By Ray Bourhis and Alexander MacDougall
The issue of determining the present value (PV) of insurance policy benefits can be as complicated as it is important. Issues that come into play include:
- The monthly benefit
- The life of the policy
- The claimant’s age at the time he or she became disabled
- The existence of mortality associated issues
- Whether or not there is a Cost Of Living Adjustment (COLA) provision in the policy and if so, when the COLA kicks in and for how long it takes effect
- Whether a discount rate needs to be applied in calculating the PV in order to account for inflation
- Whether periodic, optional, benefit increases have been factored in
- The percentage of the discount rate and how it is calculated
- Whether or not the insured is entitled to factor in an incentive for it to agree to a lump sum payment
For example, if the claimant is a 40 year-old surgeon with a $5,000 a month disability policy with lifetime benefits but no COLA or periodic benefit increases, who has contracted a medical impairment that does not affect life-expectancy (like arthritis) the calculation would be as follows. Use the monthly benefit of $5,000 to calculate the annual benefit, $60,000 then multiply that by the remaining life expectancy figure of 42 years.
This amount comes to $2,520,000.
In applying the discount rate, the insurance company will argue for a higher discount rate based on the company’s ability to earn more money on its investments than the average policy holder (and also based on the company’s desire to negotiate a lower buyout figure). Our experts argue for a lower discount rate on the basis that they are required to use a conservative investment strategy in order to preserve the principal. To illustrate the difference, using the example described above, an 8% discount rate results in a PV of only $720,402. Applying a discount rate of 4%, the PV would be $1,211,138. It is important to note that if a given policy contains a COLA, that will greatly reduce the need to use a discount rate to calculate the PV. That is because the COLA is already taking inflation into account.
Insurance companies may also try to decrease a PV figure by saying that a claimant might not reach their estimated life expectancy. We disagree with this position. In calculating life expectancies, actuarial tables already take into consideration risks such as this. In addition, an insured can and often will exceed their estimated life expectancy. Therefore, claiming that the amount should be further reduced to account for this risk is essentially double-dipping on the part of the insurer.
The bottom line in all of the above is that establishing a PV can be a very complicated process. Neglecting to take the above considerations into account or failing to advocate these issues effectively can be very costly to a policy holder. Not all lawyers are sufficiently aware of these concerns. Be careful.