When evaluating most investments, either initially or periodically, smart investors use financial statements, conduct credible analysis and seek genuine expertise.
Cash-value life insurance (e.g., whole life, universal life, etc.) can be a terrific product, providing both financial security and attractive investment returns. However, when it comes to the life insurance industry’s products, finding reliable information, analysis and expertise (not to overlook mentioning quality policies) can be more than just a little bit difficult. Typically, those who are buying or renewing a cash-value life insurance policy use policy illustrations as well as financial ratings agency rankings and summaries. Unfortunately, not only do those approaches create serious problems, but the problems are seldom recognized or understood.
First, a few facts about policy illustrations and their widespread misuse. More than 20 years ago, the Society of Actuaries recommended that the following warning appear across the top of all policy illustrations: “Sales illustrations [as well as illustrations for in-force policies] should not be used for comparative policy performance purposes.” Policy illustrations are not financial projections upon which anyone ought to rely. Contrary to many advisers’ and clients’ presumptions, illustrations are not required to be financially sustainable. Unfortunately, many draw erroneous conclusions following, for instance, pseudo-analytical reviews in which policies are compared based on rates of return on illustrated cash values and death benefits. Apparently, they have forgotten that “garbage in equals garbage out.” News of many policyholders’ alarm with life insurers raising costs of insurancecharges provides fresh evidence of the widespread misplaced reliance and pseudo-analysis that is still being done using policy illustrations.
The value a policyholder receives from a cash-value life insurance policy—aside from peace of mind and the benefits paid to the beneficiaries of those who die prematurely—depends ultimately upon the financial performance of the insurer and the quality of the particular policy sold to the policyholder. (Almost all life insurers’ product lines contain policies of drastically different quality, cost and value.) These facts are true even for guaranteed no-lapse policies, given that a guarantee is only as good as the guarantor. While the final assessment of the competitiveness of a policy is an empirical matter that is determined over time, no one should fail to understand that such a favorable future determination is obtained by achieving competitive value year after year.
Questions to Ask
To see whether you or someone advising you understands how to find quality products or to evaluate an existing policy, assess your or their knowledge of life insurers’ current financial performance. Consider asking basic questions such as the following:
- What is the insurer’s rate of return earned on its relevant investments and credited on its policies?
- How cost-effective and productive are the life insurer’s home office and your agent?
- Of the insurer’s pool of insureds’ coverage, what share was underwritten in the past five years, and what share remains on the books even 10 years after being issued?
- How competitive are the insurer’s average mortality costs, and what are the implications of uncompetitive costs for you?
- How fairly does the insurer distribute its earnings?
- What is the insurer’s approach to managing its capital?
An Example of an Insurer’s Financial Statements
Answers to these and many other important questions can be obtained by focusing on an insurer’s data regarding its individual life insurance product line contained in its financial statements—called the Blue Book—filed annually with state insurance regulators. Figures 1, 2 and 3 show data for Knights of Columbus, a $20 billion fraternal life insurer.
Modified Income Statement
Figure 1 is a modified income statement; all investment-related aspects are contained in Figure 2. Total premiums for Knights’ individual life insurance product line include premiums collected (including even those paid to reinsurers) and exclude dividends (which, when left as paid-up additions, are counted as premiums in the industry’s statutory forms). Actual annual claim costs have been calculated as the difference between death benefits paid and reserves released on death. Home office expenses, sales commissions and reinsurance costs are plainly listed (the last is not nearly as significant for Knights as for many other life insurers). Lines 12A and 12B show the range in the amount of premium dollars Knights could have applied to increase policyholders’ cash values. The maximum figure arises if Knights used none of the amount by which premiums exceed expenses for its own profits. The minimum arises if all of Knights’ profits on this product line came from premiums.
Specific measures of Knights’ cost effectiveness can be calculated when Figure 1 figures are combined with other financial statement data (i.e., the number of policies, the total amount of insurance in force) or when they are further analyzed, such as when premiums and sales costs are disaggregated into the first year versus renewals. For instance, Knights’ home office expenses on average cost each policyholder about $55 per year, a cost that anyone who is knowledgeable about the industry would recognize as very low and attractive. Knights’ average annual mortality costs are approximately $1,980 per million dollars of coverage, which, of course, is not to imply that every policyholder each year directly bears such cost. Delving into the premium and sales costs data, we learn that Knights pays its agents 95% of its policyholders’ first-year premiums and approximately 4.7% of all single and renewal premiums. (This fraternal insurer’s compensation to its agents may give new meaning to being part of the brotherhood—that is, the brotherhood of Knights agents!) While these analytical results ought to only be used properly—that is, used with knowledge of industry norms and the calculation’s own limitations—these facts spotlight subjects every prospective and current policyholder needs and deserves to know.
