Whole Life (WL) is the most complex product ever developed by the life insurance industry. Complex in the sense it cannot be broken down into its parts. It is a bundled product.
Anyone who intends to read this write should first read the “How it Works – Whole Life Box” write up. It provides a design framework that sets the stage for a more detailed discussion of WL’s various moving parts.
INTRODUCTORY COMMENTS
The WL box story focuses on a conceptual understanding of the product. Which is an important first step in gaining a better understanding how this ridiculously complex product works. WL is not the “simple” product many who sell it seem to believe it to be.
If it were a simple product this “How it Works” series could not contain almost a dozen 20 and 30 page write-ups on the product. There would be no need for this avalanche of information.
Prior to reading this write-up it is highly recommended the write-up on “guarantees and dividends” be reviewed. This write-up will skip over this discussion which is essential to understanding what will follow in this discussion of the WL products underlying design.
What complicates matters with WL is the fact it is a bundled product. One where all the moving parts are obscured. No individual income or expense information is ever made available to those who sell it, or those who buy it. Only a few company executives and actuaries have access to this information.
Those who favor selling WL often base their understanding on a handful of half-truths and misunderstandings shared with them as fact by under informed or misinformed (albeit well intentioned) mentors or peers. A bold statement perhaps, but sadly one that all too often has proven to be true.
Only when a properly educated individual asks detailed questions (the answers to which they already know) does the validity of the above statement become painfully clear. Those who understand how WL works are endlessly amused (or saddened) when witnessing the floundering efforts of those who do not attempting to explain it to others who do.
Offsetting this lack of knowledge, or perhaps because of it, WL is often sold with an almost evangelical fervor. Assertions surrounding its guarantees often make the product sound as if it embodies all that is good and holy. A biblical level of enthusiasm often prevails.
Unfortunately, even those with the best of intentions and deeply held beliefs can end up making blatant misrepresentations. Which can be every bit as damaging as the falsehoods shared by those with ill intent. Or, worse since considering the level of sincerity of the person sharing the misinformation.
The WL product itself is neither good nor bad. It’s just a design developed before the advent of computers which made it possible to track every little detail of a products structure. Computers also made it possible to track and report each and every income and expense factor on an individualized policy owner basis. Imagine the challenge of attempting to do so with tens of thousands of policyholders with a manual hand based calculation and posting system.
The decade’s old design of WL allows cash values to accumulate within a policy and death benefits to be paid covering said tens of thousands of policy holders. Its design allows this to be done without the need to segregate the general account assets that support the cash values in any given individual policy. The same is true with the expenses paid from the general account.
With WL those factors are bundled together and allocated based on formulas embedded in the WL product design. This collection of interrelated formulas is often referred to as the “master” WL formula. Which differs for every individual WL product ever sold.
As with any product design WL has its pluses and minuses. What makes WL good or bad at any given point time is a function of what is, or has transpired in the real world since its sale.
So, at any given time and depending solely on economic and other realities, WL may or may not be the best product for any given person. Something that also depends on the intended use of the product and the focus of any given purchasers goals or needs.
As noted earlier, it does not require ill intent to misrepresent a products features or benefits. Ignorance works just as well. Most of those who sell WL have nothing but the best of intent. It’s just their lack of actual knowledge that creates problems. The WL product is typically sold as a product rift with guarantees that eliminate all the elements of risk. Which sadly just isn’t so.
Economic trends, in particular those pertaining to interest rates, have a tremendous impact on WL products since it is an interest sensitive product. As a result, whatever is happening with interest rates (or whatever has happened since the product was purchased) has a tremendous impact on the products ability to deliver on illustrated cash values, dividends and death benefits.
Regulations also have a tremendous impact on the value a WL product can deliver. Among a great many other things regulations prohibit investing general account funds in equities (stocks). They allow only a modest level of stock ownership which usually relates only to stock owned in subsidiaries of the company selling the WL product. Beyond this regulations also require reserves for different asset classes that can impose tremendous cost levels and capital constraints on companies selling WL products.
