Life insurance sense and nonsense.by Daily, Glenn S.
It's a safe bet bad decisions will be made about life insurance this year--people fail to heed the advice in Homer's Odyssey. Before listening to the Siren's song, Ulysses took the precaution of having himself tied to a mast. It's likewise appropriate to save yourself by being informed before listening to the truths, half-truths, and hype in life insurance sales presentations.
Uses of Life Insurance
No two observers describe the uses of life insurance the same, but three broad categories cover the territory:
Protection. Replacing lost income due to a breadwinner's premature death is an obvious use. In fact, life insurance is the only financial instrument that can guarantee the payment of a predetermined amount whenever death occurs. Key-man insurance fulfills a similar protection role in the business arena; it indemnifies the firm against losses caused by the death of an active owner or executive.
Financing. Life insurance can be used as a funding vehicle for numerous obligations. For example, death proceeds can be used to pay estate taxes, eliminating the need to sell less liquid assets at discounted prices. Life insurance is also used routinely to fund buy- sell agreements and deferred compensation plans as an alternative to relying on a business's future earned income.
Investment. Life insurance competes with other investments in two ways. Life insurance cash values can be thought of as a separate asset class, with distinctive risk and return characteristics that might make it appropriate as a savings vehicle for retirement, education, or other goals. Life insurance can also be purchased as an investment for heirs or for charity; the life insurance death benefit is an alternative to the values at death available from other investments, such as stocks, bonds, or real estate.
Term Life Insurance
Life insurance products can be divided into two basic groups, term and cash value. Term insurance is pure protection and has no cash surrender value. The most common varieties are:
Annual Renewable. Premiums typically increase each year, and the policy can be renewed to some maximum age.
N-year Renewable. Premiums remain level for five to 20 years, at which time the policy can be renewed at a higher premium level for another multi-year period. In most cases, you must provide evidence of insurability to qualify for favorable renewal rates; otherwise, the policy reverts to expensive annual renewable term.
Cash Value Life Insurance
In contrast to term insurance, cash value life insurance combines protection with savings. Every cash value policy can be viewed as an interest-bearing checking account. You pay premiums into an internal fund, the insurer deducts insurance and expense charges, and credits interest.
Figure 1 locates the most common cash value products along two dimensions: flexibility and transparency. The most flexible products imaginable would let you increase or decrease the premium, increase or decrease the death benefit, withdraw a portion of the cash value, and choose the investments backing the policy. No product can reach this ideal because of restrictions dictated by tax laws (IRC Secs. 7702 and 7702A) and good business practice.
The most transparent products imaginable would disclose the insurance and expense charges, interest credits, and all the pricing assumptions that lie behind the policy values. No product can reach this ideal because insurers regard much of this information as proprietary.
The following questions are a starting point for becoming familiar with a cash value product:
* How does the product work?
* How is interest credited?
* How is the cost of insurance deducted?
* How are other expense charges deducted?
* How does the company recover its expenses and make a profit?
* How flexible is the product, both before and after issue?
* How can you change the premium?
* How can you change the death benefit?
* How can you change the cash value?
* How can you change the investments backing the policy?
The main types of cash value life insurance are:
Traditional Whole Life. This is the oldest type and still has the largest market share. Premiums are fixed, guaranteed, and based on conservative interest and mortality rate assumptions. Each year the company pays a dividend that reflects the difference between actual and assumed experience. Among other options, dividends can be used to reduce the premium or purchase additional whole life insurance at bargain rates. Many companies also offer paid-up additions and term riders that allow the buyer to design a customized plan before issue and make limited adjustments after issue. Partial surrenders may also be allowed.
Adjustable Life. Adjustable life is more flexible than traditional whole life. By changing the premium, death benefit, or dividend option, you can move between different insurance plans, such as whole life paid up at age 65 or term to age 70.
Universal Life. Universal life lets the policyholder change the premium, death benefit, and cash value, within limits. There is no fixed premium, but the policy will lapse if there isn't enough money in the accumulation account to pay the various charges. All monthly credits and deductions are shown in an annual statement. One common myth is that universal life lacks guarantees. You can get the same level of guarantees that traditional whole life provides if you pay a whole life premium each year. The two products differ in flexibility and transparency, not in the strength of their guarantees.
