Selecting a permanent life insurance policy can be confusing. Insurers offer a wide variety of life insurance policies, including whole, universal, and variable life policies (read more about types of policies in "Intro to Insurance: Types of Life Insurance"). Once you decide on the permanent life insurance you would like, you should ask your independent agent to send you an illustration of the policy to help you understand the terms.

What is a Life Insurance Illustration?

The term "life insurance illustration" is a bit misleading because these are not simple charts or pictures. These illustrations are instead hypothetical ledgers that show exactly how a policy might perform under many different circumstances and outcomes. The illustration can be comprised of up to 15-20 pages of complex text, but it does follow a general format and guidelines established by regulators. Yet, even with the standardized format, there is no denying that illustrations are difficult to understand, even for professionals. 

To create a life insurance illustration, the agent plugs many different variables into a software program. Some of these variables will include your age, health rating, and family medical history. Other variables include how you plan to pay, the assumed rate of return, and the age you will be at the end of the policy. These variables help the software calculate the cost of insurance, policy charges, expenses, and riders. Finally, the variables determine a planned or target premium.

Check Your Variables on the First Few Pages

The first few pages of the illustration contain an explanation of the coverage, terms, and definitions. Every company’s illustrations differ, as do illustrations for different kinds of coverage. As you look through these pages, you want to verify that the agent entered your correct variables--check that your rating, age, and how you plan to pay are all correct. Also, check any riders that are part of the policy, the premium, and if the policy has a level or increasing death benefit (sometimes called option 1 or 2). If you have a policy with a level death benefit of $250,000 and a $25,000 cash value, the policy will only pay out $250,000. A policy with an increasing death benefit of $250,000 and a cash value of $25,000 would pay $275,000 (the $250,000 death benefit plus the $25,000 cash value). Since you are buying more insurance with an increasing death benefit, the numbers in the illustration will differ.

There should also be an explanation of current and maximum policy fees and expenses as well as a minimum guaranteed and current interest or dividend rates. It's very important to check that all the variables are correct because once the company issues the policy, contractually guaranteed items, such as your age or rating, can’t change. However, the insurer can adjust fees and crediting rates. No lapse policies are not affected by these changes since the insurer absorbs any interest rate risk or policy cost increases and guarantees. As long as you pay the premium on schedule, the policy will stay in force until a set age. But in exchange, the policies build little cash value.  

Read the Ledger or Table

Next, you want to look for a ledger or table, usually on or near a page that requires your signature. Based on the proposed premium, these ledgers (labeled guaranteed and nonguaranteed) illustrate, in five-year increments, how the policy could perform under different scenarios.

The guaranteed column (a worst-case scenario) illustrates how long the policy would stay in force if the insurer charged the maximum fees and paid the minimum interest or dividend crediting rate. Usually, the policy lapses long before your expected mortality, and to keep it in force; you would need to pay a significantly higher premium.

The nonguaranteed column may include two ledgers, sometimes called current or illustrated and midpoint. Using the proposed premium, the current ledger (a best-case scenario) shows the death benefit and how much cash value the policy could build based on the current policy fees and a high assumed interest or dividend crediting rate. The midpoint ledger (a most likely scenario) shows how the policy would perform assuming current policy fees, but with an interest or dividend rate that is between the current and guaranteed. The assumed rate of return is usually shown at the top of each ledger column. The illustration will also include many pages of detailed ledgers showing the guaranteed and nonguaranteed values year by year, as well as supplemental reports showing policy fees and expenses.

Examine the Rate of Return Assumptions

When reviewing the ledgers, it’s important to think about your risk tolerance and the rate of return assumptions. If an aggressive return is illustrated in the nonguaranteed ledger, for example, variable policies often assume a 7-8% return after fees and expenses, and the actual return is less the policy could lapse prematurely, or you will have to significantly increase your premium payment at some point in the future. Remember, the proposed premium is a suggested payment based on the assumptions in the illustration. In most policies (with the exception of no-lapse guarantee and whole life policies), you have the flexibility to pay a higher or lower premium.

The Bottom Line

Since you are buying permanent life insurance to cover the rest of your life, it's a good idea to take a conservative approach. Don’t get sold on the best-case scenario of high returns every year and endlessly growing cash values. For example, policyholders who bought universal life policies 10-15 years ago (when fixed interest rates were 5-6%) are experiencing problems with those policies today. In today’s low-interest-rate environment, these policies only earn the minimum guaranteed rate, and many are lapsing, or the owners, often retirees, are forced to pay significantly higher premiums to keep the coverage.