The reality of interest rates today could not possibly be more different than the reality of interest rates that existed decades ago in the heyday of WL product sales. In fact, the realities today are literally 180 degrees opposite.
As the number of other “How it Works” WL write ups suggests this is only one of many factors impacting existing policy holders and new potential buyers of WL products today. But it is a very important factor that has crippled the WL product for the last two or three decades.
FORMULAS, FORMULAS, AND MORE FORMULAS
WL values illustrated at the time of sale, and the subsequent actual values appearing on annual statements, are all determined by a series of complicated and interrelated formulas. When combined these are sometimes referred to as the “master formula”.
The software systems used to create a WL policy illustration are built around these many formulas. The formula’s themselves include a myriad of assumptions, some tied to future expense and earnings factors and others not. All of which may or may not come to past. It’s important to understand that aside from expenses and earnings there are many other factors built into these formulas and assumptions. All of which impact the values illustrated and the subsequent actual values that accrue over time.
The foundation of the WL product consists of the formulas and assumptions devoted to the products guarantees. The “house” that is WL is built on that foundation. Which consists of potential dividend fueled increases in cash values above guaranteed levels.
The guaranteed values shown in a WL illustration are totally dependent on premiums. If premiums are paid in all years the values in those columns are in fact guaranteed. Premiums initially must be paid “out of pocket” by the policy owner. Over time it typically becomes possible to pay them from two other policy based sources. One source is the use of past and current dividend values (referred to as additions). The other is using policy loans secured by its cash values typically utilized when dividend accumulations are exhausted.
If premiums are not paid the WL policy will lapse. Lapsing can take several forms, meaning there are alternatives in some cases depending on the facts at that time. These are referred to as forfeiture options. A topic for another day.
Policy values above guarantees shown on annual year end WL statements represent the cumulative actual positive net experience from prior year(s). Each years actual results replace the original assumptions used in the formulas used to create the original sales illustration. Each years “net” actual experience is added to the combined results of all prior year’s actual experience.
This is a somewhat over simplified statement but it is essentially correct; at least in concept.
Over time it is the accumulated past experience that becomes the driver of what is possible in the future. If after decades the actual cash value accumulations are half of what was anticipated in an original illustration it would require double the assumed initial earnings rate going forward to match the originally illustrated annual future dividend amounts going forward. It would then require an even higher earnings rates to also actually catch up on the past years cash value shortfall.
At a point the chance of ever “catching up” realistically becomes impossible.
NOTE: This is a very important point. Past performance has the power to drive future growth above illustrated levels, or stifle it. This fact is little understood. The further behind the accumulated values are vs. the originally illustrated results the less likely it becomes that future actual values will ever recover to originally illustrated levels. Which is today’s reality. Conversely, the further ahead WL cash value growth is versus the originally assumed totals the more likely ongoing actual results will exceed illustrated values in all future years. This was the situation in the 1970’s and 1980’s.
At a point it is possible either a WL policy has reached the point its cash values will always exceed the originally illustrated values, or the point where they never will.
EXAMPLE: Consider “Scenario #1” where we take $10,000 and compound it for 25 years at 6%. We get a year 25 total of $40,489. We can then multiply that by 6% to calculate the 26th year earnings; the result being $2,429. Think of that as the originally illustrated assumed dividend amount for the 26th year. Compare this to “Scenario #2” where a 3% average rate of return was actually earned for that same 25 year time frame; resulting in a far lower total of $20,328. Even if we then multiply that by the originally assumed 6% the result for year 26 is only $1,220. Half of what was anticipated in the original illustration. All else being equal it would actually take a 12% earnings rate in year 26 to equal the originally assumed dividend dollar total for year 26. An earnings rate unlikely to ever be achieved, especially if only an average of 3% was earned over the prior two and a half decades.
