Implementing a modern reinsurance management system enables complete automation, controls and audit trails. It will generate Schedule F and statutory reporting at a click of a button. This, in turn, will reduce Schedule F penalties to the bare minimum.
Regulatory compliance is hardly the only reason to use dedicated software to track ceded reinsurance. Intricate reinsurance contracts and special pool arrangements, numerous policies and arrays of transactions create a massive risk of having unintended exposures. Inability to ensure that each insured risk has the appropriate reinsurance program associated with it is a recipe for disaster.
An insurer must track and integrate many reinsurance processes. They include cession treaties and facultatives, claims and events, policy management, technical accounting (billing), bordereaux/statements, internal retrocession, assumed and retrocession operations, financial accounting, accounts payable, accounts receivable, regulatory reporting, statistical reports (such as triangulation per line of business, type of contract and region) and business intelligence.
With fragmented solutions such as spreadsheets and manual processes, things often fall between the cracks because there are so many reinsurance-related items to manage. Financial information for trends, profitability analysis and exposures becomes unreliable. Automating processes can reduce the chances of missing something important to almost zero.
Stanching Claims Leakage
One of the biggest problems is claims leakage. How do you know when a reinsurer owes your company money? Answering that question is not as straightforward as it seems, given the complexity of many different types of reinsurance contracts.
For instance, after implementing a reinsurance solution, a European insurer detected more than $1 million of overlooked claims. (You can’t file a claim if you don’t know you have one.) It contacted its reinsurer, which paid promptly.
The situation for insurers that don’t automate will only get worse. Many of the experienced reinsurance administrators have retired or will be retiring in the next few years, and there are few in the pipeline coming up. With reinsurance becoming ever more complicated, the only feasible answer for insurers is a comprehensive reinsurance system that puts everything in one place. The effort and cost are well worth the benefits in staff productivity, risk reduction, better claims tracking and improved regulatory compliance—to avoid RMORSA remorse and a host of other problems.
The complexities of the current regulatory environment undoubtedly pose significant challenges for the broad spectrum of financial services companies, as regulators continue to expect management to demonstrate robust oversight, compliance and risk management standards. These challenges are generated at multiple (and sometimes competing) levels of regulatory authority, including local, state, federal and international, as well as, in some cases, by regulatory entities that are new or have been given expanded authority. Their demands are particularly pressing for the largest, most globally active firms, though smaller institutions are also struggling to optimize business models and infrastructures to better address the growing regulatory scrutiny and new expectations.
Across the industry, attentions are focused on improving overall financial strength and stability, guided by the recommendations of international standards-setting bodies and U.S. regulatory mandates that encompass governance, culture, risk management, capital and liquidity. Though historically under the purview of individual states, the insurance sector in the U.S. has been responding to influences at both the international and federal levels. The efforts of the International Association of Insurance Supervisors (IAIS) to develop insurance core principles (ICPs), a common framework for the supervision of internationally active insurance groups (IAIGs) and capital standards, have all laid the foundation for global regulatory change. These efforts have been further supported by new authorities given to the Federal Reserve Board, the Financial Stability Oversight Council and the Federal Insurance Office and by the designation of certain nonbank insurance companies as systemically important financial institutions (SIFIs). Following are some of the key regulatory issues we anticipate will have an impact on insurance companies this year:
1. Strengthening Governance and Culture
Despite heightened attention from regulators and organizations to strengthen governance structures and risk controls frameworks, instances of misconduct (i.e., professional misbehavior, ethical lapses and compliance failures) continue to be reported across
the financial services industry, including the insurance sector,
with troubling frequency. Boards and senior management are
now expected to define and champion the desired culture within their organizations; establish values, goals, expectations and incentives for employee behavior consistent with that culture; demonstrate that employees understand and abide by the risk management framework; and set a “tone from the top” through their own words and actions.
Line and middle managers, who are frequently responsible for implementing organizational changes and strategic initiatives, are expected to be similarly committed, ensuring the “mood in the middle” reflects the tone from the top. Regulators are also assessing an organization’s culture by looking at how organizations implement their business strategies, expecting firms to place the interests of all customers and the integrity of the markets ahead of profit maximization. They will consider business practices and associated customer costs relative to the perceived and demonstrable benefit of an individual product or service to the customer, giving attention to sales incentives and product complexities.
