Life insurance sales nearly always rely on multiple-year policy illustration sheets. There are some basic similarities among policy illustrations, such as a listing of the annual premium and the policy�s cash value for each policy duration up to 20 years after policy issuance. However, despite the similarities, there were no uniform standards applicable to policy illustrations prior to 1997. The organization of illustrative information within a single report varies drastically from one insurance company to another even if the same information is contained in the report.

Policy illustrations or ledger sheets usually cover at least 10 years of data and often cover 15 or 20 years. The years are usually presented in a single column of such an illustration with the figures in this column referring to the number of years after the date of policy issuance. Some illustrations present both the years column and an attained-age column in order to show the age of the insured at each displayed policy duration. There are, however, some illustrations that present only the attained-age information and do not present the years of duration since policy issuance. Presentation of only one of these columns is not a serious omission because the omitted column can be derived from the column that is included in the illustration.

The one convention that is very frequently followed is to represent separate years on separate rows of the policy illustration. Each column generally represents a separate category of data such as age, premium, cash value, loan, death benefit, and so forth.

The following is an example of one of the simpler illustrations showing only policy year, gross annual premium, dividends, and net premium after dividends. Policy illustration 1 in table 10-2 does not even present the cash values for the policy.

There are some shortcomings with even this simple type of illustration. The summation of premium payments from the different years is inappropriate unless the values are adjusted by an interest factor to make them comparable. In fact, it is inappropriate to combine any dollar amounts from different time periods unless they are adjusted for interest.

It is appropriate to add or subtract values from the same time period. In the example, the dividends are deducted from the gross premium due in the same period in order to correctly determine the net premium due. These net-prem-ium-due values can all be adjusted for interest to determine what beginning balance would be needed in an interest-bearing account to pay all of the net-premium-due amounts as they become payable. This adjusted amount is the present value of all 20 net-premium payments. When a 5 percent interest rate is used, the present value of these net premiums due is $2,273. In other words, an account with a present balance of $2,273, which is earning 5 percent interest, would be sufficient to pay all 20 premiums because the interest earnings of $1,484 plus the starting fund balance would cover the aggregate payments of $3,757.

Another way of adjusting payments from different time periods is to calculate the accumulated values. This calculation merely adjusts all payments to the end of the selected time period. The same result is obtained by depositing each net premium due into an interest-bearing account and letting the interest accumulate in the account. The balance in the account at the end of the period is the accumulated value for the specified interest rate, time period, and payments. This accumulated value for the example in policy illustration 1, based on 5 percent interest for the full 20 years, is $6,032. This value may be thought of as an opportunity cost of the premium payments. The policyowner is giving up the equivalent of the accumulated value that could have been invested had it not been allocated to life insurance premiums.

Obviously the particular interest rate used has a strong influence on the adjusted present values and accumulated values. There is an inverse relationship between the interest rate and the resultant present values. That is, higher interest rates result in lower present values, and lower interest rates produce higher present-value amounts. To illustrate this point, reconsider the present value given above. The value was $2,273 when based on 5 percent interest. The calculated present value of the same premiums was $1,524 based on 10 percent interest. Similarly the accumulated value of those 20 net premiums was $6,032 when based on 5 percent interest, but would have had an accumulated value of $10,252 if it had been based on 10 percent interest. This demonstrates the direct relationship between interest rates and accumulated values. Higher interest rates produce higher accumulated values and lower interest rates produce lower accumulated values.

The choice of the proper interest rate is both important and difficult. The difficulty arises from the fact that the rate chosen should represent actual aftertax investment rates of return for the particular policyowner over the selected future period. Any attempt to represent unknown future interest rates is necessarily an estimate or a guess. It is important to select an interest rate that is a relatively accurate representation of actual rates over the period because slight changes in the interest rate result in significant changes of the present values and accumu-lated values being calculated and compared.

The interest-adjusted indexes required by law in nearly every state specify an interest rate of 5 percent. The concern of these state statutes or regulations is not the accuracy of the interest rate in representing the actual future interest but rather a need for comparability of indexes for different policies. Indexes based on different interest rates are not directly comparable. Thus the prescribing of one interest rate results in comparison indexes that can be used without needing any further adjustments.