That’s how WL works. If the actual general account balance supporting any given series of WL policies a company has sold is far lower than originally assumed then all subsequent future growth will be lower than originally illustrated even if original earnings rate once again is achievable thereafter. Sadly, that is the situation that exists today as pertains to the vast majority of outstanding inforce WL policies people own.
MASTER FORMULA COMPONENTS
What follows is a partial list of some of the major assumptions built into in a “master” WL formula. Think of each area listed below as representing a segment of a master WL product design formula. When combined they represent the “master” formula. Companies vary the assumptions to differentiate their products in one desired way or another. For instance, premiums per $1,000 of death benefit at any given age will vary dramatically from one company to another. They will even vary between WL products sold by the same company.
Here are some of the major components of a typical master WL formula:
- Average general account yield on invested assets; a
function of
- The average assumed maturity duration of general account assets
- The mix of asset classes making up the general account
- Company overhead costs to be paid from the general
account
- Including rent, staff and all related operational expenses
- Surrender factor percentages and their duration used to restricting access to prior premiums and earnings thereon
- Lapse assumptions that result in triggering of surrender charge forfeitures on prior premiums and earnings thereon not as yet made available in cash values
- Average face amounts sold and dividend crediting breaks for varying policy sizes
- The mix of insureds by age, sex and tobacco use
- Premium rates per $1,000 of death benefit at each age by sex and tobacco use status
- Additional premium rates for medically rated policies for various conditions
- Expected current mortality experience versus underlying guaranteed mortality rates
- Commission and renewal payments related to the sale of the WL policies
- Premium amounts to be set aside in regulatory required reserves
- Premium tax rates; either blended for all State’s, or State specific
- Earnings to be retained (not credited as dividends) to meet required capital levels and maintain financial strength ratings
ASSUMPTIONS, ASSUMPTIONS AND MORE ASSUMPTIONS
There are two primary “moving parts” embodied in any given WL policy design. There are formulas and there are assumptions contained within each formula.
It’s one thing to know the typical components of any given WL master formula. It’s entirely another to know the assumptions built into the formulas.
Knowing what the formulas address, or the purpose of each segment of the master formula, is clearly a first step in understanding the WL product design. Still, on a factual level, knowing what types of things these formulas deal with (or the area of concern each addresses) isn’t going to shed any light on the actual values included in the formulas as “assumptions”.
These assumptions are never published or shared. Not with those who sell WL products and not with those who buy them.
The assumptions are known to only the company’s top executives and actuaries. What those who sell and buy WL see is the combination of these formulas and assumptions in the form of the illustrations they present to prospective buyers at the time of sale.
WL product design committees often base financial assumptions on historical experience. Others may be tied to marketing approaches. Those marketing assumptions may be focused on promoting the sale of their WL products to certain targeted buyer groups (by age or sex for instance). Or, they may relate to the intended use of any given WL product by stressing low premium affordability or higher premium levels geared to leveraging higher levels of illustrated cash value growth.
NOTE: Literally hundreds of assumptions are built into the formulas for any given WL policy series. Those serving on product design committees may have these lists of types of assumptions shared with them. However, only the senior most members of the design committee (top executives and actuaries) will know what the actual assumptions rates and factors are. They are also the only ones who will know how subsequent actual experience results compare to original assumptions.
Absent actual details on the myriad of assumed values used in these formula components “we” can’t really dig much deeper into this aspect of WL policy design. Without knowing the assumptions embodied in any given WL illustration it’s not possible to assess their reasonableness. Or, as time goes by, determine how actual results driving the amounts appearing on policy statements compare to the assumptions built into the original sales illustration software.
All one can do is compare over time the original illustration values to those appearing on subsequent annual statements. With WL that’s as good as it will ever get.