Investment and Capital
The top lines of Figure 2 summarize Knights’ total investment earnings. The portion of these annual investment earnings, after investment management expenses, distributed to the individual life insurance product line (amounts distributed to all of its other product lines have been omitted from this presentation because of our chosen focus) range between the amounts shown in lines 9A and 9B. Also shown is the absolute growth in Knights’ capital/surplus over each of the four years shown, which amounts to a paltry compounded annual return of 0.12%. Consequently, we also see that—on average—throughout the four-year period of 2008 through 2011 (this period having been chosen to show an aspect of life insurance company operations noted below), Knights earned 5.23%, incurred investment management costs of approximately 13 basis points (0.13%), and yet on average credited policyholders with investment returns of approximately 6.54% (Line 10 minus Line 11), even after having deducted a 68 basis points (0.68%) capital charge for profits.
No doubt, given the steady multi-year decline in the returns on bonds—which comprise over 90% of Knights’ investment portfolio—its current investments returns are lower. Admittedly, to fully understand and assess the attractiveness of Knights’ or any other life insurer’s investment returns, much additional information is necessary; for example, facts about the portfolio’s composition, average duration, its riskiness, its competitive benchmarks, etc. There can, however, be no denying the usefulness of this information. For instance, such facts no doubt surprise some who have always thought life insurers aren’t, or can’t be, attractive investment managers.
Reconciliation of Obligations to Policyholders
Figure 3 shows how Knights’ obligations to its individual life insurance policyholders changed each year. The amounts of the inflows from premiums and investments, less the total product line’s profits—retained to grow its capital, thereby preserving its financial strength—are shown in Lines 4-6. Next, in Lines 8-10, the primary payments made to policyholders are shown: the amount of dividends policyholders received in cash, the reserves paid out upon death claims and the reserves paid out upon policy surrenders. While life insurers sometimes make adjustments between their policyholder liabilities and their capital that could also have to be recorded, Knights seldom does. Its total year-end obligations to its life policyholders are listed in Lines 13-15. Any errors in reconciling Knights’ policyholder liabilities per its financial statements and its liabilities calculated via this format are shown in Line 16, their insignificance thereby providing additional verification of the validity of this analytical format.
Figures 1, 2 and 3 spotlight the critical factors affecting the financial performance of a life insurer and its cash-value policies. Facts about Knights’ costs for the six primary components of a cash value life insurance policy (sales, claims, home office administration, investment management expenses, premium taxes and capital charges) are presented. This clarity leads naturally to further follow-up questions about these components actual costs in any specific policy. Similarly, insight is gained regarding the insurer’s investment performance and the manner in which it shares this with its policyholders. For instance, in 2008 when Knights suffered losses on its investments (like most investors that year), the analysis shows how it used its capital to smooth out financial returns for its policyholders. Indeed, throughout all four years, Knights was actually subsidizing the returns provided to its policyholders by not growing its capital. The management of a life insurer’s capital is truly a vital subject that every cash-value policyholder ought to understand, but one that virtually none learn anything about from their agents or other financial advisers.
This introductory presentation shows just some of the many insights that can be gained from understanding the financial performance of life insurers. While ignorance or wishful thinking can often seem blissful, everyone eventually realizes just how terribly costly they really are.
Given that few, if any, policyholders (and even few other marketplace participants) ever obtain or use real relevant financial information and expert financial analysis of policies, it ought not surprise anyone that cash-value life insurance as an investment is so seriously misunderstood and widely disparaged. While in theory, the product has several very valuable characteristics and tax privileges, in practice consumers are almost always sold (and often keep) policies that no informed consumer would ever want.
Yet, for those who obtain good information and genuine analytical expertise, tremendous value can be readily obtained.
This post was adpated from Brian Fechtel’s article in the April 2016 issue of the AAII Journal. For the unabridged version, click here.