Unbeatable Life Insurance Suitability
Life insurance product suitability is taking on all new importance. 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. Because of the way we style our BOLI type life insurance policy, pretty much all other IULs are no longer suitable.
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:
- Client’s Needs and Objectives: The primary factor is understanding the client's unique needs and objectives. These can range from wealth transfer and estate planning to business succession, income replacement, and tax planning. For TOLI, the purpose might be to finance estate taxes or ensure a legacy for beneficiaries. The selected insurance product must align with these goals.
- Client’s Financial Situation: It’s essential to consider the client's current financial health, risk tolerance, and future financial projections. This includes assets, liabilities, income, expenses, and any existing insurance policies. For example, a high-premium variable life insurance policy might be unsuitable for someone with limited cash flow or a conservative risk profile.
- Product Features and Benefits: Different life insurance products come with varying features and benefits. These can include guaranteed death benefits, investment components, cash value accumulations, loan provisions, and surrender values. It's vital to evaluate which product's features align best with the client's objectives.
- Product Costs and Charges: Life insurance products can have a range of fees and charges, such as mortality and expense risk charges, policy administration fees, fund management fees for investment components, surrender charges, and loan interest rates. It's crucial to ensure that these costs are transparent and understood by the client, and they should be weighed against the benefits the product offers.
- Performance and Reliability of the Insurer: The insurer's financial strength and reputation play a significant role. Clients are placing a long-term bet on the insurer's ability to pay a claim possibly many years into the future. Therefore, reviewing the insurer's ratings from agencies like A.M. Best, Moody’s, and Standard & Poor’s is essential. Additionally, the track record of the insurer in terms of claim payments, customer service, and product performance should be taken into account.
The evolving regulatory landscape has elevated the importance of suitability in life insurance product selection. With potential legal liabilities increasing, agents and brokers must be vigilant in ensuring that the products they recommend truly serve the best interests of their clients. This involves a comprehensive understanding of the products available in the market, keeping abreast of regulatory changes, and continually reassessing the client's evolving needs and circumstances.
How These Factures Effect Suitability
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).