Permanent cash-value life insurance sales are usually based on illustrations, which are prepared by either a company or an agent, using software supplied by the insurance company.
The illustration typically highlights projected interest rates while estimating the future value of the policy. Since it’s a sales tool, it naturally highlights the positive aspects of the proposed policy.
Meaning, consumers are led to believe that there is a greater assurance that the illustrated values will actually be achieved; but, in reality there are many variables that can adversely affect the performance of the policy.
Such variables are mortality costs, expense/administrative charges, and future investment experience. All of these, to some extent, are not directly controllable by the insurance company.
Results can and will certainly vary. So, think of the illustration more as a convenient way of showing how the policy could work rather than as a reasonable estimate of future values.
However, knowing how all the components interact is integral to understanding how and why the policy performs as it does. When a policy is issued, the company is at risk for the entire death benefit.
That’s because the early premium payments goes towards covering mortality and other expense charges, leaving little or nothing to apply to the cash value. When a cash value does start to accumulate, this gradually reduces the company’s net amount at risk.
For example, we’ll use a policy issued for $100,000. When it is issued, the entire $100,000 figure is at risk to the insurance company. The cash value of the policy acts as a reserve account, reducing the amount at risk to the insurance company.
Therefore, if the cash value in the 30th year of the policy is $60,000 at a certain point, then the net amount at risk to the insurance company is $40,000.
The mortality cost is applied to the net amount at risk based on the insured’s attained age. With increasing age, the mortality cost per thousand of net amount as risk increases.
The theory is that the total mortality cost will decrease as the cash value increases. As long as increases in the cash value are greater than the mortality costs and other expense charges, the policy should continue to grow and remain in-force.
When the increases in the policy do not offset the charges, the cash value will commence a rapid descent leading to policy termination with no value.
It is also necessary to understand how the various factors are applied to the policy every month: First, the premium paid is added to the cash value from the end of the prior period. Then, mortality costs and other expense charges are subtracted. Finally, interest is credited to this value (after costs).
Therefore, the interest credited to the policy is not the actual internal rate of return. The internal rate of return, an important financial yardstick, is always less than the current interest-crediting rate.