The Interest-Adjusted Cost Method of Comparing Life Insurance Policies

The interest-adjusted methods of comparing the cost of life insurance policies consider the fact that policyowners could have invested the money spent on premium dollars elsewhere earning some minimum after-tax return (5 percent is usually assumed.) Because a policy may terminate, either when the policyowner surrenders the policy or when the insured dies, there are two different interest-adjusted indexes to measure the cost: (1) the net surrender cost index; and (2) the net payment cost index. The indexes do not necessarily define the true cost of policies, but they are useful in comparing the relative costs of similar policies. All other things being equal, a low index represents a better value than a high index. Note, however, that the interest-adjusted indexes are only indexes and nothing more. The true cost of a life insurance policy, if it can actually be measured prospectively, depends on when and how a policy terminates.

Interest-Adjusted Net Surrender Cost Index

This index is a relative measure of the cost of a policy assuming the policy is surrendered. It works like this:

1. Accumulate each year’s premium at some specified rate of interest. (Most policy illustrations use a 5 percent rate.) Perform the calculation over a selected period of time such as ten, fifteen, or twenty years.

2. Accumulate each year’s dividends projected on the ledger sheet at the same assumed rate of interest over the same period of time.

3. Subtract the total dividends (plus interest) from total premiums (plus interest) to find the future value of the total net premiums paid over the period being measured.

4. Add the cash value and any “terminal dividends” shown on the ledger statement as of the end of such period (and minus any surrender charge) to find the net cash value.

5. Subtract the net cash value from the future value of the net premiums to arrive at the future value of the total net cost of the policy over the selected period.

6. Divide the result by the future value of the annuity due factor for the rate assumed and the period selected. The result is the level annual cost for the policy.

1. Divide the level annual cost for the policy by the number of thousands in the face amount of coverage. The result is the interest-adjusted net annual cost per thousand dollars of coverage using the surrender cost index. (In the figure above, numbers were calculated per $1,000 of coverage from the start.)

Interest-Adjusted Net Payment Cost Index

This index is a relative measure of the cost of a policy assuming the insured dies while the policy is in force. It works like this:

1. Accumulate each year’s premium at some specified rate of interest. (Most policy illustrations use a 5 percent rate.) Perform the calculation over a selected period of time such as ten, fifteen, or twenty years.

2. Accumulate each year’s dividends projected on the ledger sheet at the same assumed rate of interest over the same period of time.

3. Subtract the total dividends (plus interest) from the total premiums (plus interest) to find the future value of the total net premiums paid over the period you are measuring.

4. Divide the result by the future value of the annuity due factor for the rate assumed and the period selected. (Use the same factors that were used in the Net Surrender Cost Index, above.) The result is the level annual cost for the policy.

5. Divide the level annual cost for the policy by the number of thousands in the face amount of coverage. The result is the interest-adjusted net annual cost per thousand dollars of coverage using the payment cost index. (In the above figure, numbers were calculated per $1,000 of coverage from the start.)

Planners usually will not have to do these computations because most ledger sheets will contain these indexes at the bottom of the front page of the ledger statement. However, the ledger statement usually shows the indexes only for ten and twenty years, and sometimes for the insured’s age sixty-five.

Most states require that insurers/agents provide prospective policyowners with a policy’s interest-adjusted indexes. Planners should therefore understand how this measure works, understand its limitations and be able to explain it to sophisticated clients. 

Among the weaknesses of the interest-adjusted methods are these:

1. If the policies being compared are not quite similar, the index results may be misleading. For instance, if the outlays differ significantly, the planner should establish a hypothetical side fund to accumulate the differences in the annual outlays at the assumed rate of interest to properly adjust for the differences. This will be the case where an existing policy is compared with a potential replacement. There will almost always be a material difference in the projected cash flows. This makes the interest-adjusted methods unsuitable (unless adjusted) for “replacement” comparisons.

2. The interest-adjusted methods are subject to manipulation (although to a lesser extent than the traditional net cost method) and in the commonly used measuring periods, such as ten or twenty years, insurers/agents can design them to provide more favorable estimates of cost than for other selected periods.

3. The interest-adjusted methods are valid only to the extent that the projections of cash flows materialize as assumed. Therefore, the calculations cannot consider the impact of an overly optimistic dividend scale. 

4. It is possible in the comparison between two policies for each policy to be superior when ranked on one of the two indexes and inferior when ranked on the other index. However, relative rankings on each index tend to be highly correlated. That is, a policy that is ranked higher than others using one index tends to also rank similarly using the other index.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

Leave a comment

A Quick and Easy Life Insurance Needs Calculator