State and federal insurance regulators have joined the global push for enhanced governance, and, in 2016, insurers can expect heightened attention in this area through the Federal Reserve Board’s (Federal Reserve) supervision framework and its enhanced prudential standards (EPS) rule; the Financial Industry Regulatory Authority’s (FINRA) targeted review of culture among broker-dealers; and the National Association of Insurance Commissioners’ (NAIC) Corporate Governance Annual Disclosure Model Act, which became effective Jan. 1, 2016, and requires annual reporting following adoption by the individual states. Given the regulatory focus on conduct, insurers might experience some pressures to put in place governance and controls frameworks that specifically recognize and protect the interests of policy holders.
2. Improving Data Quality for Risk Data Aggregation and Risk Reporting
Financial institutions continue to struggle with improving their risk-data aggregation, systems and reporting capabilities, which means insurers, in particular, will be challenged to handle any coming changes in regulatory reporting, new accounting pronouncements, enhanced market opportunities and increasing sources of competition because of legacy actuarial and financial reporting systems. These data concerns are augmented by information demands related to emerging issues, such as regulatory interest in affiliated captives. In addition, there are expected requirements of anticipated rulemakings, such as the Department of Labor’s Fiduciary Rule, which necessitates a new methodology or perspective regarding product disclosure requirements and estimations of the viability and benefits of individual products. There is also the Federal Reserve’s single counterparty credit limit (SCCL) rule, which requires organizations, including nonbank SIFIs, to track and evaluate exposure to a single counterparty across the consolidated firm on a daily basis. Quality remains a challenge, with data integrity continually compromised by outmoded technologies, inadequate or poorly documented manual solutions, inconsistent taxonomies, inaccuracies and incompleteness.
Going forward, management will need to consider both strategic- level initiatives that facilitate better reporting, such as a regulatory change management strategic framework, and more tactical solutions, such as conducting model validation work, tightening data governance and increasing employee training. By implementing a comprehensive framework that improves governance and emphasizes higher data-quality standards, financial institutions and insurance companies should realize more robust aggregation and reporting capabilities, which, in turn, can enhance managerial decision making and ultimately improve regulatory confidence in the industry’s ability to respond in the event of a crisis.
3. Harmonizing Approaches to Cybersecurity and Consumer Data Privacy
Cybersecurity has become a very real regulatory risk that is distinguished by increasing volume and sophistication. Industries that house significant amounts of personal data (such as financial institutions, insurance companies, healthcare enrollees, higher education organizations and retail companies) are at great risk of large-scale data attacks that could result in serious reputational and financial damage. Financial institutions and insurance companies
in the U.S. and around the world, as well as their third- party service providers, are on alert to identify, assess and mitigate cyber risks. Failures in cybersecurity have the potential to have an impact on operations, core processes and reputations but, in the extreme, can undermine the public’s confidence in the financial services industry as a whole. Financial entities are increasingly dependent on information technology and telecommunications to deliver services to their customers (both individuals and businesses), which, as evidenced by recently publicized cyber hacking incidences, can place customer-specific information at risk of exposure.
Some firms are responding to this link between cybersecurity and privacy by harmonizing the approach to incidence response, and most have made protecting the security and confidentiality of customer information and records a business and supervisory priority this year. State insurance regulators have a significant role in monitoring insurers’ efforts to protect the data they receive from policyholders and claimants. In addition, they must monitor insurers’ sales of cybersecurity policies and risk management services, which are expected to grow dramatically in the next few years. Insurers are challenged to match capacity demands, which may lead to solvency issues, with buyers’ needs and expectations for these new and complex product offerings. The NAIC, acting through its cybersecurity task force, is collecting data to analyze the growth of cyber-liability coverage and to identify areas of concern in the marketplace. The NAIC has also adopted Principles for Effective Cybersecurity: Insurance Regulatory Guidance for insurers and regulators as well as the Cybersecurity Consumer Bill of Rights for insurance policyholders, beneficiaries and claimants. Insurance regulatory examinations regularly integrate cybersecurity reviews, and regulatory concerns remain focused on consumer protection, insurer solvency and the ability of the insurer to pay claims.
