Life Insurance and Annuity Illustrations – An Actuary’s Role
Spotlight Issue 3 – 2011
I started my career as an Actuarial Trainee back in 1982 working for a life insurance company that was involved quite heavily with the burgeoning interest sensitive life market. Universal Life had burst on the scene and many life companies were trying to develop and market these plans as quickly as possible.
Shortly after I started working, my boss gave me a look at a life illustration that he wanted me to review for accuracy. Back then, the entire “proposal” was two pages long. Aside from the figures and column headings, there was no verbiage disclosures to be found anywhere on the proposal.
Fast forward nearly 30 years and the story is quite different. Life insurance and annuity proposal software sophistication have evolved tremendously. I’ve seen proposals in excess of 100 pages or more!
As an actuary, my involvement in life and annuity proposal systems has been fairly consistent since the beginning of my career. Today’s market has been trending toward products, regulation and financial reporting standards that are quite complex and have a direct impact on proposal software.
It is important these days for companies involved with developing proposal software systems (illustration and/or inforce) to have adequate on-staff actuarial support to help increase the odds of a successful product implementation on a software proposal system, as well as increasing the speed to market factor. Actuaries with life and annuity backgrounds in pricing, financial reporting and/or systems can make significant contributions as a direct result of their training and experience. The presence of actuarial expertise at the vendor level can even be utilized to assist companies in the product development process, accelerating the pace by acting as an additional actuarial resource for the client company and increasing the odds of getting the product to market sooner.
The Early Days
The 1980s were a transitional period for life insurance and annuity companies. Products, regulation and financial reporting of newer products were evolving at a rapid pace. Universal life, variable life, and a host of other like products began to make their way into the marketplace. Until then, life insurance had been thought of solely as protection for one’s family; whole life and term were, at that time, fairly conservative products with few (if any) bells and whistles.
The 1980s saw changes to the standard valuation law for life insurance and annuities, as well as updating of mortality experience for pricing and valuation purposes. These and other changes were beneficial in helping to promote an entrepreneurial environment for life insurance and annuity product development.
On the life side, universal life set the industry ablaze as the UL policy’s structure was different than what anyone had seen in the past. Flexible premiums, flexible death benefits and interest sensitive crediting with rates that were closer to market rates than ever before combined to form a powerful and intriguing policy form that sold very well during this decade. Regulators were trying to get their arms around it all.
The lack of regulatory framework for UL was seen as a competitive disadvantage for other segments of the financial services industry. Before long, there were new laws and regulations that life insurance companies had to contend and comply with, such as the Deficit Reduction Act of 1984 (DEFRA), the Tax Reform Act of 1986, and the Technical and Miscellaneous Revisions Act of 1988 (TAMRA), that imposed newer and tougher standards for life insurance companies to comply with.
Nonetheless, life insurance and annuities sold quite well during the 1980s. Interest rates were high and many life issuers were taking advantage of these higher rates in their life insurance proposals. The most recent update to the Commissioners Standard Ordinary (CSO) Table, the 1980 CSO, had also helped by updating the mortality standard from the previous and quite outdated 1958 CSO. All in all, the landscape was very promising.
As with the rest of the industry caught up in the excitement and revamping of the life industry brought about by the advent of universal life and other newer products such as variable life, everything was moving quickly, sales were booming and the future looked solid.
There was not much change to the basic structure of the life insurance illustration during the 1980s. They were still fairly straightforward and simple as companies began to grapple with some of the more comp-lex issues of how to illustrate certain items or how to integrate new rider forms into the illustrative process. The 1980s was an era of entrepreneurial achievements and rapid growth in the life insurance industry, which left very little time to play or even think about defense.
There were a few companies out there that read the writing on the wall and began to put disclaimers and caveats into their illustration output. There were even some that would limit the interest rate that could be illustrated on the current ledger to something less than the prevailing market rate. While these companies seemed a bit prudish at the time, in retrospect their actions were just a glimpse of what was to come.
Tough Days Ahead
Life Insurance Industry Groups As the industry entered the 1990s, the collapse of the S&L industry, the failure of a few prominent life insurance companies and the intense recession that followed were a sobering wake-up call to the financial services industry. Life insurance industry groups began to take a closer look at these new interest-sensitive liabilities and built a financial reporting framework that more adequately captured the nature of these liabilities. This ultimately led to more companies setting aside more capital as well as maintaining higher reserves for such products.