Ledger statements and policy illustrations that do not include interest adjustments are really based on an implicit assumption that the interest rate is zero and the inflation rate is zero. Dollar amounts from different time periods are comparable without adjustment if, and only if, funds can be borrowed without paying interest and if prices remain stable or unchanged over the time interval. The subtotals in the first illustration after every 5 years are examples of unadjusted values from different years that have been added together. Similar illustrations that include policy cash values often imply that the coverage is free because the cash value eventually exceeds the aggregate premiums paid unless the premiums are adjusted for interest. Many policy illustrations are intended to preserve the traditional net-cost policy comparisons that ignore interest. Illustrations that present interest-adjusted figures are preferable because of their enhanced accuracy over unadjusted values.

There are many types of policy illustrations. The simplest types, which are similar to the illustration already discussed, merely show how much will have to be paid out-of-pocket to keep the policy in force. Many illustrations omit the suggested dividends but contain cash value and death-benefit values. It is very common for policy illustrations to show increasing death benefits based on the application of policy dividends to purchase paid-up additional insurance. The use of dividends to purchase one-year term insurance is another method of increasing the policy death benefit without altering the policy.

The more complex policy illustrations can be separated into the following five categories: minimum-deposit policies, split-dollar policies, comparisons of two policies, policies with side investment funds or annuity contracts, and universal life policy illustrations. Many of these illustrations are dependent on the policyowner�s marginal tax rate for federal income taxes.

Policy illustrations that have more than four columns of values often derive some of their data from information that is not provided in the illustration. The relationship between columns is sometimes defined in the footnotes to the policy illustration, but often the relationships between columns are only partially described, if at all.

Policy illustration 2 in table 10-3 is an example showing where policy dividends are used to purchase additional coverage. The basic policy is for $18,000 of whole life insurance, supplemented with additional paid-up coverage purchased with dividends. There are no figures in the illustration to indicate the level of the policy dividends, but there is a footnote indicating that the dividend levels assumed for the calculation are not guaranteed. The first column merely lists the policy year or duration. The second column shows the gross annual premium that is constant for this policy. The illustration does not show that any funds were borrowed from the policy cash value.

The third column of illustration 2 is labeled "total paid-up value." This label is ambiguous because it does not indicate whether the paid-up value is for the dividend additions only or for both coverages as a result of applying the cash values of both coverages. Study of the illustration reveals that a paid-up value occurs in the second policy year before there is any cash value associated with the coverage purchased with dividends. Thus it can be deduced that the total paid-up value is the amount of fully paid-up coverage the policyowner is eligible for if the total cash value is applied to the purchase. This illustration is based on the assumption that the policyowner will not exercise any policy loans during the 20 years displayed.

The column titled "guaranteed cash value end of year" is relatively easy to interpret. The word guaranteed indicates that this is the scheduled cash value for the base whole life policy. Values for the supplemental coverage cannot be guaranteed because the dividends used to purchase the additional coverage are not guaranteed.

The "enhancement reserve fund" column essentially shows the cash value for the paid-up supplemental policies purchased with policy dividends. The "total cash value end of year" column merely lists the sum of the guaranteed cash value and the enhancement reserve fund.

The last two columns in illustration 2 show the relationship between the premium paid and the annual increase in the policy cash value. During the first through eighth policy years the policy premium exceeds the incremental increase in the cash value. The cash value increases exceed the policy premium in the ninth and all subsequent policy years. Although this comparison may lead some consumers to think they are getting their coverage free after the ninth policy year, such an interpretation is incorrect because the cash value is not made available to the policyowner other than as policy loans that are subject to compound interest charges.

The three column totals in illustration 2 have the same flaw as those in the previous illustration: they are only appropriate if both interest rates and inflation rates are zero. The accumulated value of the $320 annual premium after 20 years is $11,110 based on 5 percent interest, or $20,161 if it is based on a 10 percent interest rate. The accumulated value of the last column in illustration 2 is only $557 if based on a 5 percent interest rate. This is less than the column sum of $1,038 because of the negative quantities in the first 8 years, which accrued larger negative balances until they were counterbalanced in subsequent years with positive values. The accumulated value is $1,076 for a 10 percent interest rate.