4. Recognizing the Focus on Consumer Protection
In the past few years, the Consumer Financial Protection Bureau and the Federal Trade Commission have pursued financial services firms (including nonbanks) to address instances of consumer financial harm resulting from unfair, deceptive or abusive acts or practices. The DOL Fiduciary Rule redefines a “fiduciary” under the Employee Retirement Income Security Act to include persons — brokers, registered investment advisers, insurance agents or other types of advisers — that receive compensation for providing retirement investment advice. Under the rule, such advisers are required to provide impartial advice that is in the best interest of the customer and must address conflicts of interest in providing that advice. Though intended to strengthen consumer protection for retirement investment advice, the rule is also expected to pose wide-ranging strategic, business, product, operational, technology and compliance challenges for advisers.
In addition, the Securities and Exchange Commission (SEC) has announced it will issue a rule to establish a fiduciary duty for brokers and dealers that is consistent with the standard of conduct applicable to an investment adviser under the Investment Advisers Act (Uniform Fiduciary Rule). The consistent theme between these two rules is the focus on customer/investor protection, and the rules lay out the regulators’ concern that customers are treated fairly; that they receive investment advice appropriate to their investment profile; that they are not harmed or disadvantaged by complexities in the investments markets; and that they are provided with clear descriptions of the benefits, risks and costs of recommended investments. In anticipation of these changes, advisers are encouraged to review their current practices, including product offerings, commissions structures, policies and procedures to assess compliance with the current guidance (including “suitability standards” for broker/dealers and fiduciary standards for investment advisers, as appropriate) as well as to conduct impact assessments to identify adjustments necessary to comply with the DOL Fiduciary Rule. Such a review should consider a reassessment of business line offerings, product and service strategies and adviser compensation plans.
5. Addressing Pressures From Innovators and New Market Entrants
The financial services industry, including the insurance sector, is experiencing increased activity stemming, in large part, from the availability of products and services being introduced to meet the growing demand for efficiency, access and speed. Broadly captioned as financial technology, or FinTech, innovations such as Internet-only financial service companies, virtual currencies, mobile payments, crowdfunding and peer-to-peer lending are changing traditional banking and investment management roles and practices, as well as risk exposures. The fact that many of these innovations are being brought to market outside of the regulated financial services industry — by companies unconstrained by legacy systems, brick-and- mortar infrastructures or regulatory capital and liquidity requirements — places pressures on financial institutions to compete for customers and profitability and raises regulatory concerns around the potential for heightened risk associated with consumer protection, risk management and financial stability.
For insurance companies, the DOL Fiduciary Rule will affect the composition of the retirement investment products and advice they currently offer and, as such, creates opportunity for product and service innovation as well as new market entrants. Insurers will want to pursue a reassessment of their business line offerings, product and service strategies, and technology investments to identify possible adjustments that will enhance compliance and responsiveness to market changes. Regulators will be monitoring key drivers of profit and consumer treatment in the sale of new and innovative products developed within and outside of the regulated financial services industry.
This piece was co-written by Amy Matsuo, Tracey Whille, David White and Deborah Bailey.
Just as all mortgage lenders make sure every homeowner has fire insurance before approving any loan and all new car buyers make sure their auto policy covers their purchase before they drive it off the dealer’s lot, almost everyone acknowledges that protecting against catastrophes is a financial planner’s paramount obligation—if not the first imperative. Life insurance assessments and analysis, consequently, are an intrinsic part of any good and thorough financial planning done for individuals, families or businesses.
The life insurance industry, however, has lacked clarity. Unfortunately, it has not adopted the transparent practices that characterize the financial planning profession, because life insurance largely developed independently from its financial planning industry peers. This has resulted in some agents and financial planners having inadequate knowledge of life insurance matters. This article aims to remedy this by providing agents and financial planners with specific information and approaches for successfully addressing how to obtain good value in a life insurance policy.
Nearly 20 years ago, the Society of Actuaries stated, “Sales illustrations [of life insurance policies] should not be used for comparative policy purposes.” And yet, unfortunately, even today, relatively few life insurance marketplace participants—agents, financial planners and consumers—fully understand this fact and its implications. While there is certainly some awareness that an illustration is not the policy, until illustrations and policies are genuinely and separately understood, obtaining good competitive value in the life insurance marketplace will remain a very challenging endeavor—even for those who prefer term “insurance.”
