Stress Testing: Why It’s Important
The standard insurance illustration and NIW proposal show the projected collateral based on the lender’s LIBOR projections. While that is the forecast that the lenders see moving forward, it is their “best efforts” forecast and NIW wants to ensure that the client is prepared for economic fluctuations that would fall outside of these projections. This gives the client a good understanding of what their risk could look like given different circumstances.
Historically, the S&P will return 0% in 30% of years, which is something the insurance illustrations do not show, and why it is important to show a stressed scenario to every client. If the client is shown extreme stress testing (which is a very low probability event), they will have managed expectations in the event of low performance. In addition, the fact that the design still recovers gives the client increased confidence in the performance of the design, and reinforces that anything less extreme is not a cause for concern.
The two worst time periods that would affect these financed insurance designs in the US economy’s history are the Great Depression and the 1980s high interest rate environment. These two scenarios test different aspects of a financed life insurance plan. The Great Depression tests an insurance carrier’s policy, as 7 out of the first 10 years had a 0% policy credit, when the impact of contract costs is greatest. The 1980s covers the worst interest rate period in US history, and very slow bond yield response inside of the product itself.
Client’s Biggest Concern
We’ve found that a client’s biggest concern about financed plans is the required collateral, which is why we show whichever stress test has the biggest impact on the amount they need to post. By doing this, the client can be comforted in knowing that they will most likely have the appropriate collateral the design will need to not only survive, but also to achieve the plan’s objective. We do this because we want to set expectations for the client about what they will get and what it will cost to get there. The benefit of a NIW financed design is that even in stressed conditions the collateral is frequently lower than the cumulative out of pocket would have been if they purchased life insurance conventionally. By showing the stressed condition compared to the conventional cost of purchasing equivalent insurance, the client gets a better understanding of the value of this financed plan. Bottom line, if the client merely needs to post more collateral (which is returned), then the value proposition of this plan is both clear and compelling.
Lastly, the stress tests provide another valuable benefit: they weed out weak design and weak product. Most illustrations look good on paper but they don’t show the full picture of the risk factors involved. If the proper procedures are not put in place, risk factors are not controlled, and client expectations are not managed, plans that look good on paper will ultimately fail. Stress testing allows NIW and the client to reject designs that are not suited for the client’s long-term strategy and choose the products and designs that work best for their financial goals and risk comfort level.
What are your thoughts? We’d love to hear what you think in the comments below.