COUNTERCOLUMN: All Your Bias Are Belong to Us

Everyone that sells life insurance should understand how it's built, and why it's built that way.

In the beginning, there was term insurance. At first, for short time periods, then one year, and eventually, five years.

Term insurance always expired, hence the name, term insurance. Insurance for a period of time, or term of time. If one lived long enough, they'd get too old to buy new term. Most people at this time were farmers, and they worked until they died. They often owed until they died, too. No insurance, lose farm.

This is where the phrase "bought the farm" came from. Grandpa "bought the farm" with his life insurance. Until he died, the bank owned it, because they had a lien on the property. The insurance paid off the lien, hence, bought the farm.

Consumers wanted insurance that lasted their whole life, no matter how long they lived. Actuaries designed a level premium product -- ordinary life, straight life, or whole life.

This level premium product was more expensive that term, because it didn't expire. To guarantee companies could afford to pay claims, the state required that they set aside reserves. Since the law required this, eventually, the term became known as "legal reserves" for reserves required by law. Companies used this for marketing, which is why literature said "XYZ Life, A Legal Reserve Company" because it made them sound financial solid, perhaps more so than a competitor, like a mutual assurance society, or cooperative benefit association (these companies were cheaper, but went Tango Uniform with regularity). Plus, there were fraternals and assesment companies, the latter distributed by banks.

During the 1870s, there was a recession. Many farmers could not pay their premiums on their level premium whole life, so their policies lapsed. The companies kept those "extra" premiums that went towards the "legal reserves." This caused an uproar, and the several states decided that companies needed to offer something else in exchange for the higher premium. This is how "nonforfeiture provisions" were invented, and now required by law.

These nonforfeiture options included, over time:

1. Surrender for Cash (hence, cash values, loosely based on legal reserves)
2. Reduced, Paid Up
3. Extended Term
4. Policy Loan, Using Cash Surrender Value as Collateral
5. Automatic Premium Loan (to prevent lapse)

Now, with these nonforfeiture provisions, whole life became the fantastic financial foundation we have today.

From the 1870s until the 1970s, not much changed. Anti-rebating laws came about. Companies grew. Many survived the depression. State laws were tweaked, making the system of insurance solid and safe. The general agency system evolved, adding the debit agency system, and eventually, the career agency system. During this time, there were THOUSANDS of companies and THOUSANDS of products, but all fit loosely on three chasis:

1. Term
2. Whole Life
3. Annuity

That was it. Pretty simple stuff, really. Agents had one rate book, and one application.

Computers changed things. Starting in the 1950s, insurance companies invested in computers. This accelerated in the 1960s, and by the 1970s, we had some pretty sophisticated machines (albeit, slow and dumb, by today's desktop standards). These machines allowed for the UNBUNDLING of the whole life chassis.

The first real derivation was Adjustable Life in 1977, which was still more whole life than anything else, although it could look like term. It was invented by Minnesota Mutual, copied by Bankers Life of Iowa (now Principal). Principal took the lead.

E.F. Hutton introduced Universal Life in 1979. Notice it ain't around anymore? Neither is First Capital.

Computers enabled companies and agents to play with premiums, and show a customer how better than expected returns could reduce their expected premium outlay. This lead to gross UNDER funding, which in turn, lead to the massive wave of class action lawsuits against every insurer that sold interest sensitive products.

http://abc26.trb.com/business/yourmoney/sns-yourmoney-security0215,0,6325299.story

Every agent that's been around 20 years or more, has literally dozens of stories of underfunding.

Now we have companies that are promoting it. But they are greedy, and do not have the policy holder in mind.

Let's go back to the 1980s. Most companies sold ART, or Annually Renewable Term. Many companies also sold five year term, usually with level premiums, but sometimes increasing. Renewability has a HUGE impact on premiums. OYT, or One Year Term, that is NON-renewable, is the cheapest you'll ever see (next to common carrier, or accident only).

Because of AL Williams and MILICO, term insurance became very competitive, even though it still only accounted for 7% of gross premium income for the industry. Ten year term, then twenty year term, and now -- THIRTY year term.

The longer the premium guarantee period, the higher the level premium. This is fundamental. Smart agents noticed that 20-30 year term was often more expensive than current assumption UL (and in some cases, more than non-par whole life).

Except for one thing: Term has no non-forfeiture provisions. No cash values.

Granted, you could mimic the 30 year term with a UL, and at the end of the rainbow, neither policy had any value, BUT the UL would have SOME cash values (a pittance, really) during the middle of the policy term. There's a parabolic curve formed by these values, and the graph is revealing.

It's been almost 30 years since the advent of flexible premium products. The people that were stewards of policy holder money are long retired, or dead. Most managers, and most agents, and most company executives, don't even remember what the old days of stock issued non-par vs. mutual issued par whole life was like.

They are IN LOVE with the UL chassis, and for good reason. If you want to know who is making out in the insurance business, FOLLOW THE MONEY. Most mutual companies have been robbed, just like a bank, except the robbers wear blue suits and have masters degrees. Executive greed drives this thievery.

