The equal outlay method works like this: The client is assumed to outlay (payout) the same premium for each of the policies to be compared. Likewise, the client is assumed to purchase, in each policy under comparison, essentially equal amounts of death benefits year by year.
The equal outlay method is easiest to employ when comparing flexible premium type policies (e.g. universal life) because it is easy for the insurer/agent to generate the illustration with equal annual contributions.
Planners should demand that:
- the illustration projects cash values using the guaranteed rates for the policy;
- the insurer/agent run separate illustrations showing a selected intermediate interest rate assumption; and
- the insurer/agent run separate illustrations showing the current interest rate the company credits to policies.
An inspection of the projected cash values in future years should make it possible to identify the policy with the highest cash values and, therefore, to determine which is the best purchase. The procedure will be more complicated where the equal outlay method is used to compare a fixed premium contract with one or more flexible premium polices.
Here, the net premium level (adjusted for any dividends) and the death benefit of the flexible premium policies must be made to match the corresponding values for the fixed premium contract for all years over the period of comparison. This makes it possible to compare future cash values in the same manner as when comparing two flexible premium policies.
As shown in the figure above, planners also can use the equal outlay method to compare two or more fixed-premium policies, or to compare a term policy to a whole life policy, in the following manner: Hypothetically, “invest” the differences in net annual outlay in a side fund at some reasonable after-tax rate of return that essentially keeps the two alternatives equal in annual outlay. Compare cash values and total death benefits (including side fund amounts for both).
Note, quite often the result of this computation will show that term insurance (or a lower-outlay whole life policy) with a side fund will outperform a permanent type whole life plan during a period of perhaps the first seven to ten years but then lose that edge when the projection is carried to a longer duration.
There are a number of disadvantages to the equal outlay method:
1. When comparing a fixed to a flexible premium contract, the underlying assumptions of the contracts are not the same and, therefore, the analysis cannot fairly compare them. For instance, many universal life cash value projections are based on “new money assumptions,” while ordinary life policy dividends are usually based on the “current portfolio rate” of the insurer (a rate that often varies significantly from the new money rate). Because the portfolio of the insurance company includes investments made in prior years that will not mature for several years, the portfolio rate tends to lag behind new money rates. If new money rates are relatively high, the portfolio rate will generally be less than new money rates. However if new money rates are trending down, portfolio rates will generally be higher than new money rates.
This difference in the rate used to make illustrations can be misleading. For example, if new money rates are greater than the portfolio rate and the trend of high new money rates continues for some time, cash values in universal life contracts are more likely to materialize as projected. But if these economic conditions hold true, then it is likely that the portfolio rate will also rise. This means dividends paid would increase relative to those projected based on the current portfolio rate. The equal outlay method does not take into consideration either the fluctuations in rates or the differences in how they are computed.
2. The required adjustments in most comparisons can quickly become burdensome. In many cases, it is quite difficult to equate death benefits under comparison policies while maintaining equal outlays.
3. When comparing an existing policy with a potential replacement policy, the analysis must consider any cash value in the existing policy at the time of the comparison. Generally, it is easiest to assume that the cash value will be paid into the new policy. Otherwise, the analysis should probably account for the time value of that cash value and should, as closely as possible, equate total death benefits including any side fund.
4. The results, even after many adjustments have been made, may be ambiguous. Quite often the results can be interpreted as favoring one policy for certain durations, favoring another policy for certain durations, and favoring even another policy for other durations.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM