Life insurance is a necessary risk management tool, but insurance against any risk should be purchased only where a rational cost-benefit analysis can be conducted.
Life insurance is a necessary risk management tool for many families, but in our almost 40 years of experience, many buyers are misinformed, and many fail to conduct the proper research before purchasing.
This is especially true when considering “blended” insurance and investment products. We’ll show you our analysis that strips away the marketing magic and exposes the sobering reality in three specific scenarios in which insurance policies were sold, or attempted to be sold, that make no financial sense for the consumer.
Insurance companies make money in two ways — through underwriting (paying out less in benefits than they take in in premiums), and by investing the premiums, which are earned well in advance of when the benefits are paid. This is called ‘float.’
To begin with, consumers should be aware that insurance agents operate under no obligation to put the clients’ best interests before their own. The insurance agent is compensated by a commission, most of which is paid at the time of sale (this can also be thought of as a front end sales load). In fact, many insurance companies offer commissions that can be over 100 percent of the initial premium. You read that right — the agent receives more for selling you the product than the check you write for your first payment.
In other words, the insurance company is willing to take a loss at first, because the profits it can earn over time are far greater. Of course, these profits come from one place — the consumer. We are not speculating on this point — we have actually experienced it first-hand, back long ago when we were offered insurance commissions of as much as 120 percent of the first year’s premium!
The policies insurance companies want to sell — the ones in which they make the greatest profit — are actually a blend of term insurance (which can be useful, even necessary, for some consumers) with investment products (which tend to be mediocre, costly performers but which enable the insurance company to maintain higher and higher levels of float over the lifetimes of the policyholders. But term insurance, especially for young, healthy consumers, is inexpensive and therefore not terribly profitable for the insurance company. Given this fact, how do they make any money at all?
Somewhere along the line, insurance companies figured out that the more they could collect in advance and then invest — the more float there is — the more money they can make, through management and administrative fees. As a result, over many years a dizzying array of investment products married to an underlying insurance policy have been created.
The ability to blend the two together has created even greater opportunity for obfuscation by the insurance companies and their sales force. Insurance agents are masterful marketers and are able to make ordinary — and sometimes much worse than ordinary — products look like pure magic. These go by names like universal life, variable life, and on and on.
The dangerous combination of highly incentivized sales people, an emotional mindset, and a proliferation of “blended” products that are not easy to understand leads many consumers to be sold highly commissioned products that are unsuitable for them. We’ve seen many consumers own insurance products that aren’t a fit for their true needs, purchased based on emotion (encouraged by the sales person) rather than reasoning, logic and careful analysis.
But here’s the catch: the insurance companies make it really hard to determine the true cost of a blended product — it takes an experienced person with persistence and knowledge. Here are three examples of where analysis yields a sobering reality that is different from that which the sales person may convey.
What are you really getting when you buy an insurance product that blends insurance and investment exposure? All these products consist of insurance — which is easy to price and therefore to either recommend or not — and investments, which can also be analyzed and priced.
What investors need to keep in mind throughout is that capital markets provide certain returns by asset class, with attendant risks, over time, and no amount of product engineering can change that. They also need to realize that their performance in any investment is a function of the asset class, the skill of the manager (or lack thereof), and the costs.
Here’s a general rule we’ve found to be true over the last 40 years of our work:
Any time the insurance company shows you an illustration with what appear to be guaranteed rates of more than 2—3 percent, there is most likely some obfuscation going on. The 10-year treasury note currently yields just under 3 percent per year. There is no free lunch — any return above that entails some degree of risk, especially in light of the administrative and management fees on which the return is calculated.
The days of 4—5 percent returns without volatility are over — you simply can’t achieve that today with the 10-year Treasury at 3 percent. These illustrations are misleading almost by design.
When considering a “blended” product, consumers should ask themselves if the investment product, with the insurance component stripped away, would still make sense as a stand-alone investment. In reality, very few buyers will go through the exercise of evaluating the two elements separately.
But they absolutely should. The following scenario illustrates why.
We reviewed a “second-to-die” policy purchased by a couple who wanted to insure their collective demise only once they both passed.
