AAII Journal - January 1995

Selecting a specific policy and company should be based on two criteria: the financial strength of the company and legitimate pricing advantages.

Getting Specific: Selecting the Right Policy and Company

By Peter Katt, CFP, LIC

The preferred method to select the most appropriate life insurance policyto purchase is to follow these steps:

• First, determine the problem the life insurance policy will solve - forinstance, is it wealth transfer associated with estate planning, or simplybasic family protection against the death of the primary wage earner?
• Next, select the basic policy design, such as increasing death benefitswith the maximum continuous premiums.
• Third, determine the type of policy - for instance universal life, variablelife, or whole life.
• Last, decide on the specific policy and company.

For example, an individual wants to transfer to his children a lumpsum that won’t be subject to transfer taxes. He decides on a program oftransferring about $23,000 annually to an irrevocable trust to purchasea $1 million permanent life policy with an increasing death benefit. Hethen selects universal life because of its greater flexibility comparedwith whole life and lower volatility compared with variable life.

Now the job is to select a specific policy and company. There are twocriteria I use when offering recommendations about the specific policyand company:

• Financial strength of the company. Researching the financial strengthratings given by the rating firms is the appropriate way to do this.
• Legitimate pricing advantages. There are two sources of legitimatepricing advantages. One is a reduction in selling or distribution expenses.The other is, at the margins, inherent pricing advantages that may be peculiarto a particular company. For example, some companies offer a bifurcatedstandard rating category. The upper case rating, usually referred to aspreferred, may hold a slight mortality cost advantage for insureds whoare likely to qualify for this more stringent category.

Financial Strength

Prior to 1989, looking up the financial strength ratings of a particularinsurance company was pro forma. However, since 1989 several large andsmaller insurance companies have been seized by insurance regulators dueto insolvency concerns. This has induced life insurance advisers and consumersto pay close attention to the financial strength rating firms (A.M. Best,Standard & Poor’s, Moody’s, Duff & Phelps, and Weiss Research;see box for contact information) when selecting a company. Unfortunately,with the exception of the more rigorous ratings from Weiss Research, theother rating firms haven’t been particularly accurate in the recent past.Nevertheless, I don’t know of a better system. Reviewing an insurance company’sratings from these firms is still the best measure of financial strength,especially the company’s Weiss rating.

In my practice, if the Weiss rating is A, I will accept ratings in thetop three categories for Standard & Poor’s, Moody’s, and Duff &Phelps, and top two categories for A.M. Best. Or, if the Weiss rating isB, I want the other ratings at least one notch higher. Another thing tonote is whether the company’s rating has been falling or rising. Companieswith falling ratings should be examined more closely, and perhaps avoided.

Some consumers believe purchasing insurance from large companies offerssome degree of greater safety. However, recent experience suggests thatcompany size isn’t much of a safety factor. Executive Life and Mutual Benefit(both seized in the past five years) wouldn’t be considered small companies.

Many life insurance companies keep financial data on their competitorsand offer it to their agents in the form of computer-generated reportsthat purport to objectively compare such things as past investment yields,mortality rates, expenses, etc. I suggest, however, that you stick to ratings,despite their problems, rather than give much credence to the ad hoc comparisonsoffered by competing salesmen.

Legitimate Pricing Advantages

The key issue regarding possible pricing advantages is whether theyare legitimate, or simply a mirage - exaggerated promises of future policyvalues offered by an aggressive life insurance company.

Cash value life insurance policies have several important pricing components:

1. Cost of paying death claims (mortality experience);
2. Investment yields;
3. Expenses; and
4. Number and timing of policy cancellations.

When considering policy pricing, the first rule is to remember thatpolicies are priced-to-the-market. Changes in the pricing components willconstantly affect the actual performance of a policy relative to what hadbeen projected and new projections for future performance. The second ruleto remember is that the policy values depicted on the proposal illustrationmay be exaggerated by the company in order to gain an unfair advantageover its competitors.

Many life insurance salesmen justify exaggerated pricing projectionsbased on the claim of their company’s historically superior performance.There are two problems with this claim. First, the data used to supportthis claim may be misinterpreted or distorted. Second, I am wary of acceptingthe claim that actual superior past performance is a good predictor offuture superior performance. With the exception of several mutual companiesthat have exhibited a long history of good results and fair policyholdertreatment, there are plenty of examples of fallen heroes. The most dramaticexample of problems using past and current performance as a guide to futureperformance is Executive Life. By investing heavily in junk bonds duringthe 1980s, Executive Life’s actual policy performance was superior to mostevery other life insurance company due to higher investment yields. Whatwasn’t measured or reported by the financial strength rating firms (exceptWeiss Research) was the risk Executive Life policyholders had assumed.With the seizure and rehabilitation of Executive Life, policyholders whowere promised superior performance based on their recent performance havesuffered big losses.