The only important concept to be discerned from this illustration is that the premium is sufficient to create an internal buildup of funds in the policy, which also earns investment income. These internal funds are essential for the level-policy mechanism to work.

Policy illustrations can get very complex. It is important to use a marginal tax rate in the policy illustration that is the same as the marginal tax rate for the prospective policyowner. Minor variations in the tax rate can result in significant changes in the aftertax costs to the policyowner and other involved participants. Illustrations based on tax rates that are significantly different from those of the prospect are misleading and could be considered deceptive sales practices. The size limitations of standard office stationery tend to limit the amount of information that can be displayed on a single sheet. Consequently many related items are not included in policy illustrations.

It is essential to show both the corporate information and the individual insured information for this type of illustration.

The final illustration presents an early version of a universal life policy. This particular policy provides a death benefit of $100,000 until the policy cash value exceeds $95,000. Thereafter a death benefit will be $5,000 higher than the policy cash value. Policy illustration 3 in table 10-4 shows the annual premium of $1,300 is paid for 25 years. The illustrations for universal life policies may include (as this one does) a column for partial withdrawals. These are policyowner withdrawals of funds from the policy cash value that are not policy loans and do not accrue interest, nor are they expected to be returned to the policy. Because universal life policies can have both policy loans and partial withdrawals, it is likely that some illustrations will have columns for both. If the

total of all partial withdrawals ever exceeds the total premiums paid for the policy, the excess will be subject to federal income tax.

The premium less withdrawals column in illustration 3 is a non-interest-adjusted column indicating the cumulative amount of past premiums paid after reductions for any partial withdrawals of funds. The present value of these premiums over 25 years and of withdrawals in the subsequent 5 years is $10,512 based on 5 percent interest. If the premiums had been deposited in a 5 percent interest-bearing account, that account would still have a balance of $45,432 after the five annual withdrawals of $6,500 each. Based on 10 percent interest, the same calculations indicate a present value of $10,478 and an accumulated value of $182,835. These adjusted figures negate the impression that the policyowner will have no investment in the policy at the end of the 30 years, as the unadjusted numbers might imply.

This illustration is quite different from a traditional policy illustration in that it has three separate cash value columns, each calculated for a different assumed rate of interest earnings for the cash value. The "guaranteed cash value" column is comparable to the traditional examples because it is based on the interest rate guaranteed in the policy. However, even the "guaranteed cash value" column has its own properties for universal life policies because the premium level is usually inadequate if the cash value interest earnings do not exceed the guaranteed rate. That is why the cash values peak at $11,449 in the 19th policy year and decline to zero by the 26th policy year.

The column showing the assumed cash value is calculated using the assumption that the cash value will earn 9 percent interest every year. At that level of investment earnings or higher, the $1,300 premium for 25 years is clearly adequate to keep the policy in force. This scenario would develop ever-increasing cash values for the policy. There are no guarantees or suggestions that the investment earnings will always equal or exceed 9 percent. This is merely an example of how the cash value would grow if the actual earnings turn out to be exactly 9 percent each policy year.

The "current cash value" column is another example of how the cash value will increase at an even higher interest rate if that rate is earned every policy year. The interest rate used in illustration 3 for the current cash value is 11 percent each year. These columns are just demonstrations of what compound interest can do at sustained high levels. During the 1981�82 high-interest-rate period, there were companies using rates as high as 14 percent in their illustrations. There were many arbitrary predictions during that time, one being that interest rates would never again drop below 12 percent. These predictions have already proven to be erroneous. It is unrealistic to expect interest rates to stay at historically high levels over any protracted period of time. There is a very low probability that the cash value of the policy in illustration 3 will reach $134,000 in the 30th policy year. It is questionable whether even a 9 percent rate of return is achievable over such an extended period. The assumed cash value of $74,000 after 30 years may turn out to be overly optimistic.

As previously stated, this policy is of the earlier design and would not be offered with such a narrow final amount of at-risk death protection. The policies issued after the tax law change in October 1986 would provide a larger spread between the cash value and the death benefit. The cash value in the illustrated policy is too high for the $100,000 death benefit in the 24th policy year if the amounts in the "current cash value" column are actually attained. If the cash value of the policy attains the amounts in the "assumed cash value" column, there will be no problem of satisfying the test for life insurance in Sec. 101(f) of the Internal Revenue Code.

