As Seen in National Underwriter AdvisorFX

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

Last month we talked about how cash value is influenced by the different cash value investment options, the historical performance of such cash value investment options, and cost-effectiveness of the various cash value allocation options. This month we talk about using the most advantageous and consistent rate of return. There are different ways that companies publish rates of return depending on the type of life insurance. Rates of returns available for life insurance illustrations are as follows:

• Gross Rate – The gross policy interest/earnings rate is that rate of return credited to policy cash values reported before deduction of investment‑related fund management expenses (FMEs) and before deduction of cash-value-based insurance expenses.  The gross rate is typically disclosed in variable life products but not typically disclosed in traditional universal life and whole life products, and either way is directly related to the rate of return on invested assets underlying policy cash values. Gross Rate is more of a general “asset‑class rate of return” than a policy‑specific rate of return. While the Gross Rate may be an interesting piece of information as it relates to benchmark performance of the respective asset classes underlying policy cash values, it does not reflect the earnings actually credited to policy cash values. It is most useful as a starting point in setting reasonable expectations as to the investment performance of policy cash values. 
• Net Rate – The net policy interest/earnings rate is that rate of return credited to policy cash values reported after deduction of investment‑related FMEs, but before deduction of cash-value-based insurance expenses.  In other words, this “Net Rate” is equal to the Gross Rate minus FMEs, and as such is most closely analogous to the “investment rate of return” on policy cash values (e.g., universal life policy interest crediting rates and whole life dividend interest crediting rates are generally reported, if disclosed at all, after corresponding investment expenses in the same way as bank certificates‑of‑deposit report interest after deduction of related investment expenses. Variable life separate account earnings rates are reported after corresponding investment expenses in the same manner as how mutual funds report earnings after deduction of related investment expenses).  Since the Net Rate is derived directly from the Gross Rate for the given asset allocation, and because FMEs are a function of that asset allocation (i.e., FMEs are lower for conservative fixed‑income cash value allocations than for aggressive equity allocations that may include higher‑cost international and/or emerging market asset classes), the Net Rate is most used while running multiple hypothetical policy illustrations between different products, and is thus used to review the performance of the policy under evaluation to the hypothetical performance of its  benchmarks.  For reasons explained further immediately below, this Net Rate can also be referred to as the “Single Net Rate”. 
• Net-Net Rate – The net-net policy interest/earnings rate is that rate of return credited to policy cash values reported after deduction of both investment FMEs and cash‑value‑based insurance “wrap fees” (e.g., M&Es).  In other words, this “Net‑Net Rate” is equal to the Net Rate minus M&Es, and because this Net‑Net Rate reflects the rate of return reported on policy cash values after all cash‑value‑based fees, it can also be referred to as the “policy rate of return” or the “Double Net Rate” (i.e., the rate of return on policy cash values after deduction of both investment and insurance “wrap fees”, but not considering COIs, FAEs nor premium loads).  Because this Net‑Net Rate is a function of the individual policy holding, and is not a function of the policy asset allocation, nor the expected Gross Rate corresponding to that asset allocation, nor the corresponding investment expenses for that asset allocation, the Net-Net Rate is most useful in measuring the appropriateness of policy expenses (e.g., because the Net-Net Rate is the rate of return at which cash values would otherwise grow but for the deduction of all other policy expenses, the Net‑Net Rate is also useful in accounting for differences in the timing and amount of COIs, FAEs and premium loads between one policy holding and another). 

While certain practitioners may disagree with the use of a consistent Net Rate for comparison of hypothetical performance and corresponding expenses, and instead suggest that using a consistent Gross Rate produces as a more accurate means of policy comparison, the use of a consistent Gross Rate for the purposes of such comparisons is only valid when the appropriate cash value allocation is known and also made consistent in all products under evaluation.  For instance, consider a comparison of performance and costs between two products based on a consistent 8.0% Gross Rate but where the cash value allocation is assumed to be balanced among both fixed income and equity asset classes with an average FME of 100 bps in Product A, while Product B is assumed to allocate 100% off cash values to a stable value account with low FMEs of only 25 bps, as shown below: 

As shown above, comparing policy holdings based on a consistent Gross Rate, but without knowing and also making consistent the cash value asset allocation, can result in understated investment expenses and overstated policy performance.  Because there is no way of knowing the proper asset allocation for the policy under evaluation, you cannot ensure consistent review of policy performance and costs based on the Gross Rate.  In addition, because the asset allocation can and typically does change over the life of a given policy, which in turn also changes investment expenses for that policy, and because Separate Account funds are frequently added to and deleted from a given product, which in turn again changes investment expenses for that policy, comparing policy holdings based on a consistent Gross Rate produces inconsistent results over time (e.g., a product considered to offer low costs based on one illustrated asset allocation could be assigned a different ratings based on a different cash value allocation).  On the other hand, because cash‑value‑based insurance expenses (e.g., M&Es) are set at the time of policy issue, and do not change from that pre‑set schedule, reviewing policy holdings based on a consistent Net Rate will produce consistent results over time.