If we eliminate from consideration companies that don’t have very substantialfinancial strength ratings and companies with weak reputations for fairpolicyholder treatment (unfortunately, this latter characterization isnot easily measurable), there is no good way to predict which of the remainingcompanies will have superior policy performance, since we cannot predictwhich companies will have better mortality experience, higher investmentyields (without greater risks) and lower expenses.

Does this mean that all excellent companies will have the same results?No, it just means that we have no way of knowing in advance which oneswill perform better, everything being equal at the time of purchase.

But sometimes everything is not equal at the time a policy is purchased.

Reduced Policy Selling Expenses

The amount of selling or distribution expenses can be very different.Differences in selling expenses are significant because they can be verylarge. For a typical whole life or universal life policy the first-yearselling expenses can be 90% to 110% of the first-year premium and 6% to12% of subsequent premiums for a period of four to nine years. If theseselling expenses can be substantially reduced, it is predictable theirreduction will improve policy performance or reduce the annual premiumin order to achieve the same values.

Low-load policies offer much lower selling expenses. A typical low-loadpolicy will have first-year selling expenses of 15% to 20% of the first-yeartarget premium, with no selling expenses in subsequent years.

As would be expected, the traditional life insurance industry, sellingfull-load policies, has been able to find allies willing to claim thatthese lower selling expenses don’t really improve the performance of low-loadpolicies relative to full-load policies. March of 1994 had several examplesof these claims. In a March 30, 1994, Wall Street Journal article, insuranceconsultant Elliott Lipson was quoted as saying, "I’m disappointed in manylow-load companies...the difference between (low-load and) traditionalpolicies evaporates by the eighth or ninth year." Another insurance consultant,Richard Weber, writing about low-load and full-load policies in Life InsuranceSelling (March 21, 1994) stated, "...The long term results (generally beyond10 years) typically show no difference in policy values between the two." The only basis for these claims would be to compare policies based on their projected values, which favors companies willing to make exaggerated claims.Frankly, low-loads haven’t been on the market long enough to be able to compare the "long term." Any actual short-term comparison favors low-loadsbecause full-loads wouldn’t have had sufficient time to make up the differencein selling expenses. It isn’t a mere coincidence that Ameritas and USAA(low-loads) have had superior surrender value results at the five-yearmark in recent A.M. Best surveys.

If we limit our universe of companies to those with substantial financialstrength ratings and admit that past performance hasn’t been particularlyhelpful in predicting the future, statements such as those quoted are questionable,at best.

Let’s examine the estimated performance of a low-load and full-loadcash value policy, keeping the pricing assumptions constant for both. Thenlet’s use reverse engineering techniques to estimate the advantage thefull-load policy must experience with lower mortality, higher investmentyields, and/or lower policy expenses in order to catch up with the low-loadpolicy in 10 and 20 years.

For this examination I am using a $1.0 million policy for a non-smoking50-year-old male, assuming standard rates. The policy death benefit increasesas the cash value increases. The annual premium is $23,268, paid continuously. Table 1 depicts the projected cash values for the low-load and full-load,as well as the net present value difference in the projected cash values(using the same pricing assumptions for both, except for first-year sellingexpenses).

As you can see, there is a first-year $17,900 difference in sellingexpenses between the full-load and low-load. The net present value differenceis increasing over time due to higher residual selling expenses. The first-yearselling expense savings are immediate and certain. The question is, canthis difference be overcome by better actual investment yield, mortality,and/or policy expense experienced by a full-load policy? (Remember, weare comparing full-load and low-load companies with similar characteristicsin terms of very substantial financial strength ratings and a history offair policyholder treatment.)

Looking at Table 2, you can see it is nearly impossible for this low-loadadvantage to be overcome within 10 years unless the low-load company’smanagement takes off with all of the money:

Investment Yield Only (the investment yield advantage a full-loadpolicy would have to experience over a low-load to produce the same cashvalue after 10 years): Obviously, companies with prudent investment portfoliosaren’t likely to obtain a 41% (10.28% to 7.28%) investment yield advantagefor 10 years over competitors also investing prudently enough to enjoysubstantial financial strength ratings. A Morningstar 15-year return surveyshows a 28% (11.04% to 8.63%) difference, from the top fund to the lowestfund, between those invested in general corporate bonds. (Life insurancecompanies’ predominant investment is corporate and government bonds; forhighly-rated companies the range appears to be 50% to 80%.)