There are many other possibilities that could be illustrated for universal life policies and traditional policies. Universal life policies can be used in any type of situation in which whole life policies can be used. Whether they would be the preferred policy can only be determined after analysis and realistic estimation of future interest earnings in the policy. (The required space for further illustrations puts them beyond the scope of this chapter.)

The most important thing to remember about illustrations is that the values in the columns should be adjusted for interest before adding column values. When the illustration does not include interest-adjusted values, it is advisable to provide present values and accumulated values�at representative values�for the aftertax cash outlay columns. Another element of extreme importance is the use of appropriate marginal tax rates in illustrations that match the applicable tax rate to the prospective policyowner.

The proliferation of illustrations since the early 1980�s prompted calls for standards or guidelines. The American Society of CLU & ChFC took the initiative and adopted a Professional Practice Guideline, which is a checklist of guidelines for sales material and presentations. Although these guidelines were not intended to be minimum standards, they did give explicit guidance on many issues concerning illustrations. This document was adopted by the membership of the American Society of CLU & ChFC at its 1988 annual meeting and is presented on the following pages. It was one of the first steps on the slow journey to establishing some standards for policy illustrations.

The principal items addressed in the checklist were interest rates, mortality expenses, dividends, benefit changes, surrender charges, waiver-of-premium benefit base, policy comparisons, and issues of replacement. This document can be used to ensure that all relevant questions have been explained to a prospect. Obviously, not every item will always be applicable. For example, dividends might not be involved in a proposal because of the type of coverage under consideration.

One suggestion is to make customized copies of the guidelines that are tailored to specific policies and situations. These checklists could even be shared with prospects to see if they feel that all of their questions have been answered and that they understand all of the answers. There could be separate guidelines for a nonparticipating policy, a participating policy, a universal life, each type of policy replacement, and any other anticipated situation. Making separate guidelines would eliminate any questions that are not appropriate for an individual situation.

The practitioner should frequently review the full checklist as a reminder of all the relevant issues. It is important to include a discussion of each applicable factor in presentations. Some additional items that fit each practitioner�s special needs might be added to the checklist. The guidelines should be reviewed and a copy should be kept handy for frequent use.

The American Society for CLU and ChFC took further initiative regarding policy illustrations in 1992 by adopting the Life Insurance Illustration Questionnaire. (See pages 271�274.) It was intended to stimulate agents to question and more thoroughly understand the intricacies of illustrations so they could better explain them to purchasers and prospects. The questions were directed to the insurance company regarding the assumptions and methodology underlying the responding insurer�s illustrations. Nearly all of the major life insurance companies have responded to the questionnaire and provided their answers to their own agents.

Insurance companies are reluctant to provide their questionnaire responses to agents from competing companies or to the consuming public. This is understandable because of both competitive concerns and the detailed nature of the information itself. It would take even the best of agents a lot of time and effort to explain the intricate information provided in the questionnaire response of any one insurance company.

The American Society of CLU and ChFC had no power to impose a standard for illustrations by its development of the Professional Practice Guidelines and the Life Insurance Illustration Questionnaire helped prod the National Association of Insurance Commissioners (NAIC) to adopt standards for life insurance policy illustrations in 1996.

Policy illustrations are projections of what could happen under a policy if actual experience serendipitously mirrored all the assumed factors used to calculate the illustration. However, it is almost a certainty that actual experience will deviate from the illustration on multiple factors. The actual future numbers for each�cash values, premiums, and death benefits�can vary drastically from those shown in an illustration.

A study of policy illustrations by a task force of the Society of Actuaries, released in 1992, showed the following major findings:

Another opinion was provided in the October 26, 1992, edition of Probe by John C. Angle, FSA. He proposed that rather than trying to educate producers and consumers about interpreting illustrations, it is advisable to issue a prospectus for the policy that would disclose in minute detail how the insurance company determines each aspect of the policy and reveal any subsidization being provided. Such disclosure is already being provided for variable life insurance policies.