Interest Sensitive Whole Life. This is also called fixed premium universal life. The monthly credits and deductions are shown in an annual statement, as with flexible premium universal life, but there is a fixed premium, as with traditional whole life. Some flexibility is available through riders and premium recalculation options.
Variable Universal Life. Variable products add another dimension of flexibility--investment choice. Unlike book-value-based products, where the insurer declares a fixed rate of interest and bears the investment risk, variable life products allow the policyholder to choose among a family of stock, bond, and other funds, with a fluctuating value. Like universal life, variable universal life permits adjustments to the premium, death benefit, and cash values. Fixed-premium variable products are also available, although their current market share is much smaller.
Variable life is more transparent than non-variable products because there is more required disclosure of policy loads. For example, asset- based charges are specified in the contract, whereas generally you do not know the company's interest rate spread on universal life or the difference between the earned rate and the dividend interest rate on traditional whole life.
Survivorship. Survivorship, or second-to-die products have received much attention recently, even though fewer than 25,000 policies are sold throughout the U.S. each year. Their main use is providing liquidity to pay estate taxes at the second death. In theory, survivorship policies can be created using any of the forms for single-life products, but the major players tend to use traditional whole life as the chassis, with paid-up additions and term riders available for more flexibility.
In addition to policy form, second-to-die products also differ in what happens at the first death. Under one approach, all policies are treated the same, regardless of whether one or two insureds are still alive. Under a second approach, policies are placed in three separate pools--both alive, male alive, and female alive--and cash values and dividends jump up at the first death. When there is a term rider, the rates may or may not increase at the first death, so different designs have different levels of risk.
First-To-Die. Interest in first-to-die products has been growing as more people explore the applications in family and business situations. For example, first-to-die insurance can be an economical way to satisfy the protection needs of a dual-income family. As with second-to-die, any policy form is possible in theory.
Riders. In addition to pure forms of single-life, second-to-die, and first-to-die policies, many companies offer riders that expand the usefulness of the base policy. For example, a beneficiary purchase option attached to a single-life policy creates a second-to-die death benefit, or a first-to-die or single-life rider may be attached to a second-to-die policy to provide a benefit at the first death.
Is Life Insurance Magic?
In a word, no. There's certainly nothing magical about term insurance. On average, companies pay out less than 80% of term premiums for death claims. The rest goes for acquisition and maintenance costs and profit. Term insurance solves the need for protection, but you pay for the risk-pooling service performed by the insurer, just as you do with homeowners or automobile insurance.
It's much harder to dispel the notion of magic in cash value life insurance. On one hand, these products are burdened with high sales expenses. Total acquisition costs--including distribution, underwriting, and issue--often exceed the first-year premium. On the other hand, cash value life insurance enjoys several tax advantages, some of which are just different ways of saying the same thing:
* Investment earnings within the policy grow tax-deferred and escape income tax entirely upon death.
* The cost basis is the sum of premiums paid, without any reduction for the cost of insurance.
* Insurance and other charges within the policy can be paid with pre- tax dollars by drawing upon the accumulated investment earnings.
* With flexible policy designs, future insurance costs can be prefunded at a discount rate equal to the credited interest rate.
Are the tax advantages of cash value life insurance sufficient to offset the higher expenses? That depends on the products you compare. In general, however, you can divide policyholders into three groups: those who surrender early (say, within the first 10 years), those who surrender later, and those who hold their policies until death. Figure 2 summarizes the consumer experience for a typical block of policies. Not surprisingly, the large numbers of people who surrender early fare the worst; they often lose all or most of their investment and would be much better off if they bought cheap term insurance and invested their money elsewhere. People who surrender their policies after a longer period will generally do as well or better than if they bought term insurance and chose other investments of comparable risk. Cash value policies offer the best value when held until death. Because so many people drop their policies after only a few years, cash value life insurance in a present value sense does not increase the wealth of American consumers in the aggregate. Most of the lost wealth is transferred to agents through high first-year commissions.
