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Issues of Interest to Advisors Today Presented by Wayne E Thomas, CLU® Member Agent, The Nautilus Group A service of New York Life Insurance Company May 23, 2012
Disclaimer This seminar is for informational purposes only. Neither New York Life Insurance Company (NYLIC) nor its employees or agents are in the business of providing tax, legal or accounting advice, and none is intended nor should be inferred from the foregoing comments and observations. Everyone should be advised to seek the counsel of their own tax, accounting and legal advisors who must form their own independent opinions on these matters based upon their independent knowledge and research. Wayne E. Thomas, CLU® is an Agent of New York Life Insurance Company. Wayne E. Thomas, CLU® is a Member Agent of the Nautilus Group, a service of New York Life Insurance Company.
The “Hidden” Assumptions “Once the policy is in force, I won’t have to look at it again. ” • Life insurance – can’t get it and forget it – Long-term – Requires ongoing evaluation • Advisor may be asked for advice in managing • the life insurance results – Doesn’t have to be an expert. – Does have to know what to look for and where the problems areas lie.
The “Hidden” Assumptions “Get along with the grantor and all is well. ” • Trustee may think working for grantor but accountable to beneficiary “Interest rates will stay the same. ” • Most policies placed more than 5 -10 years ago designed to benefit from higher interest rate. • No action now, may require higher premiums later. – Will money be available? – Will gifting be available to transfer funds to trust?
Longevity is the Key Word • When buying policy - longevity of the: – Insured – Policy – Life insurance provider • Responsible advisor must synchronize duration of insured, policy and provider – Looked at individually – Coordinated together – Assessed on a regular basis • How long does policy need to last?
Longevity of a Person • Starting point – life expectancy – Expected number of years of life remaining at given age based upon average • Actual number of years remaining varies widely • Selecting the right policy – not insured’s life expectancy, but how long insured might live. Chances that a 65 -year-old will live… Source: Annuity 2000 Basic Mortality Table; projected with Scale G.
Advisor Checklist • Questions about the Insured – Do you know the insured’s life expectancy? – Do you know what the chances are of the insured living beyond his/her life expectancy? – Have you reviewed how long the policy is projected to stay in force? – If the policy ends, would your client qualify for new coverage?
Longevity of a Policy • Life insurance intended to be in force at death • Policy purchased based on assumptions in force at that time • In real life, circumstances change, which may alter expected results • Advisor should continually measure performance by actual results
Frequently Asked Questions About a Policy • How accurate are illustrations? – Illustrations based on assumptions – Actual experience may be different than illustrated projections • What would cause the policy to terminate before your client dies? – Type of policy – Assumptions used • What assumptions were made for the policy?
Product Basics • Term Life • Whole Life • Universal Life
Pricing Basics • Financial models built to develop and price products • Need to make assumptions about the future • Each product group has distinct assumptions and drivers of profitability
Why Would Term Insurance End? • Policy designed to end after term of years • Premiums not affordable • Premiums not paid
Why Might a Whole Life Insurance Policy End? • Premiums not paid – Whole life policies have non-forfeiture options – Default option varies by company • Reduced paid-up policy – reduced face amount • Extended term policy – same face amount for a period of years • Loans taken, interest due not paid, interest and loans exceed available cash value* * The cash value in a life insurance policy is accessed through policy loans, which accrue interest at the current rate, and withdrawals. Loans and withdrawals will decrease the cash surrender value and death benefit.