Most UL innovations come from stock companies. Mutual companies copy them, but the driving force in policy innovation comes from the stock side of the industry. Is innovation good? You tell me.

Let's examine what is going on.

First, a primer on whole life. Dig deep, and here's what whole life has:

1. Guaranteed level death benefits
2. Guaranteed level premiums
3. Guaranteed cash values that ENDOW at age 95 or later.

Endowment is key. That's where the guaranteed cash vaules EQUAL the face amount of the policy, or guaranteed death benefit. If you live to age 95, the company can write you a check for the death benefit, without ANY financial risk, because they have set aside that money, and using the time value of money, they've already made their underwriting profit. The money is yours. Of course, if you take the cash, you'll owe taxes, mostly likely. Defer your claim until death, and you can avoid that. Pretty neat.

Stock companies began issuing UL with secondary guarantee riders. Monkeying around with contract language, excess interest crediting rates, and internal COIs (Costs of Insurance), companies have created policies that LOOK like whole life, but in fact, are not.

What do they have?

1. Guaranteed level death benefits
2. Guaranteed level premiums

But there's something missing here.

Guaranteed cash values! These policies often do not endow, on a guaranteed basis (and most agents do not know how to see this, unless it is shown to them by a student of the industry).

20 year term, with no surrender value, then
30 year term, with no surrender value, then
UL that looks like whole life, with little or no surrender value

Anyone having difficulty seeing where this is leading?

One of the advanced areas of statistics, something actuaries are intimately familiar with, is Option Pricing Theory. The subject is too vast and complicated to detail here, but I'll sum it up:

Every choice one can make has a present value, and a future value. If one digs deep enough, they can figure out which value is higher, today, and tomorrow, particularly with guarantees offered by a life insurance company.

If you lapse ANY policy, other than ART, BEFORE the end of the term, you have OVERPAID for the protection you received.

There is ONLY one type of policy that adequately remunerates a policy owner for pre-mature lapse, and that is whole life.

Insurance companies know this. They WANT to issue UL, because WHEN people lapse, that boosts the company bottom line. Few people have the ability to determine what each option value is. Moreover, the fact that they are getting screwed by lapsing early is rarely even discussed, much less analyzed.

The better agents understand "lapsed based pricing" and most agents may have heard the term. Virtually ALL UL issued today has a variable built in that is based on lapse rates.

Whole life CAN be priced using lapse rates, but regulators frown upon it, and if it's done, it's very conservative. If they mess up, the policy owner still makes out okay with the whole life, but NOT with the UL. Flexible premiums are great, right? The company thinks so, too, because they ALSO enjoy flexiblity -- flexible costs of insurance and flexible expenses, not to mention flexible crediting rates.

Sure, one CAN almost get there with UL, but on a guaranteed basis, premium for premium, death benefit for death benefit, cash value for cash value, there MUST be a cost for flexibility, so the UL MUST cost more, somewhere, OR is MUST deliver less benefit. This is fundamental.

If you pay less than a whole life premium, you will get less in return, but the "less" is not directly correlated to the difference in premium. To the contrary, the return on paying less is often negative, while the return on paying the whole life premium is always positive.

These new ULs with so-called "guarantees" -- will they pay a death benefit? Yes. And how many people will keep the policy until that time? Less than 100%, which means that a number of people will have OVERPAID, and will get LESS than they deserve. They will suffer a loss.

Where does this loss (money) go? It goes to the bottom line of the company, in the form of profits. Who benefits? The stockholder (as well as the executives, through their various forms of compensation).

Our society is no longer agrarian, and we have forgotten the recession of the 1870s that fostered the development of nonforfeiture options. Shame on us.

If an agent looks at the pricing structure of most modern UL chasis, they will find that the policy is designed to bamboozle all but the most intelligent of people. Few companies operate at the guaranteed level of costs and expenses. Instead, they "illustrate" that they operate at lower costs with lower expenses. The companies have ultimate control over the internal costs of their inforce business, and many companies have already exercised this control to the detriment of the policyholder, often without any public notice at all.

M Financial, one of the largest producer groups in the country, has exposed this crime. They monitor their inforce business, and compare it to how a policy was illustrated at issue. They found that several large carriers were making changes to their internal Costs of Insurance (COI), particularly at later duration (older ages), where it can do the most damage, and where the policy owner has fewer options for policy rescue.

Actions like these drive persistency DOWN, which will LINE THE COFFERS of these companies, boosting profits, driving stock prices North, and making company executives richer than rich.

To be blunt: A mutual company can reduce dividends to zero, but they can't fuck the policyholder. A stock company selling UL? They can bend the policy owner over, and stick it to them where the sun don't shine, without the courtesy of adequate lubrication.

And what are you going to do when your UL is fucking you? Lapse it? That's EXACTLY what the company executives WANT you to do.

NOTE: I'm not saying that all UL is bad. Sometimes, that's all you have to solve a particular problem. That said, all things being equal, I'd rather own whole life.