At the same time, interest rates continued their downward trend and it soon became evident that this continuing trend would have an adverse effect on existing life insurance illustrations that had been illustrated using what seemed to be reasonable rates at the time. Most companies did not factor in that many of the higher earning investments would ultimately roll off the books and have to be replaced with lower yielding investments or, as many companies found to their chagrin, default as the result of a company going under.
For those who purchased interest-sensitive life insurance products in the 1980s with the promise of “vanishing” premium payments, the 1990s lower interest rates brought the unfortunate surprise to many of these consumers that premiums were not going to vanish as scheduled, or even vanish at all. As more consumers began to fall victim to having to pay more premiums than they anticipated, class action litigation attorneys began to take note.
The 1990s continued with a spate of class action litigation aimed at life insurance companies. Most of these lawsuits focused around life insurance illustrations and the inability of the life insurance industry to credit rates at what was originally proposed. The life insurance illustration itself became somewhat of a smoking gun.
All of these factors ultimately led to the Life Insurance Illustrations Model Regulation proposed in the latter part of the 1990s. While there are many facets of the model regulation, the intent was to increase the standardization of life insurance proposals as well as to protect the consumer. This model act also brought the requirement that a company marketing life insurance products must have a designated “illustration” actuary who was responsible for certifying that the company’s illustrations met the standard of the model regulation. The New Millennium
As we entered the 2000s, life insurance and annuity companies were continuing to move forward in the implementation and ongoing development of their systems so as to better handle all the vital legislation that had come down the pike in the prior decades. My experience has been that it takes several years to fully comprehend, implement and administer many of these prominent regulatory changes simply because they can be quite complicated to understand (gray area), there is often the need for clarification from the author of the regulation (IRS, e.g.) and company employees still have other critical work that needs to get done, such as developing new products or updating existing products in this incredibly competitive landscape.
Companies were still developing creative and viable product structures, such as shadow account UL, indexed annuities, return of premium term, indexed life and so on.
As with the regulatory initiatives and financial reporting standards, product complexity with respect to moving parts and general understanding continued to increase. Aside from developing and enhancing newer forms of life insurance and annuities, the creative process continued down to the rider level, such as the proliferation of living benefits for variable annuity products.
This led to a plethora of life insurance systems work that involved the company’s administrative system(s), life and annuity illustration platforms, as well as inforce ledger proposal platforms as companies continued to work diligently towards satisfying ever-increasing compliance standards, as well as continuing to turn out new products or retool existing products to combat the ever diminishing shelf life of life and annuity products.
Life Insurance and Annuity Illustrations
Of course, all this increasing complexity has had a major impact on life insurance and annuity illustrations. Even though annuities were not covered under the Life Insurance Illustration Model Regulation, annuities are scrutinized just as much as life products if not more. There is currently an Annuity Disclosure Model Regulation that has been proposed by the NAIC that includes a section on annuity illustration standards.
As mentioned, the first life insurance illustration that I held in my hand was two pages in length. Recently, I had a life insurance/LTC combo product illustration in my hands that was more than 100 pages (closer to 200 pages actually) long.
Quite a bit of this increase in length is due to the presence of explanatory and disclosure language, intended to assist the insured in better understanding the product and its possible limitations or outcomes. There are also supplemental illustrations, intended to show the effects of disbursements (for example) or alternative scenarios. There are “midpoint” ledgers (ledgers that use the average of the current scale and guaranteed scale assumptions) to show a prospective insured what would happen to illustrated values if charges and credits were somewhere in between current and guaranteed.
Furthermore, there are descriptions of applicable premium limits and how those limits are applied, driven by the Guideline Premium Test / Cash Value Accumulation Test (DEFRA) and 7-Pay Test (TAMRA).
While there are more items that can be listed that have led to the increased length of illustrations, let it be said that illustrations have and continue to evolve in sophistication and complexity.
The Actuary’s Role
Going back to the early 1980s when I saw my first life insurance illustration (all two pages of it), quite a number of the companies I was exposed to handled their life illustrations internally, often as a part of the marketing department.
A few illustration providers popped up along the way, yet it wasn’t until the 1990s when the increasing complexity brought about by regulation, financial reporting standards and more sophisticated life insurance products, that companies began to look to outside vendors to produce their life illustrations. Maintaining an internal illustration department is not only costly, but is also subject to fluctuation as employees come and go through the department. In short, having a viable, stable vendor for life insurance proposal software is very important in today’s market, especially as several vendors have also come and gone during the past 20 years.
I’ve always been a bit intrigued by non-traditional actuarial roles, having held a few in my time. At the end of the 1990s, I helped develop an “actuarial systems” department at the company I was working for at the time. This department was involved in helping to ascertain the accuracy and integrity of the large number of calculations developed by the company’s administrative systems (there were three to four different legacy systems), the company’s vendor developed proposal (illustration) software and the internally developed inforce ledger system.
