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Journal of Financial Planning - October 1994 "Commission-driven insurance selling, the low-load approach, and fee-only insurance advice all have their place in the life insurance industry. Our columnist analyzes the role of each approach, and which type of client best fits each approach." A Perfectly Rational World by Peter Katt, CFP, LIC There are two distinct systems used to market and sell life insurance, and another that provides life insurance planning and purchase advice
Each system has its strengths and weaknesses, and there are good reasons for each system to exist. (I am a fee-only life insurance advisor, which may cause actual or perceived prejudices to surface.) Commission Approach The commission-driven system features life insurance companies paying their salespeople very high commissions, usually 50 to 90 percent of the first year premium and 5 to 10 percent of subsequent premiums for another 4 to 9 years. Sales commissions comprise a large part of a policy's acquisition expenses. The combined acquisition expenses are typically 90 to 110 percent of the first-year premium. The commission structure is the linchpin of the life insurance industry. Without the offer of such a high financial reward for successfully completing the sale of a life insurance policy, the industry would have a difficult time recruiting agents and convincing them to perform the distasteful tasks of solicitation and the hard selling of potential buyers. This system actually has a good deal of resonance in the marketplace because many consumers would not otherwise focus on their life insurance needs. Most consumers need to be "tricked" into discussing insurance, and the salesperson must master as much selling skill as possible in order to convince the consumer to buy a policy. (If this were not true, the policy cancellation rate would not be as high as it is; a 1990 study by the Life Insurance Marketing and Research Association, Inc. (LIMRA) found that 54% of the whole-life policies they reviewed had been canceled within the first 7 years.) The high commissions are paid as a reward for successfully soliciting and hard selling. Consequently, agents' performance standards focus on the amount of premium generated, not on the quality of purchase recommendations, accurate policy analysis, or servicing. Solicitation and hard selling is what the market requires; it isn't a giant life insurance industry conspiracy. We see a similar pattern among our political elite. Many citizens vote for politicians who overpromise. Many consumers buy life insurance from salespeople who hype planning issues and policy performance, and then ignore the messes left behind. In moments of candid reflection, politicians and life insurance salespeople both acknowledge their regret for the process they must use, while realizing to be successful it is what each of their respective markets require. Low-Load Approach The direct-to-consumer, low-load approach - offered by such companies as Ameritas and USAA and general-agency-type arrangement such as the Wholesale Insurance Network - entails consumers taking the initiative by calling the toll-free numbers to order insurance illustrations and ultimately buy a policy. The direct-to-consumer companies and agencies have benefited from numerous positive media stories and some of the direct-to-consumer outlets also advertise. The selling expenses of a typical low-load policy are 15 to 20 percent of a specific target premium. The low-load salespeople generally are paid salaries. As such, they are relatively low-key in their dealings with consumers compared with the commission-driven, full-load salespeople. They are less likely than their full-commission counterparts to propose that consumers pursue complicated life insurance planning schemes. Furthermore, it is implicitly understood that direct-to-consumer customers don't want to be "sold." They have probably found the solicitation and hard-selling tactics of the full-commission salesperson hard to take. However, low-load salespeople do have a substantial interest in having the consumer buy a policy from their company. Therefore, they have the same conflict of interest with the customer as commission-driven salespeople, though with less selling pressure. Certain Savings Low-load policy purchases offer immediate and certain savings. If a 55-year-old male (nonsmoker) buys a $1-million-level-death-benefit policy and pays continuous premiums of $17,500, the approximate net-present-value savings after 5 years (discounted at 6.3%) is $11,900, compared with a full-load policy. Another way of expressing this difference is that a full-load policy's annual premium would have to be $18,750 (7% higher) in order to duplicate the values of the low-load policy, assuming identical pricing assumptions. It is possible that these immediate low-load savings can be overcome by better long-term performance for some full-load policies. However, my crystal ball is insufficient to predict which companies, if any will produce such long-term pricing advantages to overcome the low-load advantage. Low-load policies should be subject to the same level of due diligence and scrutiny as full-load policies. Pricing assumptions should be checked out, the low-load company's financial strength ratings should be excellent, and the overall