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Life Insurance Product Suitability

As Seen in National Underwritier AdvisorFX

By Barry D. Flagg, CFP®, CLU, ChFC, Founder & Inventor of Veralytic

Life insurance product suitability is taking on all new importance.  Last year, the first breach of fiduciary duty lawsuit involving the suitability of a trust-owned life insurance (TOLI) policy was adjudicated.  Over the past 2 years, FINRA arbitrations involving breach of fiduciary duty for product suitability have doubled and litigation against agents and brokers involving product suitability under the common-law definition of breach of fiduciary duty is also on the rise. 

Also, New York Producer Disclosure Regulations impose a higher standard of care on agents/brokers beginning in 2011, and the Dodd-Frank Wall Street Reform and Consumer Protection Act empowers the SEC to impose a fiduciary standard of care sometime thereafter, which they appear to be leaning towards.  This column will, therefore, discuss life insurance product suitability and its growing relevance. 

Suitability, by definition, is the requirement to determine if a life insurance product is appropriate for a given client, based on the client's goals and financial situation.  In other words, suitability is a matter of both matching product attributes to client objectives and measuring product qualities against peer-group product alternatives.  Investigating suitability, therefore, involves measuring strengths and weaknesses of at least the five major factors, as follows:

  • Financial Strength and Claims Paying Ability
  • Cost Competitiveness
  • Pricing Stability
  • Cash Value Liquidity
  • Historical Performance of invested assets underlying policy cash values

All five factors contribute to suitability, and no single factor is sufficient to determine suitability. While cost is clearly important, buying insurance is different than other consumer purchases. With many consumer products, price is often directly related to quality, and the higher the price the better the quality, durability, or service. For instance, the higher the financial strength of a bond issuer, the lower the interest rate (i.e., the lower the price the issuer must pay to attract investors, and the lower the market value of the bond on the open market).

This direct correlation between policy cost and quality doesn’t necessarily exist in life insurance products. For example, higher ratings for greater financial strength and claims-paying ability don’t necessarily dictate higher costs because a number of other factors influence pricing.  When two products have similar costs, but one insurer has higher ratings, the product offered by the more highly rated carrier is generally more suitable. Conversely, when two insurers have similar ratings, but one insurer has lower costs, the product offering lower costs is generally more suitable.

For permanent life insurance, pricing depends upon a number of factors, and the product appearing to offer the lowest illustrated premium or the highest illustrated cash value or death benefit may not always be the most suitable. Illustrations of hypothetical premiums, cash values and death benefits are a comingling of comingling of undisclosed costs and often arbitrary performance assumptions.  For this reason, the chief regulatory body for the financial services industry considers comparing Illustrations of hypothetical policy values to be “misleading”. 

Instead, cost-competitiveness is a function of what the insurer expects to charge for cost of insurance charges (COIs) to pay death benefit claims and expenses for policy design, distribution, underwriting, cash value management, administration and service.  The stability of such pricing representations should also be considered.  For instance, a product in which COIs and expenses are based on actual mortality experience and actual operating experience is generally more suitable than one priced on assumed mortality improvements and assumed operating gains. 

Access to cash values can also be a suitability consideration, but products with lesser cash values can also be suitable if cash values are unimportant to client objectives, particularly if foregoing cash values results in an additional pricing advantage.  For products with cash values, the actual historical performance of invested assets underlying policy cash values is clearly also a suitability consideration, for the same reason that few if any investors would invest in a mutual fund without at least inquiring about past performance. 

In all cases, suitability is relative to both client objectives and peer-group product alternatives.  For instance, products with guarantees and correspondingly higher expenses can certainly be more suitable for clients with a conservative risk profile than would be products with lower expenses but no guarantees.  Products within whichever peer-group best matches client objectives also offering lower and stable expenses and superior actual performance of invested assets underlying cash values are most suitable of all. 

For previous coverage of the suitability and fiduciary standards in Advisor’s Journal, see Dodd-Frank Wall Street Reform and Consumer Protection Act (CC 10-35) & What You Don’t Know Yet Might Hurt You: A Broker’s Duties under the Financial Reform Act (CC 10 40).