Mortality Only (the mortality advantage a full-load policy wouldhave to experience over a low-load - as a percentage of a non-smoker/smokerversion of the 1975-1980 Select & Ultimate Basic Table NAB - to producethe same cash value after 10 years): Zero mortality is impossible.

Combination (the investment yield, mortality, and policy expenseadvantage, in combination, a full-load policy would have to experienceover a low-load to produce the same cash value after 10 years): A 27% investmentyield advantage, 30% mortality advantage and reduction in annual administrativeexpenses equal to 1% of the $23,268 premium, or $233, is very improbable.For companies with similar ratings, this amount of difference is virtuallyimpossible.

Table 3 is identical to Table 2, except it covers a 20-year period ratherthan a 10-year period. Table 3 depicts the improvements in investment yieldonly, mortality only, and a combination of investment yield, mortality,and policy expenses full-loads must experience in order to overcome theimmediate and certain low-load advantage.

After 20 years, the picture is somewhat brighter, but there are stillproblems. The advantages required for the investment yield only and mortalityonly scenarios are highly improbable. However, the combination scenario - an investment yield advantage of 10% (8.0% to 7.28%), a 10% mortality advantage,and better policy expenses by 1% of the annual premium ($233) are all possible.

I conclude, based on the reverse engineering of my constant pricingassumption, that a full-load policy could make up the difference in sellingexpenses after 20 years. To put this in perspective, if three low-loadpolicies from excellent companies and 12 full-load policies, also fromexcellent companies, were to compete over 20 years, it is very possiblefor several of the full-load policies to overcome one or all of the low-loadpolicies’ advantages, but that the expected order of finish would mostlikely be the three low-load policies in the first five or six positions,with the remaining full-loads (nine or 10) coming in behind the three low-loads.Since I have no way of predicting which of the full-loads will actually make up this difference, the odds of selecting the right full-load aren’tvery good. And of course there is the higher cash value advantage for thelow-loads over at least a 10-year period. This would be important if thepolicy is canceled within 10 years for its cash value.

Other Inherent Pricing Advantages

There are other legitimate pricing differences between companies thatcan offer consumers modest advantages. Life insurance companies do riskselection by measuring a prospective insured’s overall health. The classificationfor prospective insureds who have no significant health problems is referredto as standard. Many companies have bifurcated their standard categoryinto an upper-case, commonly called "preferred," for insureds who are inexcellent health with a good family health history, and a lower-case, usuallyreferred to as "standard," for insureds who, for example, may be slightlyoverweight, have controlled hypertension, or poor family health history,but otherwise having no significant problems. Typically, the upper-casemortality costs may be 10% below the baseline standard, and the lower-casemortality may be 10% above. The availability of companies that offer asingle standard category and others offering a dual standard category shouldbe used by consumers to achieve the best possible result for their individualsituation.

Here are some examples:

• Someone in excellent health with a good family health history shouldseek a company that offers a preferred underwriting category. This mayprovide a legitimate reduction in mortality costs form baseline standard;
• On the other hand, a prospective insured who is slightly overweightand whose father had heart disease, but is otherwise in good health, shouldseek out a company that has a single standard rating, where marathon runnersand the slightly overweight insureds are in the same rating category payingbaseline mortality costs. This will usually reduce mortality costs by about10% compared with someone who receives a lower-case rating from a companyoffering the dual rating system.

There are other esoteric pricing differences, such as particular companieshaving better rates for smokers, or for older insureds, but it is difficultto find specific companies with these advantages and even more difficultto analyze whether the presumed advantage is legitimate. For example, tobe legitimate, and not just marketing hype, a company with presumed lowercosts for older insureds would need to have higher mortality costs foryounger insureds. Any advantage must be offset for it to be legitimate.

Conclusion

Life insurance purchase decisions should be based on evaluating insurancecompany financial strength ratings and obtaining legitimate pricing advantages.

By far the largest pricing advantage is to be found by dramaticallyreducing a policy’s selling expenses, since this provides immediate andcertain savings. It is possible that these selling expense savings canbe overcome after about 20 years by a company selling full-load policiesif it has better investment yields, and lower mortality and expenses.

The trick is knowing in advance which full-load policies will outperformlow-load policies.

Reprinted with permission by the AAII Journal, Volume XVII, No. 1, January 1995.