Key Drivers of UL Pricing • Product design – Determination of policy charges • Policyholder behavior – Premium funding pattern – Lapse/surrender/loan • Mortality – Proper underwriting – Reinsurance • Interest crediting strategy – Portfolio vs. new money – Spread
Key Drivers of UL Pricing - continued • Reserves – UL reserve requirements – Financing solutions • Cash Surrender Value • Expenses and Taxes • Required Capital – Company ratings matter – Higher rated companies = more supporting capital • Producer Compensation
Post Pricing Hurdles • Filing & State approval process • Illustration certification – Illustrated scales must qualify as disciplined current scales (DCS) – Must break-even within certain period – Cannot be overly reliant upon surrenders – Prevents bait & switch • Non-guaranteed Elements (NGE) testing – Must declare method for changing in advance – Must demonstrate profitability is higher/lower than declared before NGE can be changed
Why Might a Universal Life Insurance Policy End? • Two types of coverage – Guaranteed UL* – Non-guaranteed UL • Non-guaranteed UL – 3 elements • Premiums • Crediting Rate • Mortality charges – Policy no longer has enough cash value to pay monthly insurance charges. * All guarantees are subject to the claims paying ability of the issuing company
Why Might a Universal Life Insurance Policy End? • Most policies originally designed to endure, but something changes: – Less premium paid – Lower crediting rate than expected – Higher expenses than expected Premium $ Paid $ $ % Rate Credited $ $ $ Monthly Expenses
Advisor Checklist • Questions about the Policy – When was the last time the life policy was reviewed? – At current levels of interest, charges, and premium payments, how long will your client’s policy stay in force? – Have any premium payments been late, reduced, or missed? – Have any loans or cash withdrawals been taken?
Advisor Checklist • Questions about the Policy – continued – For term insurance policies • Will the policy remain affordable as long as you need it? • Are there conversion privileges to a competitive permanent product? – Is your client’s policy subject to dramatic market fluctuations?
Advisor Checklist • Questions about the Policy – continued – Will the death benefit be jeopardized or lost if cash is withdrawn or borrowed? – What guarantees are there that the policy will be around when the beneficiaries need it the most? – Is the policy subject to dramatic market fluctuations?
Longevity of a Life Insurance Provider Promise to be there in future Premiums Insurance provider must be Strong and Solvent • Why are ratings important? • What if insurance provider’s rating are downgraded?
Advisor Checklist • Questions about the Insurance Provider – Has the financial strength of the insurance company changed? – What is the current insurance provider’s rating/financial outlook? – Does the insurance provider have an adequate surplus of assets? – What is the investment policy for the provider’s general account assets?
Life Insurance Financial Strength Ratings • If you do estate planning or individual income tax planning you have probably been asked to evaluate life insurance policies – Compare specific policies of different companies – Find best coverage for the money • But, the financial strength of the carrier may be equally important – Need to know that the company will be able to pay off future claims
Overview • • • Why is financial strength a critical issue? Current rating systems Validity of the ratings Company presentation of the ratings How the ratings are determined What happens when a company fails
Importance of Financial Strength • More important for an insurance company than for other companies because of the very long-term obligations – For a 50 -year-old insured, claims may be paid up to 40 to 50 years in the future – Should deal with a company having a conservative long-term perspective
Possibility of Financial Impairment • Rare for large companies with a long history • Risk is much greater for smaller companies – At least 69 insurance companies taken over by state insurance departments since 1983* – In today’s environment, even some large companies not run properly (but with midpoint ratings) could experience financial impairment – Current recession might make financial impairment more common in the future *National Organization of Life and Health Guarantee Associations (NOHLGA) Website, Facts & Figures, Impairments & Insolvencies
Possibility of Financial Impairment • Current recession might make financial impairment more common in the future • National Organization of Life and Health Guarantee Associations (NOHLGA) Website, Facts & Figures, Impairments & Insolvencies • A. M. Best Special Report, July 19, 2010, 19762009 Impairment Review.