There May Be Magic in Existing Policies
Existing policies deserve a quick look before we move on. Because of the front-loading of commissions and other expenses, a policy that looks unattractive to a prospective buyer can offer good value after purchase. This is demonstrated in Figure 3, which shows the average annual rates of return at issue and one and two years later. The average annual rate of return is the compound return that you would have to earn to match each year's cash value if you bought term insurance and invested elsewhere. To recover acquisition costs quickly and to encourage policyholders to keep their contracts in force, this company builds a heavy load into the product in the first two years. A careful shopper would probably look at the dismal rates of return through the tenth year and walk away. However, someone who makes the mistake of buying it and discovers the error two years later is in a very different position; the policy is now an excellent investment.
How to Navigate Through the Marketplace
Getting in and out of the life insurance marketplace with your sense of competence intact requires a set of skills. Here are some important ones.
Choosing an Adviser. You may or may not need help in getting from start to finish. Most insurance advice is given by agents and brokers who receive commissions and other compensation from insurance companies for product sales. If you don't buy something, they don't get paid. Commission-based distribution systems dominate the marketplace because most people won't buy life insurance without sales pressure. High commissions are needed because most sales efforts fail and it takes time to explain the product and shepherd the application through all the steps. The obvious disadvantage of the traditional system is that you can't be sure the agent's advice isn't being distorted by the need to sell a product. Some agents manage to overcome this inherent conflict, while others don't.
Fee-for-service sources of life insurance advice are becomming more available. Fee-based advisers receive most of their compensation in fees, although they may also represent and receive compensation from insurance companies. Fee-only advisers receive no compensation from product providers; they work strictly on a fee basis. (For a referral, contact the Life Insurance Advisers Association, 800-521-4578.)
If you decide to rely on a commission-based agent, it's best to choose only one. It may seem clever to invite several agents to make proposals, but you'll often wind up with stacks of paper, conflicting assertions, and no quick way to get at the truth.
Evaluating a Complicated Proposal. When you combine life insurance with qualified plans, charitable remainder trusts, and whatever else marketers can think of, it can be a challenge to make sense of it all. Most agents are not trained in finance, and their ultimate goal, after all, is to sell more life insurance. There is no simple way to evaluate a complicated proposal, but the starting point is always a simple question--what makes it work? The proposal may draw upon the usual tax advantages of life insurance. Life insurance combined with charitable remainder trusts is one example of no value added beyond what's available in an individually owned policy. You may also discover that some benefits are attributed to life insurance when in fact they have nothing to do with life insurance; for example, the difference in corporate and individual tax rates in executive bonus plans.
Some proposals draw upon additional tax advantages of life insurance; for example, the interest-free loans of split-dollar plans and the exemption of life insurance death proceeds from the 15% penalty tax on excess accumulations and distributions from qualified plans. In these cases, a more thorough analysis may be needed. This is particularly true when using life insurance within qualified plans; it's easy to be seduced by the simplistic argument that you can pay premiums with tax- deductible dollars.
Cash value life insurance is sometimes touted as a private pension plan that can provide high retirement benefits through tax-free loans. These schemes have significant drawbacks, however, and are not as financially astute as the sales pitches make them sound. In many cases, they violate the basic rule that you shouldn't borrow money if the after-tax cost of borrowing is higher than the after-tax rate of return on your invested assets. The cost of borrowing is one of the most misunderstood features of life insurance; the agent may describe the net cost of borrowing as 2% or less, when the effective cost is higher than for a home equity loan. These proposals require a comprehensive discussion of risks and rewards.
Choosing a Product
There's really no mystery about how to do life insurance due diligence; it's the same common sense process as for any other investment. Figure 4 summarizes the steps, with a brief commentary. The commentary is presented with a bit of tongue-in-cheek. The questions are, for the most part, worthy of a serious answer. Much of what passes for due diligence at the retail level is just feel-good stuff that hides how little agents really know about the products they sell. For example, information about a company's overall operations is often used as a proxy for product-specific pricing assumptions, even though it is affected by product mix, age distribution of insureds, and other factors. In my experience, agent-recommended companies always meet all the criteria on the due diligence checklist. A cynic might ask which came first, the checklist or the recommended companies? The following paragraphs contain some practical guidance on how to find an appropriate product for the intended use.
Choosing an Objective. Novice insurance buyers want the best product; they are unaware of tradeoffs and uncertainties. Experienced insurance buyers know that finding the best product is a matter of luck more than skill and your chances of picking the best product improve if you forget picking the best product and lower your sights to very good. Money managers often strive to be in the top quartile of their peers; that's a useful target for life insurance buyers also.