CUMULATIVE IMPACT OF FAILURE TO MEET ASSUMPTIONS
A very important point worth stressing for any given series of WL policies sold over the last few decades pertains to times when actual results vary further and further from originally illustrated values. At a point the resulting trends become irreversible.
When it comes to negative actual versus illustrated results there are typically two possible major causes contributing to this result. That said, there are other less likely factors that can also either individually have a major impact on future results, or in combination do so.
- One would be the payment of excessive levels of death benefits. This might occur if there were systemic failures in a company’s underwriting of proposed insureds or if a company is too aggressive in quoting lower premium rates for health circumstances. There is little ability to make this determination since that level of information is unlikely to be published by any given company relative to any given WL series sold.
- The other would be lower earnings rates being realized in the general account versus those assumed and illustrated when the product was sold. Which is the case today; a situation that has persisted for several decades now. The impact of this shortfall literally has compounded to the point it has become irreversible.
The reality is general account earnings levels have been far lower than were assumed decades ago with no likelihood that will change any time soon. While there has been a continued modest improvement in mortality experience versus that which was illustrated. The latter has not been sufficient to offset the former.
AVAILABILITY OF HISTORICAL INFORMATION
Other “How it Works” WL write-ups discuss the difficulty in comparing the WL products of different companies both currently and as pertains to policies issued over time. For a complete discussion of that topic please consult those write-ups. They cite certain sources of information that can prove insightful.
For purposes of this discussion suffice it to say there are sources of information available that are helpful to anyone trying to compare WL products, or companies selling them. To some degree this information does make it possible to “see” what is actually happening behind the WL curtain to some degree. The “source” of this data is typically State regulators who collect certain data from the companies they regulate. This data is public information and certain entities access it from time to time and publish various comparisons and summaries which are available to certain other entities.
Some sources focus on the composition of general accounts. Among other things they provide information on account composition by asset class, maturity durations, unrealized capital gains and average yields on its invested assets.
Other sources focus on comparing ten and twenty year old illustrated values to those that have actually been realized for selected WL selling companies. These comparisons can be most insightful.
RECAP OF FORMULA AND ASSUMPTION DISCUSSION
It is not clear to the casual observer that illustrated whole life values are the result of a myriad of assumptions, with ongoing compounding of assumed subsequent accumulations and multiple other interrelated calculations.
There is nothing stated in the illustration, or its footnotes to explain what’s involved. Even if the various calculations were referenced there would still be no specifics provided relative to all of the assumptions built into the calculations.
WL is by design a “trust me” bundled product with hundreds of hidden moving parts.
That’s really what it is. Albeit a trust that is easily and perhaps often violated by companies as the need arises. Made all the more possible by the lack of transparency the WL product affords since most or all of what determines WL values is hopelessly bundled and hidden from view.
It is fair to say that at some level and to some degree it is possible to take apart a few of the WL policies guaranteed elements. But while possible to some degree even this can be difficult, confusing and at a point it also becomes impossible.
WL is an absolutely ingenious “pre” computer creation. A product developed at a time the computing power needed to track endless discreet details did not exist, nor was it even imagined it ever could exist. A time where it was necessary to devise an approach that would allow a bundled product to deliver individualized benefits.
If the economic environment would remain positive and stable, if human nature were more trust worthy and if regulatory aberrations were not allowed to interfere it might even be the best life insurance product ever devised.
Sadly, those are not the realities impacting the WL policy design.
WRAP UP COMMENTS
The manner in which WL policies function, meaning how guarantees and dividends combine to make up the WL product, are discussed in more detail in other write-ups.
If they’ve not been read as yet, I’d suggest them as “must” reading for anyone inclined to continue the quest to better understand how WL works. Knowing about WL design basics, when combined with what was learned in the “WL box” story, provides a very good start indeed.
Combine that knowledge gained with knowing how policy guarantees work and how dividends find their way into a WL policy and you have a good start to understanding the mystery that is WL. But even then that’s just a start!