Rating Agencies • Four main life insurance company ratings agencies: – Moody’s – Fitch – Standard & Poor’s – A. M. Best • Moody’s, Fitch and Standard & Poor’s are sometimes referred to as the “Big 3” Ratings Agencies – Better known for their bond ratings – Also rate sovereign debt • A. M. Best is the oldest and rates only insurance companies
Rating Scales • The rating scales are very different • The following slides show the scales for the four main rating agencies and an explanation of what the ratings mean • The ratings are sometimes divided into two categories—secure and insecure • The secure ratings on the first chart are shown in green and the insecure ratings in red
Rating Scales Rank A. M. Best Standard & Poor’s Moody’s Fitch 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 A++ A+ A AB++ B+ B BC++ C+ C CD E F AAA AA+ AA AAA+ A ABBB+ BBBBB+ BB BBB+ B BCCC+ CCCCC R Aaa Aa 1 Aa 2 Aa 3 A 1 A 2 A 3 Baa 1 Baa 2 Baa 3 Ba 1 Ba 2 Ba 3 B 1 B 2 B 3 Caa 1 Caa 2 Caa 3 Ca C AAA AA+ AA AAA+ A ABBB+ BBBBB+ BB BBB+ B BCCC+ CCCCC C
Meaning of the Ratings AM Best S&P Moody’s Fitch A++ and A+: Superior ability to meet ongoing insurance obligations AAA: Extremely strong capacity to meet financial commitments. Highest rating. Aaa: Exceptional financial security. While the financial strength of these companies is likely to change, such changes as can be visualized our most unlikely to impair their fundamentally strong position. AAA: Exceptionally strong capacity to meet policyholder and contract obligations. This capacity is highly unlikely to be adversely affected by foreseeable events. A and A-: Excellent ability to meet ongoing insurance obligations AA: Very strong capacity to meet financial commitments. Aa: Excellent financial security. Together with the Aaa group, they constitute what are generally known as high-grade companies. They are rated lower than the Aaa companies because long-term risks appear somewhat larger. AA: Very strong capacity to meet policyholder and contract obligations. This capacity is not significantly vulnerable to foreseeable events. B++ and B+: Good ability to meet ongoing insurance obligations A: Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances. A: Good financial security. However, elements may be present which suggest a susceptibility to impairment sometime in the near future A: Strong capacity to meet policyholder and contract obligations. This capacity may nonetheless, be more vulnerable to changes in circumstances or in economic conditions. (See pages 16 -17 of the Special Section in Resource Guide for complete chart. )
Comdex Ratings • Composite score for ratings of Moody’s, Fitch, Standard & Poor’s and A. M. Best • A company must have ratings from at least two of the rating agencies to receive a Comdex score – Companies rated on a scale of 1 to 100 in relation to other companies – The numbers reflect percentiles – A score of 90, for example, would mean the company scored higher than 90% of all companies rated • In this environment, recommend only buying from companies with the highest possible Comdex score
How Good are the Ratings? • Criticisms – Conflict of interest because most rating agencies are paid by the companies they rate • Percentage of ratings paid for by insurance companies: – Moody’s……………… 100% – A. M. Best………………. 100% – S&P…………………. 82% – Fitch………………… 44% – Too slow to spot negative trends and revise ratings • Particularly troubling is their recent failure to spot problems with mortgage backed securities.
How Good are the Ratings? • Evidence – 2003 Federal Reserve study • Rating agencies more concerned with guarding reputation than pleasing clients • Only minor distortions in ratings • Ratings ordinarily reliable
A. M. Best Study - Conclusions • Conclusions – Ratings correlate strongly with future financial impairment – Significant difference even between A++/A+ and A/A- ratings – Suggests that although a AA rating or 90 Comdex score is considered very good, an A++ rating or 95100 Comdex score might be significantly better over a long period of time – Percentages increase rapidly over time • What would they be after 30 or 40 years? • Extremely important given the long-term nature of policy obligations
Company Presentation of Ratings • Insurance companies and/or agents could selectively present ratings in their marketing materials • These ratings can be difficult to assess for several reasons – The scales are not directly comparable – Companies present their ratings in the most favorable manner possible – Ratings tend to minimize differences between the higher rating categories
Differences in the Rating Scales • A given letter might mean something quite different in one scale than in another – B is “fair” for A. M. Best, but “weak” for Fitch – A+ is “superior” for A. M. Best, but only “strong” for Fitch and S&P • A letter might have a higher rank in one system than in another – For A. M. Best, A+ is the second highest rating – For Fitch or S&P, A+ is only the fifth highest rating
Differences in the Rating Scales • The rating systems have different numbers of categories – Fitch, Moody’s and S&P all have 21, while A. M. Best has only 15 – A given rank on the A. M. Best scale may not be comparable to the same rank on one of the other scales
Favorable Presentation • A company with ratings at or near the top from every rating agency would simply present all of the ratings • Companies with somewhat lower ratings might present only their better ratings, perhaps making the company look better than it really is