Choosing a Product Type. Flexibility and transparency are two features that might affect your decision. More flexibility is generally better than less, but people who are not disciplined savers might welcome the nudge of a fixed premium. Transparency is important if you follow the adage that you shouldn't buy what you don't understand, although life insurance sales would plummet if people took this latter advice seriously.
Of course, performance is important too, but generic conclusions are hard to make. A fixed premium probably reduces a company's administrative expenses and its uncertainty about future cash flows, but the effect on pricing is limited. The common view that universal life is backed by short-term, lower-yielding, investments and traditional whole life are backed by long-term, higher-yielding, investments is an exaggeration; typical portfolios vary no more than a few years in duration, so whole life's yield advantage is likely to be small. It's also misleading to compare the dividend interest rate on universal life. With traditional whole life, more of the expenses are recovered through hidden loads. Many whole life companies still enjoy an above-market portfolio yield due to past investments, which adds to the confusion.
The most significant difference in performance is between variable and non-variable products. To the extent that stocks tend to outperform fixed-income instruments over the long run, variable universal life should outperform non-variable products. However, variable products also pass more investment risk onto the policyholder. By one actuary's estimate, it costs insurers about 25 basis points to provide the cash value guarantees for non-variable products, and it would cost variable life policyholders much more than that to duplicate those guarantees, because individuals can't hedge as efficiently as institutions can. The choice between variable and non-variable products is complex and must take into account your entire investment portfolio and the specific alternatives.
Among the non-variable products, you can probably eliminate interest- sensitive whole life, because traditional whole life should perform at least as well and has a much longer track record.
Evaluating Financial Strength. The best way to assess a company's financial strength is to hire a valuation actuary to prepare a comprehensive analysis, which might cost at least $100,000 per company, not a paltry investment. Fitch Investors Service recently announced its intention to undertake this project.
The next-best, but more pragmatic approach, is to look at the published ratings and reports of four well-known agencies: A.M. Best (900-420-0400), Standard & Poor's (212-208-1527), Moody's (212-553- 0377), and Duff & Phelps (312-368-3157). The ratings represent informed, but fallible opinions, and the reports provide background information and explain the reasons for the rating, as well as factors that might affect the rating in the future. Each agency uses its own approach involving a combination of quantitative and qualitative factors, with information obtained from public sources, such as statutory financial statements, and discussions with management. They also adjust their methodology as circumstances warrant; Moody's and Standard & Poor's recently made changes to their benchmark capital models. In 1991, Standard & Poor's expanded its coverage of the life insurance industry by introducing qualified solvency ratings for most companies that did not already have a claims-paying ability rating. The qualified solvency ratings have had some success in identifying troubled insurers, but they are no substitute for a comprehensive claims-paying ability rating.
It's a popular pastime these days to formulate rules of thumb for playing it safe, such as buying from insurers rated AA or better. There's no justification for these binary rules. If a rating system is working properly, a lower rating means higher risk, not the certainty of failure. For example, only about 20% of the insurers rated C by A.M. Best in 1978-81 failed during the next 10 years.1 Your threshold should be driven by product selection, not simplistic rules. If you can find attractive products from AAA companies, there's no reason to accept less. If the product you want is issued by a lower-rated company, the tradeoff may be reasonable, bearing in mind that financial strength can affect future product performance. One advantage of variable products is that there is some, but not complete, protection from insolvency risks.
A Time-Saving Tip. You won't learn much by wading through the pages of financial ratios that salesmen now like to distribute. These materials are typically prepared by each company's marketing department. Just throw the stuff away.
Predicting Future Performance
That's a tough one. Many insurance buyers equate premium with price. In their view, a low premium means a good deal. That's a dangerous way to shop for cash value life insurance, because it's easy for a company to project low premiums. Also, unless the projected death benefits are the same until maturity, you'll be comparing apples and oranges. It's more useful to think of performance in terms of the entire package of premiums, death benefits, and cash values. In theory, if you can match up the premiums and death benefits, you can judge performance by looking over the cash values. Rigid product designs, however, often make that impossible.