Illustrations of any and all cash value life insurance policies can be made useful, bringing genuine clarity and understanding of these policies to all. From such transformation springs the realization of the critical importance of actually understanding a cash value life insurance policy’s financial mechanics, its operating practices and the insurer’s future financial performance. Given that a policy’s financial performance depends on a series of annual costs and annual rates of returns, there are several ways that financial planners and agents can use the understanding gained from these transformed illustrations. The significance of these changes is manifold: better value for consumers, better product usage, better societal allocation of resources and a transformation in both the practice and the public perception of the expertise, trustworthiness and overall professionalism of those selling and advising about insurance products.
A Review of Cash Value Life Insurance Policy Illustrations and Analytical Approaches
Illustrations show various policy-related values—such as premiums, death benefit and cash values—for every year until the insured’s potential 121st birthday. These pages of numbers, however, are not projections; that is, they are not meant as estimates of future performance. An illustration is simply a snapshot of current or assumed performance; the underlying factors of performance are “illustrated,” essentially remaining constant (or as is) over the years. Illustrations are fundamentally nothing but calculations of numerous policy-related values, based on the assumed and largely undisclosed input factors—the underlying factors of performance.
Countless problems have arisen from misunderstandings of the limited nature of illustrations. The sales scandals of the 1980s and 1990s, where premiums did not “vanish” as proclaimed, are well-known examples. In response, the National Association of Insurance Commissioners (NAIC) mandated multi-page illustrations that now contain not only guaranteed and illustrated values but also mid-point values and definitions of terminology. While mid-point values do indicate there is some uncertainty about the “illustrated values,” they do little to foster the necessary and genuine understanding of cash value policies. Many consumers now erroneously think the mid-point values are somehow more likely and more reasonable than the illustrated values.
More problematically, many insurers and agents currently rank policies as competitive or not based on policy illustrations. Misleading conclusions about a policy’s attractiveness are also frequently drawn, for example, from its illustration’s cash value rate of return after 20 years, without simultaneously acknowledging such attractiveness is merely produced by the illustration’s assumptions (and is therefore virtually meaningless in measuring real competitiveness). Moreover, agents—especially when selling whole life and other cash value policies—often use a supplemental illustration like the one in Table 1; they save the NAIC multi-page form, with its text that tediously covers simple matters while ignoring significant ones, for the insured to sign when completing the application. While there is currently no news in the mainstream media regarding problematic life insurance illustrations and sales practices, there are still extensive and serious problems in the life insurance marketplace arising from the use and misuse of policy illustrations and information.
A review of the literature shows that a handful of approaches have been used to try to analyze cash value life insurance policies. The NAIC introduced the interest-adjusted indices in the 1970s, but this approach is inherently flawed. Its attempt to represent (what is at least) a two-dimensional product with one measurement is as flawed as trying to completely describe a rectangle with one measurement. The NAIC measurements are neither a rate of return nor a readily understood cost and are therefore not helpful in the financial world, where costs and rates are the primary concerns. The measurements cannot be used to compare “dissimilar” policies, and, as currently disclosed and implemented, they are based solely on illustrated values.
Some practitioners still use an approach developed in the 1960s by actuary Albert Linton. This approach analyzes whole life policies by making assumptions about the cost of such term coverage and calculating a yield or rate or return on the stream of “net” premiums (net of mortality costs) and the illustrated cash values. On the other hand, Professor Joseph Belth has proposed a policy disclosure approach that relies on applying an individually chosen discount rate to an illustration’s values to calculate yearly costs. Neither Linton’s nor Belth’s approach, given their assumptions, can be called “disclosure,” as neither provides an explanation of what really is being illustrated or what really occurred, in the case of an actual policy history. Both approaches are akin to viewing a policy through a funhouse mirror—they show you something, but it is not a truly accurate picture.
Others use homespun analytical approaches, often focusing on one aspect of these three approaches, such as rate of return of cash values or death benefits on premiums paid. Still other practitioners, who advocate viewing cash value policies as packages of options (not an invalid perspective, as almost anything can be viewed from an options perspective, but not a particularly useful one), have then either failed to provide the costs of such bundled products or have erroneously confused analysis of an illustration for analysis of a policy. All such approaches fall short of proper, accurate and complete analysis of a cash value life insurance policy.