reputation of the low-load company should be considered. There is nothing inherently "pure" about low-load policies. (Please refer to my July 1993 column, "Piety and Perils of Low-Load.") Fee-Only Approach The third system available to consumers for life insurance planning and policy analysis is the fee-only approach. Fee-only life insurance advisors should be distinguished from fee-based advisors. Fee-based advisors usually are life insurance salespeople who occasionally operate on a fee basis. But how do fee-based advisors decide when to charge fees and when to earn commissions? In my experience, the fee-based approach has been used as a bait-and-switch tactic. Consumers believe they are working with a fee advisor, only to discover that a commission has been earned or expected. Another distinction is also necessary. There are fee-only financial planners offering "objective" life insurance advice without sufficient knowledge about the intricacies of planning issues and policy analysis. Some fee-only life insurance advisors charge fees based on a percentage of the amount of life insurance sold. 1% of the face amount is common. For example, if a client buys $1,000,000 policy, the fee-only advisor's fee would be $10,000. Aside from this fee being perhaps too high, this fee arrangement doesn't remove the conflict of interest with the consumer. The fee-only advisor using this type of fee structure has as much interest in the client purchasing life insurance (and the amount), as do full-commission salespeople. By charging fees based on a percentage of the amount of life insurance purchased, any sense of objectivity is lost. Some fee-only life insurance advisors charge fees based on an hourly rate or a fixed fee for a particular case. Under these arrangements, the fee-only advisor has no financial interest in the decisions made by the client. These fee-only advisors are financially rewarded for being objective. They are fiduciaries. Their clients gain access to wholesale life insurance purchases since one of their primary motivations is to reduce the selling expenses of a policy. This is done by either recommending low-load policies or restructuring full-load policies to reduce the selling expenses. Finally, fee-only advisors can arrange for substantial commission rebates where it is permitted. Fee-only advisors (especially those basing fees on an hourly rate) are particularly needed for the review of existing policies. The other systems, which derive their compensation from the sale of life insurance (including fee-only advisors who charge based on a percentage of life insurance purchased), are unsuited for objective analysis of in-force policies. Matching Consumers to Approaches Not all consumers are well matched with fee-only advisors. The ideal fee-only advisor client understands that the issues are complicated and they are seeking objective life-insurance-planning-options, detailed policy analysis, purchase advice, and ongoing management of their life insurance "portfolio." Not particularly suited for fee-only life insurance advisors are consumers who don't believe that life insurance planning and policy analysis are complicated issues. They will ultimately object to paying the fee they agreed to because they will believe that the conclusion has been obvious from the start. This type of consumer is probably better going directly to the low-load companies and buying their life insurance in the direct-to-consumer system. Another consumer type who will find it difficult working with the fee-only advisors are consumers seeking a "cheaper" policy. These consumers would be better working with full-commission salespeople who sometimes make what I believe to be exaggerated claims about policy performance. Finally, consumers who need to be pressured into their life insurance purchased won't find direct-to-consumer salespeople or fee-only advisors prepared to apply the needed pressure. Several times each year, I will work on a complicated case, decisions are made, full payment of fees is made, yet I never hear from the client again. I suppose they lose interest. Because I am paid fees based on the time involved, I have no motivation to take actions that would "convince" a client that they should ultimately buy life insurance. I figure if they lose interest, or otherwise decide not to buy the life insurance that they thought they wanted it is their decision. Numerically, consumers who don't believe that life-insurance-planning and policy-analysis are all that complicated, those wanting "cheaper" policies, and reluctant buyers who need to be pursued far outnumber consumers who have the opposite opinion or behavior. This is why the commission-driven system is consistent with what the majority of life insurance consumers need. The system continues to be essential because it rewards agents able to solicit and complete sales to consumers who otherwise might not consider or complete the purchase of life insurance. In a perfectly rational world this wouldn't be necessary. But we don't live in such a world. Perhaps someday our political elite and strident consumer advocates will come to realize this and accept the life insurance marketplace as a reflection of human behavior. Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 7, Number 4, October 1994.
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