Caution—What the Ratings Do Not Show • The ratings reflect expectations that a company will be able to make good on its future policy commitments. • They are not an evaluation of: – Any specific insurance product – Whether a company’s products provide good value for the money – Whether specific policy provisions are desirable
How are the Ratings Determined? • The rating agencies have somewhat different methodologies, but the method used by A. M. Best, summarized below, is typical – Four factors considered: • Balance sheet strength • Recent operating performance (profitability) • Business profile • Information from meetings with management team on a company’s prospects
Balance Sheet Strength • Three general factors— – Capitalization – Adequacy of loss reserves, asset valuation reserve (AVR) and surplus – Quality, diversification and liquidity of assets
Capital Adequacy • Moody’s provides the following chart showing capital as a % of total assets for various ratings* – – – Aaa…………. >12% Aa……………. 8%- 12% A…………… 6%- 8% Baa…………. . 4%- 6% Ba……………< 4% *Moody’s Global Rating Methodology for Life Insurers, 2006
Quality of Assets • Moody’s provides the following chart showing the percentage of high risk assets held by companies with various ratings* – – – Aaa…………. <10% Aa…………… 10% - 20% A…………… 20% - 30% Baa…………. . 30% - 40% Ba……………>40% *Moody’s Global Rating Methodology for Life Insurers, 2006
Diversification • Investment portfolio diversification – Spreading investment funds among a variety of assets and asset classes to: • Minimize risk for any given level of expected return, or • Maximize expected return for any given level of risk • Product and business line diversification – Diversify by insurance product and region – Possible diversification into related businesses like capital management • Highly rated companies are well diversified in both ways and have efficient investment portfolios
Liquidity • Ability to meet policy obligations without selling long -term assets. • Most important measure is liquid assets as a percentage of policyholder reserves. • Other measures: – Quick liquidity ratio • Liquid assets/total liabilities – Current liquidity ratio • Total current assets/total liabilities
Liquidity, Cont’d • Moody’s provides the following chart showing liquid assets as % of policyholder reserves for various rating categories* – – – Aaa…………. >80% Aa…………… 60% - 80% A…………… 40% - 60% Baa…………. . 20% - 40% Ba……………<20% * Moody’s Global Rating Methodology for Life Insurers, 2006
Profitability • Profitability is an important part of a company’s ability to meet policy obligations • Basic measure = return on equity (ROE) • ROE = Net income/shareholder’s equity • For a stock company both earnings and capital appreciation are important • For a mutual company, earnings and surplus are the key indicators
Profitability • Moody’s provides the following chart showing ROE for various rating categories* – – – Aaa…………. >15% Aa…………… 10%-15% A…………… 5%-10% Baa…………. . 0%-5% Ba……………<0% * Moody’s Global Rating Methodology for Life Insurers, 2006
What Happens to a Company with Financial Difficulties • The company can be taken over by state regulators – They will first try to sell policies to another company • Even if they are successful, owner may lose coverage or end up paying higher premiums • If insured dies while regulators have policy, there may be a long delay in paying off the policy. – If the policies can’t be sold, the failed insurance company is generally liquidated. • All 50 states have life insurance guarantee associations that protect policyholders of failed companies from shortfalls in the liquidation proceeds.
Companies with Financial Difficulties - continued • Unfortunately, the benefit cap in most states for an individual life insurance policy is only $300, 000. – Given that the recommended life insurance coverage for a median-income family is about $500, 000, many policyholders would not be fully compensated if covered under a single policy. • NOHLGA reported that from 1991 through 2008, state guarantee associations covered only about 82% of all life insurance liabilities. • The benefit cap for cash surrender or withdrawal value is even lower, at $100, 000.
Mutual vs. Stock Companies • Easier for a mutual company to maintain high asset quality and long-term focus • Stock companies generally must produce shortterm returns to keep stockholders happy – Potential pressure to make riskier investments that favor stockholders over policy holders and may not be in the best long-term interests of the company • A mutual company has no stock, so the interests of the policy holders are better aligned with the longterm interests of the company
Who should I buy from? • Why focus on the company? Why not just comparison shop and buy the cheapest option? • Questions to ask • For Current Assumption UL, Non-Guaranteed Element (NGE) – (Non- Guaranteed Element) can change – For Guaranteed UL, there are no NGEs to change- how do you know the company will be there in 30 years? – For WL, what is the history of paying dividends? • In the end, the client is buying a promise
Next Steps Talk to your agent. Annually review the policy. Adapt or change policy to realign with your beneficiaries. Determine if policy meets beneficiaries’ objectives & trustee’s fiduciary responsibilities. Research & analyze the policy. Review questions regarding the insurer.