An Informative Illustration: Its Construction and Use
Cash value life insurance policies, while bewildering to many, are fundamentally simple products. Annual costs and compounding rates are the building blocks of these policies and the basic input assumptions that create the illustration. Merely using a whole life policy’s illustration, as shown in Table 1, and its embedded information, as shown in Table 2, presents this whole life policy’s illustrated values in a much more informative way. This informative illustration is constructed by reverse-engineering the illustration’s values. To do so, the illustration’s current values in Table 1 are discounted by the illustration’s assumed dividend rate, and the guaranteed values are discounted by this policy’s guaranteed interest rate. Given that this particular whole life policy was issued in 1989, the then-current illustrated rate was 10%, and the guaranteed rate was 5.5%. Just as it is essential when disassembling a house to take it apart by its components, it is similarly essential in deconstructing an illustration. Only by discounting with the rate used to construct the illustration does one acquire the specific stream of cost assumptions used in the illustration.
In addition to calculating the maximum and illustrated streams of annual costs for the total amount of coverage provided, it is useful to calculate the cost per thousand dollars of coverage by dividing each annual cost by that year’s specific at-risk amount. Only then, after the illustration’s specific stream of annual cost assumptions has been extracted, is it appropriate to use a user-chosen discount rate (in this case 5%) to discount the stream of costs to calculate present value figures, which then can be compared with other similarly calculated figures. And, as will be discussed below, the stream of total annual costs can be disaggregated into its three primary components: (1) sales-related, (2) taxes and (3) claims. The last includes all other non-sales and non-tax costs, such as underwriting and administration, which can be compared with, or expressed as, a percentage of the relevant maximum Commissioners Standard Ordinary (CSO) mortality table figures.
From this straightforward information, users can readily see the input assumptions regarding maximum annual costs, illustrated annual costs, illustrated costs per thousand dollars of coverage and the compounding rate(s) on which the illustration was built. Users can also readily comprehend that the differences between illustrated and guaranteed values are a function of: (1) the differences between the guaranteed and illustrated annual costs and (2) the differences between the guaranteed compounding rate and the illustrated rate applied to cash values. This informative illustration perspective does not prevent or preclude a more traditional approach in which an illustration might be re-run at a lower interest rate or be “mentally modified” to adjust for seemingly favorable and unrealistic mortality costs. Similarly, it does not prevent or preclude any practitioner from conducting any conventional rate-of-return analysis, such as a rate of return that the cash values provide on the premiums, which is simply a netting of the impact of insurance costs out of the illustration’s rate.
This perspective provides a more structured, straightforward and simple framework from which to make, disclose and analyze policy features. For example, Table 2 shows that the insured in a whole life policy, belying common agent misrepresentations, does not pay for a lifetime of coverage upfront and that the annual costs of coverage continue to increase as the insured ages. Table 2 could be amended to include any other Table 1 values, such as dividends. Table 2 brings a transformative understanding to the otherwise opaque NAIC and traditional illustrations. The illustration is shown to be the consequences of its assumptions, and those assumptions are revealed.
When a client buys a cash value policy, she is actually buying the insurer’s operating practices and future financial performance, not the illustration. Again, the illustration is not the policy; demystifying the illustration leads to a vivid understanding of this fact. When consumers and planners fully understand the mechanics of an illustration—that it is based on assumptions regarding annual costs and compounding rates—they are motivated to demand information relevant to assessing such matters for the actual policy. Insight and understanding lead to inquiry.
While no decision should ever be based on a sales illustration itself, by demystifying conventional illustrations, the informative illustration shines the spotlight on the input factors that are worthy of evaluation. Policy illustrations no longer remain simultaneously alluring and bewildering. Moreover, when the product’s factors of performance are revealed, they can be evaluated. Obviously, such evaluations require knowledge of financial benchmarks
of attractive performance, which can be assembled from various sources of financial information. While reviewing such approaches is outside this article’s scope, one common approach to assessing future performance is reviewing (correctly, and with all the appropriate caveats) the competitiveness of past performance.
