The joke is that the worst thing to happen to the life insurance industry is that once upon a time, someone sold it a computer. Before that, policy information was communicated from the agent to the prospect via a rate book. The rate book contained premium and policy values on a per thousand basis, for each age and gender.
Beginning in the early ‘80s, the policy illustration has gradually replaced the rate book as a means of explaining policy values. The illustration itself has also evolved over time, from a one or two page summary to a 10 to 20 page mini pamphlet. Unfortunately, the policy illustration is often misused and misunderstood, so much so that insurers now require applicants and agents to sign it.
It is important to understand the correct term is hypothetical policy illustration. That is because, except for guaranteed term policies, the policy performance will never match the illustration. That is because the illustration contains assumptions that are certain to change over time. For example, it is unusual when the dividend scale doesn’t change from year to year, yet the illustration depicts it as never changing.
Three other important points: 1) the illustration is not and never becomes a part of the policy, 2) there is no penalty to the insurer for not meeting the assumptions depicted in the illustration, and 3) illustrations should not be used to compare dissimilar products, e.g., universal life and whole life.
So given all this, what is a hypothetical policy illustration good for? A policy illustration can and should be used to demonstrate how a policy will react under different sets of circumstances. Most illustrations show three scenarios, albeit in abbreviated form: current, guaranteed, and mid-point. That is, if the policy guarantees a 2% interest crediting rate and currently is crediting 4%, the illustration will show both of those, along with a 3% crediting rate (the mid-point).
Additionally, the illustration can be used to show the effects of policy loans as well as intermittent funding patterns. It is important to understand those situations that could result in the policy prematurely terminating, so you can determine if that is a risk you are comfortable taking.
In the end, the hypothetical policy illustration is merely a tool that, if used properly, can shed some light on how the policy will behave under different economic conditions. It is never a prediction of what will actually happen.