When key person insurance expectations and reality don't align

Companies that insure critically important employees should monitor their plans’ performance

When key person insurance expectations and reality don't align

For some companies, purchasing life insurance on key executives is a good way to mitigate the financial losses that could arise from their death. It could also be a tax-advantaged way to compensate executives.

But when key person policies remain in force for decades, illustrations of their expected performance based on premiums paid are likely to prove inaccurate. If an insurer doesn’t get a good enough return on its invested premiums, that could leave companies — some of which hold US$50-million or US$100-million life insurance policies —  severely exposed.

“[I]ndeed, many company-sponsored policies, purchased 20 or 30 years ago when interest rates and investment returns were substantially higher, are significantly underperforming today,” said a recent article on CFO.com.

“If you bought an investment portfolio 20 years ago, and then stuck it in a drawer and pulled it out today, you would have no expectation that it had performed well,” said Tobi Silver, president of life-insurance consultancy Sterling Resources. “But interestingly, people have no hesitation about doing that with their life insurance portfolios.”

According to the article, companies must get more serious when it comes to monitoring key person insurance. That typically involves hiring consultants to audit their insurance portfolios, which requires gathering a lot of information from the insurance carrier or carriers. That includes identifying policyholders and beneficiaries, determining the premium history since the policies were issued, determining how long they would stay in force based on different premium-payment scenarios, and analysing the carrier’s financial strength.

“A worst-case scenario is a policy that lapses before the expected life expectancy of the insured,” the article said. One way that could happen is when an insurer collects “mortality charges,” which reflect an insured’s mortality risk, annually out of a policy’s cash surrender value. When there are insufficient funds in the policy to pay for those charges, a policy could lapse.

Companies also tend to overlook the need to stress-test their policies under different return scenarios. This is particularly important for equity-indexed universal life (IUL) policies, which lets a policy owner choose a stock index whose price movements would be used to measure the policy’s cash-value growth. Such policies are typically structured with caps and floors to prevent the insured from losses or gains beyond certain thresholds in a single year.

“But when you look at those arrangements, what they purport to do and what they actually do are two very different things most of the time,” said Andrew Liazos, leader of the executive compensation practice at law firm McDermott Will & Emery. Insurers are able to adjust the caps and floors every year, letting them operate with lower reserve costs — and more risk to the policyholder — compared to other product lines.

“If [IULs are not stress-tested before purchase], the policy owner is unlikely to understand the potential risks and likely to be disappointed with the ultimate results,” Silver said.


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