An Informative Illustration of Historical Policy Performance
Policy comprehension dramatically expands when historical performance is presented on a year-by-year basis, as shown in Table 3 for the illustrated whole life policy. (Again, the policy illustrated in Table 1 was actually a current illustration for a whole life policy sold in 1989; that is how its historical data is now available.) The historical performance shows that the insurer’s dividend rate declined over 20 years and that its actual costs were less than those originally illustrated. This combination of presenting an informative illustration, as shown in Table 2, with the historical information in Table 3 enables marketplace participants to readily comprehend policies and to ask various relevant and necessary questions. For instance, the illustrated 10th and 20th years’ costs were, respectively, $1,230 and $3,100, while in actuality they were $919 and $1,601. Table 3 clearly suggests an attractive policy must provide competitive performance with respect to both cost and rate components.
Again, actual historical policy performance, like any performance, needs to be assessed and understood in context and comparatively; that is, with knowledge of how it was achieved and how it compares with competitive alternatives. Table 3’s format clearly facilitates such comparisons, and many parties—life insurers, regulators, insurance professors, financial publishers, journalists, agents and planners—could play valuable roles in assembling the benchmark information necessary to conduct such comparisons.
The comparison of two policies’ actual performance data shows even more thoroughly the real value of the informative illustration format with its emphasis on policy performance factors. Policy XYZ in Table 4 has, especially over the last several years, significantly greater costs and significantly lower cash value returns. While applying historical performance data should only be done with a full understanding of its limitations (future investment performance being independent of past performance and its possible inapplicability to new products), this comparison provides useful and powerful information regarding policy replacement questions.
Three important observations regarding this policy’s actual financial performance should be noted. First, this policy’s actual financial performance, along with that of all the insurer’s other policies, can be reconciled with the insurer’s actual financial performance—as reported in its annual statement filed with the regulators. Admittedly, sufficiently precise reconciliations can be tediously challenging exercises in data collection and analysis, but, in contrast to some practitioners’ mistaken beliefs, they are hardly impossible. Second, attempts to misrepresent how a particular policy’s historical performance was achieved are largely self-defeating. For example, trying to overstate the policy’s average historical annual rate of return also overstates annual costs, thereby undermining the objective of the attempt to overstate the rate, and can prove irreconcilable with company financials and its other policies’ performances. Third, financial performance on publicly marketed products is not proprietary; preserving the secrecy of such information in the life insurance marketplace merely forces consumers to unwittingly bear the costs and consequences of non-competitive policies.
Comparing Cash Value Policies With Buying Term and Investing the Difference
When life insurance policies are understood as nothing but the functioning of a stream of costs, rates of return on cash values, the insurer’s operating practices and cash value policies’ tax privileges, it becomes relatively easy and straightforward to compare cash value and pure term policies and to help clients understand these alternatives. While many insurers and agents produce illustrations that compare a whole life policy with buying term and investing the difference (the BTID alternative), most comparative illustrations do little to facilitate a consumer’s comprehension of the causes of the underlying differences.
Suppose, for example, that a 43-year-old female client wants $1 million of life insurance coverage until age 63, and she is interested in assessing which alternative (a whole life policy or buying term and investing the difference) provides the best value over this 20-year duration. Table 5 shows the usual comparative illustration values, but it does so with the death benefits omitted (simply to save space, as they could be equal or immaterially different), and assumes the side fund grows without taxes until the end of each analyzed duration.
For the whole life policy, Table 5 also shows the illustrated annual costs, as these reverse-engineered figures are necessary to calculate and to explain the differences in after-tax values shown in Table 6. Table 6 shows that once the whole life policy’s cash value exceeds its cost basis, the differences in after-tax values between these two alternatives depend on three specific and quantifiable factors: (1) the value of the term cost tax shield, (2) the value forgone by any possible greater annual costs of the cash value policy and (3) the differences between the rate of return assumptions in the two alternatives—all calculated applying simple formulas to the basic input data. No significance should be attached to this particular table’s results.
This analytical perspective and formula bring clarity to the age-old dispute between whole life and the BTID alternative. This dispute is not an ideological matter, rather an empirical one. In particular, the 20th year’s $6,509 after-tax advantage of the cash value policy as shown in Tables 5 and 6 provides no basis for generalization, because its advantage can be seen as arising strictly from its assumed inputs, which, given the assumed difference in rates of return between the cash value policy and the separate side fund (6.5% versus 4%), might well be deemed unrealistic or unjustified. But, again, the numbers in the example have been chosen simply for educational purposes of showing how the formulas work. Table 6’s analysis facilitates comprehension of the reasons why one alternative or the other in any comparative illustration appears superior. This comprehension, just like the above comprehension of an illustration, leads to natural follow-up questions regarding the real-world performance factors of the two alternatives.