My experience up to then had led me to believe that systems work was perpetual and ongoing (a belief that has held true with a vengeance!). Given that these systems developed values for clients that they relied on, it only seemed fitting that someone trained in actuarial science be intimately involved with the development and testing of the myriad of computations that comprise these systems. While there are literally millions (or more) different combinations of the various criteria that go into the development of policy values (gender, issue age, underwriting status, base product face amount, riders, etc.), the need for actuarial expertise has also increased due to the increasing complexity of products and the newer bells and whistles they carry.
About this same time (late 1990s) I began to wonder why the illustration providers that I had worked with along the way did not see fit to have any actuaries on staff, using mathematically inclined programmers instead to handle more of the rigorous algorithms and solve techniques inherent in some product lines.
While the mathematically adept programmers that I have had the pleasure to do business with over the past quarter century have been some of the most brilliant individuals I have known, the absence of an actuarial focus had a tendency to make the process of communicating and resolving calculation issues a little tenuous at times.
As a life insurance company actuary having to deal with two (or more) software vendors at a time, I could at times be frustrated by the lack of an actuarial presence with the vendors I did business with. Given that a large percentage of an illustration or inforce ledger was calculation driven, it seemed like a perfect fit for an illustration vendor to have at least one actuary on staff.
At that time (late 1990s), the illustration vendor business model was perhaps not yet ready for adding an actuary to the payroll, products were not as complex as they are today, products had longer shelf lives and speed to market was not as accelerated as it is today.
Now, however, that has all changed and a few illustration vendors have added an actuarial role to their staff. I see this as a continuing trend. Most life insurance and annuity direct writing companies recognize the value added that well-trained and experienced actuaries bring to the table. Along with the ever increasing regulatory requirements that impact illustrations, the importance of the illustration actuary’s role and the increasing complexity of product computations (including the finer points of DEFRA and TAMRA), I really don’t see how an illustration vendor could operate without at least one actuary on staff in today’s market.
Other Ways of Helping Clients
In addition to shoring up an illustration vendor’s staff expertise, an actuary can assist clients in other ways. One of the more interesting ways of helping has been to assist the client in the product development process itself. That is, before the product is even filed or ready for illustrating!
The economic environment of the past few years has caused many employers to downsize their staffs, leaving many companies with resource issues. This rings true in the insurance business as well with many actuaries wearing many hats and working long hours.
In today’s competitive market, a company has to satisfy its sales force by continually bringing out newer products or, as is more often the case, updating existing products to stay abreast of the market.
How does this filter down to an illustration vendor’s actuarial staff? Well, for starters their actuaries can be utilized to help the insurance company’s staff in the development, pricing, filing, etc., of an up and coming product, serving as an extension of the direct writing company’s existing staff. This involvement can pay huge dividends, as having the vendor’s actuarial staff involved in the development process gives them a huge leg up when the product is ready for implementing on the illustration platform. In short, this involvement has been a win-win for several companies as the temporary increase in resource assists the company in meeting the “speed to market” demands placed upon by their marketing departments and the agents that do business with the company. This speed to market is further accelerated because by the time the company needs to illustrate the product, the vendor’s actuarial staff is already up to speed with the product.
Actuarial involvement can also be useful for non-product related issues, such as DEFRA and TAMRA compliance from an administrative perspective.
The life insurance and annuity industry have undergone major changes since the early 1980s. The 1980s were a very entrepreneurial decade for insurance companies which was aided by the overhaul of the insurance valuation model regulation as well as the updating of critical industry tables. The explosive growth of the 1980s were ultimately tempered by the recession of the early 1990s, followed by class action litigation in the mid-1990s and further regulatory changes.The life insurance and annuity illustration/inforce ledger proposal framework has grown in sophistication and complexity as have insurance regulations, financial reporting standards and insurance products. There are many moving parts and an increasing desire by issuing companies to get calculations down to the penny with little or sometimes no tolerance.
Actuarial involvement in life and annuity proposal systems has grown dramatically as well, spurred on by increasing calculation complexities as well as the advent of the Illustration Actuary and their responsibilities brought about by the Life Insurance Illustration Model Regulation.
In addition to actuarial involvement in the integrity and accuracy of proposal calculations, there is also the ability to help clients by serving as an extension of their staff in getting products developed and ready for sale.
William “Bill” Aquayo
SVP, Actuarial Research
FSA, MAAA, CFA, ChFC, CLU