A more serious problem is that premiums, death benefits, and cash values are not guaranteed for the most part, and the policy illustrations that companies provide are not reliable for comparing products. Because the assumptions underlying the illustrations are generally not disclosed, it's difficult to know if the illustrated values are aggressive or conservative; in other words, you have little information about risk. As an example, consider the persistency bonus on many universal life products; some are almost certain to be paid, while others are just scams to make the product look good on paper.
You can't take anything for granted about illustrations. It's becoming routine for agents to show alternative illustrated values using a lower interest rate. One large mutual insurer recently discovered that two of its competitors, also large mutuals, were cheating in their reduced-interest illustrations by gradually lowering the rate over many years, instead of immediately. This makes the cheaters' products look less sensitive to interest rate changes.
The problems with illustrations haven't gone unnoticed. State regulators, the Society of Actuaries, the American Society of CLU & ChFC have been exploring ways to make illustrations more useful.
For large purchases, it may be reasonable to ask the agent to provide a report prepared by an independent consulting actuary, particularly if the product outshines the competition. Sometimes this will be helpful, and sometimes it won't.
A company's past performance should be considered when comparing products, but there are problems with this, too. Published information about past performance; it may also not be relevant for new types of products, such as second-to-die. And a superior past doesn't guarantee a superior future; about one-third of the companies in the top quartile of whole life performance for 1970-80 were not in the top quartile for 1980-90.
With all of these obstacles, it may be tempting to declare a pox on all their houses and put your money somewhere else. Life insurance does not tax advantages, however, and that gives you a cushion against poor performance. Because of uncertainties about the future performances and future financial strength of any one insurance company, building a diversified portfolio of policies is a sensible and increasingly common strategy.
How to Get Better Value for Your Money
Although future performance is unpredictable, you can stack the odds in your favor by reducing the high sales expenses that typically consume 15% to 25% of all premiums paid. There are three ways to do this: lowload products, blending, and rebating.
Low-load simply means that a product has significantly lower distribution costs than traditional products, becauseit is designed to be sold either directly to the public with limited advertising or through fee-for-service advisers. Sales expenses are generally less than 20% of the first-year premium, versus 100% or more for agent-sold products. All other things being equal, these lower expenses translate into lower premiums and/or higher death benefits and/or higher cash values. High early cash values are a distinguishing feature of low-load products. In some cases, the first-year cash value will exceed the first-year premium. High cash values offer more protection than high financial strength ratings, because ratings and your own circumstances can change. More money is probably lost each year due to early lapses of high-commission products than has been lost in all the insolvencies to date.
With some agent-sold products, commissions can be reduced by substituting low-commission term and paid-up additions riders for high- commission base coverage. In effect, a portion of the commission is retained within the policy to augment the cash values and future death benefits. When done properly, blending improves performance with no increase in risk. You can abuse the technique, however, if you don't buy enough paid-up additions to cover the future term charges. Also, some questions have been raised recently about the tax treatment of blended policies; insurers disagree about whether their own products might be affected.
For large-premium cases, you can reduce commissions further by signing the contract in California to obtain a legal rebate of 50% or more. The rebate will be taxable to the recipient. Rebating is legal in Florida as well, but insurers have the right to terminate agents who rebate; this has had a chilling effect on rebating in that state.
Figure 5 shows how sales expenses affect performance. It is no surprise that the low-load product offers higher cash values in the early years, when many policies are dropped. By reducing commissions through blending, the values of the agent-sold product can also be enhanced. In this example, the blended product outperforms the low-load after about 10 years, but that's largely due to an unsustainable dividend interest rate. It's almost impossible for an agent-sold product to beat a low-load over the short run, and it's not easy over the long run, either. Just as some load mutual funds outperform some no-load funds, some commission life products may be able to beat the best of the low-loads. However, only a lucky minority of insurance buyers will pick the righ agent-sold products and hold them long enough to be rewarded.
Regardless of which product you decide to buy, the best advice is generally to pay as much as you can as early as you can. No policy will offer good value if you try to lowball the premium and then get hit with steeper outlays than you can afford down the road.
1 Lee Slavutin, "Life Insurance Company Ratings--How Reliable Is A.M. Best?", CCH Financial and Estate Planning, August 1991.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.