Academic journal article Journal of Accountancy

Life Insurance Due Care

Academic journal article Journal of Accountancy

Life Insurance Due Care

Article excerpt

Most CPAs who advise clients on business and estate planning find themselves reviewing existing or proposed life insurance coverage. It is common for CPAs to be asked for advice on transactions such as making gifts to pay life insurance premiums, placing life insurance in irrevocable trusts or using life insurance to facilitate business succession. While life insurance plays an indispensable role in these and many other arrangements, stories of policies--and even insurance companies--that did not perform as expected abound. Clients may then turn to their CPAs and ask: "What went wrong?"

To avoid such problems, due care must be taken to evaluate life insurance companies and policies using all available information. When clients plan to use life insurance to solve business, estate or investment problems, understanding the due care process will help CPAs be a more effective part of a client's team of advisers.

INTEREST RATE FLUCTUATIONS

For many years, life insurance got cheaper and cheaper. Mortality rates were decreasing; interest rates were stable or slowly increasing. Historically, it seemed conservative to use sales illustrations showing how a policy would perform if the company's current dividend scale or interest rates continued. Consumers became accustomed to policies that always performed as well as, or usually better than, initial illustrations.

The sharp increase in interest rates that peaked in 1980 changed the situation. The practice of illustrating policy performance using current results continued through most of the 1980s--few companies considered showing what would happen if high interest rates didn't continue indefinitely. As market rates declined, some companies sought continued high yields by making riskier investments. Others tried to make illustrations appear better by finding more nonguaranteed ways to reduce apparent premium requirements, not disclosing the assumptions underlying some of those results or the increased risk built into the underlying product structure.

ENTER LIFE INSURANCE DUE CARE

It's relatively easy to choose a life insurance policy that illustrates the best current performance. It's also easy to ignore illustrations and choose an insurance company with the highest safety ratings. Due care involves balancing these countervailing safety and performance objectives in a way that suits a specific client's needs, funding abilities and risk tolerance. After these factors have been identified, the due care process begins with learning the overall financial security of the insurers being considered. The next step is to assess the credibility of an insurer's policy illustrations, which determines how they are used to effectively set a range of expectations for coverage costs and benefits.

Can applying due care to a life insurance purchase impose certainty on the uncertain world of life insurance? It's impossible to make absolute predictions of future policy results. But due care can enable CPAs and their clients to make informed choices. The process can strengthen a CPA's trust in both the insurance professional and the company he or she recommends.

INSURANCE COMPANY SAFETY

In reviewing any life insurance purchase, the most basic question is whether the insurer will remain strong over the long term. There is no guarantee a stable and well-managed insurer will remain so. But a review of current financial factors and published qualitative evaluations of a company's operations lets CPAs make informed recommendations to their clients.

Making effective use of published rating service reports is the first step. Four rating services--A.M. Best, Duff & Phelps, Moody's and S&P Claims-Paying Ability rating service--routinely publish comprehensive life insurer reviews using management interviews as well as evaluations of published and supplemental financial information. Reports include letter ratings, statistical information and a narrative evaluation and conclusion. …

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