This is a typical scenario of the consumer not understanding how blended insurance products work. A cash-value life insurance policy, such as this one, has a number of characteristics similar to that of an investment: an upfront cash flow (by foregoing the cash value), periodic payments (via premium payments), and an eventual payoff (in the form of death benefit).
In this case, the couple was at a point in life where there was no longer an explicit insurable need for the death benefit. To strip away the insurance from the investment component, we put on our “investment” eyeshade and evaluated the cash flows relative to the next best investment alternative.
The consumer kept coming back to this fact: This policy allowed the survivor to double the life insurance benefit after the first of them died, without a health exam — for a cost to be paid upon the first death. The benefit sounded good on the surface, especially as the husband was concerned that his wife may want additional insurance if she were to be in ill health at the time of his passing.
But when we asked the insurance company to project the cost of that insurance bump, we found that the additional coverage would have cost the wife an exorbitant amount of money. They would have had to drain their IRAs (and pay income taxes on those withdrawals) just to pay it.
A failure to conduct proper research like this is what causes so many consumers to be “life insurance poor.” They are sold expensive policies that aren’t sustainable in the long term — all so that the insurance agent can reap a large upfront commission.
In addition to evaluating multiple alternatives in terms of competing policies, we recommend that buyers open their Excel spreadsheets and produce their own illustrations, independent of the ones that the insurance agent provides to them.
The main advantage to conducting your own analysis is gaining the ability to evaluate outcomes using assumptions that seem reasonable to you — not what the insurance company’s marketing or product development team wants you to believe.
We did this analysis on a universal life policy, and through this analysis it was made clear that unless the policyholder failed to live out his life expectancy, the policy would have been financially devastating for the consumer over time. There was, and is, no good reason for this individual, who is financially secure, to take any risk of loss on an insurance policy. Yet he faced an almost total loss of all the monies paid in during the life of the policy if he happens to live to an old age.
Insurance can be a reasonable purchase for families who want to protect themselves from catastrophic loss. While every buyer’s needs are different, we typically suggest that they look into buying term life insurance if they have a need for income protection. An example would be a family with young children in which one or two incomes would need replacement for a period of 10 years or longer.
The cost and benefit of term insurance is very straightforward. Each policy has a premium and a death benefit amount. Consumers should be aware that all term policies are not created equal.
In the sketch below, we illustrate the differences between several $1MM death benefit term policies. As we’ve said before, we recommend buyers evaluate multiple policies before buying. Notice how six different carriers were evaluated, and we look at scenarios for both 10- and 20-year time periods.
Through this diligent exercise, we were able to determine the policy that was most suitable.
Unfortunately for the insurance sales person, the commissions on term life are much lower than whole life or the other flavors listed above — and therefore that sales person in the vast majority of cases will not recommend it. Far better, he or she will say, is to combine it with an investment product!
Although insurance is purchased through an insurance agency, you don’t have to rely solely upon an agent for insurance advice. In fact, the enormous financial incentive the insurance agent stands to receive for selling a complicated policy creates a conflict of interest that precludes the agent from posing as an advisor.
The amount of insurance a consumer may need can be calculated through financial planning tools that your independent advisor should possess.
Most blended products require sophisticated analysis that consumers, on their own, would lack the ability to produce on their own. An advisor at a Registered Investment Advisor (RIA) firm is a fiduciary — a true advisor who is obligated to make decisions placing your best interest in mind before their own.
However, buyers should also be aware that some RIA firm advisors also are licensed to sell insurance or securities as an insurance agent or broker dealer representative (dual-registered), which may impair their objectivity as well.
Life insurance is an inherently emotional product. Emotion and rational analysis are diametric opposites. Insurance against any risk should be purchased only where a rational cost-benefit analysis can be done.
We know better, and we tirelessly work to educate consumers to look past the emotion and to be discerning — as discerning as if they were making any other purchase. We recommend that buyers obtain quotes for multiple policies, and that we take time to discuss and analyze them thoroughly, before a decision is made. If not, then proper due diligence has not been done and there is no way of knowing if the policy makes true sense.
The tables/figures represented are for informational purposes only. These materials do not constitute financial advice. This piece does not necessarily represent the views of FCE Group. For investment advice, please consult with an investment professional.
For more information on FCE Group, please go to www.FCEquities.com