TWO SIDES OF THE SAME COIN:

Economic Damage Models Commonly Used in Life Insurance Policy Litigation

TASA ID: 22346

When contesting the sale of a life insurance policy, the Plaintiff will typically seek economic damages for the alleged unsuitable nature of the policy sold. Two of the most prevalent economic damage models used in these types of litigation are the "alternative investment" and the "expectation" models. In the past, I have opined on economic damages regarding life insurance policies and found these models share common characteristics but often yield dramatically different results.

Model #1 - The Alternative Investment Model

This model utilizes a basic but-for calculation. It calculates the growth of money assuming the insurance policy premiums were deposited in an investment account, earning a hypothetical growth rate instead of being used to purchase a life insurance policy. In most of these calculations, experts perform Monte Carlo simulations or utilize benchmark investments to estimate performance in arriving at a hypothetical but-for value. This speculative value is then compared to the actual values of the contested life insurance policy.

While this model seems logical initially, it needs to be revised in two primary areas. First, it ignores the recurring cost of the policy's death benefit protection, and second, it may rely on improper return assumptions when calculating the hypothetical but-for values.

Cost of Death Benefit Protection

Even though many cash-value life insurance policies, including Variable Universal Life (“VUL”) and Indexed Universal Life (“IUL”), have investment-like attributes, they are unique assets that are difficult to compare to non-insurance assets such as investment portfolios. By their very nature, life insurance policies all contain a transfer of risk component not found in investment-only portfolios. Upon the insured's death, the policy beneficiary receives a death benefit often substantially greater than the policy's cash value, and there is an embedded policy cost for this protection. Without modification, the alternative investment approach ignores this inherent nature of life insurance in its calculations.

Death benefit protection is presumably one of the fundamental factors influencing a life insurance policy purchase. The additional cost for the death benefit is present in any life insurance policy; therefore, it is simply not appropriate for one to compare the performance of the policy’s cash value to the performance of a “pure” investment account without accounting for the recurring cost of the death benefit protection. Unless the Plaintiff is arguing they never desired death benefit protection in the first place, there must be an accounting of this cost.

Furthermore, it is not difficult to ascertain the cost of this death benefit protection, and the calculation is not cumbersome. The Internal Revenue Service publishes a table in its regulations that assists in calculating the price of this protection.

Reliance on Improper Returns

Many life insurance policies offer inherently safe returns incompatible with growth-oriented investment portfolios often used in damage calculations. The risk-return assumptions embedded in a life insurance policy are typically at odds with the risk-return assumptions used in any benchmark investment or Monte Carlo analysis. Moreover, any investment performance is entirely hypothetical and relies on various assumptions that may be divorced from reality. As one could expect, even with a modest historical rate of return, when policy premiums are no longer subject to the drag of death benefit protection charges, they compound dramatically over time.

When calculating damages and estimating returns, one must use a real-time perspective in considering the timing of events as the parties would have experienced them. Under this approach, it may or may not be reasonable to use hindsight when calculating the loss of use, especially if parties testify they would have been happy with returns less than actual historical returns. It may be more reasonable to utilize a cost-of-funds approach in calculating damages instead of historical returns of a growth-oriented portfolio or a benchmark investment index such as the S&P 500.

Creating a “modified” alternative investment model to include a recurring cost for death benefit protection and using realistic return assumptions yields a more reasonable result in many circumstances. This is especially true when testimony indicates a primary purpose for acquiring the contested policy was to guard against the early death of the insured.

Read more on Model #2 by downloading the entire article below.