The advantages of a cash value policy do not arise from its somehow avoiding the ever-increasing costs of coverage as the insured ages. Similarly, cash value policies do not inherently constitute unattractive investment vehicles (the historical investment-related performance in Table 3, where the whole life policy’s average annual rate of return over the recent 20-year period was 8.43%, certainly shows much conventional disparagement can be erroneous and misguided). This presentation can be useful in confronting the misinformation that has been promoted by advocates on both sides of the dispute between whole life and term. As is so often the case with contentious issues, they can be readily resolved and dispelled with facts.
The fundamental advantages of traditional cash value life insurance arise from the product’s tax advantages. These advantages are free, non-proprietary inputs, which, in a properly functioning marketplace, cannot be used to extract value from an informed consumer. While whole life was created long before our current tax system, and while some of its sales agents prefer to pretend that it is not composed of term insurance, such pretensions in light of the above analysis will be futile. Whole life’s components and operational aspects are subject to mathematical analysis just like all other financial products. This analysis strongly suggests the industry’s practices of paying large commissions for the sale of whole life and other cash value policies cannot be sustained in a marketplace of informed consumers. It also shows that assessing the competitiveness of any recommended life insurance policy, even a term policy, requires taking into account the tax advantages of a competitively priced cash value policy. The lowest-cost term policy over 20 or 30 years may not actually be the most competitive product on an after-tax cost basis—the most important basis on which to assess costs.
The costs of life insurance products comprise the following very basic components: sales-related costs, premium-related taxes and claim costs—which include all non-sales and non-tax costs, such as underwriting expenses, administration and profits. Of these component costs, some are subject to greater competitive pressures than others. For instance, while premium taxes are set by statute, and claims are largely a function of underwriting standards and policyholder persistency, sales-related costs are potentially much more subject to market forces. The whole life policy shown in Table 3 actually had total cost over 20 years of $20,195, or $83.70 per thousand dollars of coverage (costs measured on a present value basis using a 5% discount rate). Of these costs, approximately 11% were for taxes paid by the insurer, 42% were for claims, administrative costs, etc., and 47% were sales-related. Clearly, when the transparency provided by the informative illustration becomes pervasive, cash value policies with lower-than-traditional sales loads become increasingly attractive.
Current policy illustrations do not facilitate comprehension of a policy’s financial mechanics. Problems have been identified with widely used policy analysis approaches (the NAIC’s, the Linton yield, Belth’s and others). An informative illustration was created from a commonly used illustration, transforming it by revealing its inherent cost and rate assumptions. From such understanding, consumers’ demand for relevant additional information naturally rises.
Disclosure of life insurance, like that of virtually any financial product, has fundamentally been a two-step process: (1) provide a description of how the product or illustration works, and (2) provide performance information so one can assess and search for competitive performance. The informative illustration shown in Table 2 achieves the first step. Tables 3 and 4 provide examples of some of the necessary performance information to complete the second step.
Using the analytical framework of a policy’s financial mechanics—as a system with a stream of annual costs and annual rates of return—a comparison of whole life with the alternative of buying term and investing the difference brings meaningful insight to this age-old controversy. No one should buy a financial product they do not understand.
For clients’ in-force cash value policies, planners can transform any insurer-provided illustration into an informative illustration and should certainly do so for any contemplated new purchase. Then, planners can engage in financial analysis of life insurers’ operations to assess the likely competitiveness of the insurer’s future performance and that of its policies. These steps enable financial planners and agents to provide better advice to their clients and help clients better understand life insurance matters.
Practitioners usually do not assess the financial performance of life insurers’ policies with anything similar to the sophistication of financial analysis routinely applied to equities, bonds, mutual funds or other important financial products. Now, however, financial planners and agents who understand the vital role risk management plays in financial planning but have been unsatisfied by non-transparent insurance products can apply the analytical structure of an informative illustration to motivate and facilitate their work.