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Yes, I know what you’re thinking: only six? But let’s start with these, and you can add to the list.
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1. We want the benefits of being trusted, but we don’t want the constraints of being trustworthy.
Many people have observed that trust lubricates the wheels of commerce. It reduces sales effort, so salespeople naturally want to be trusted. On the other hand, being trustworthy imposes limits on what you can do, and sometimes you can’t do things that you would like to.
The business model of the life insurance industry relies, in part, on establishing trust and then betraying it. It’s fair to say that many life insurance transactions would not take place if the buyer had better information about the pros and cons. Two examples:
Most whole life policies, and some other types of policies, give the agent the ability to use riders to lower his commission and improve policy values. In my experience, agents rarely use this feature to create a process of honest negotiation about their compensation. Instead of presenting the full range of options and explaining the implications to the buyer, they choose one or more policy designs on their own and leave the buyer in the dark about what is going on.
Perhaps they are assuming that their trusting customer will never discover what took place in the sales process. Again in my experience, when a policyholder learns what the agent did, the policyholder’s view of the agent’s trustworthiness quickly changes. One of my clients was so angry that he contacted his state’s attorney general to complain.
A second example: Flexible-premium policies give the policyholder the ability to choose the amount and timing of premiums, within limits. The policy design can sometimes create significant incentives to depart from the illustrated premium schedule. Insurance companies do not encourage policyholders to explore this policy feature to make intelligent decisions. More often their communications convey a tone of “Don’t worry your little head about it; just pay the illustrated premium.”
Agents are generally unaware of the technical aspects of premium flexibility, so they are in no position to offer useful advice. They also have a conflict of interest in risking the loss of a sale if the prospect becomes overwhelmed by complexity, or in having reduced compensation as a result of premium optimization (although premium optimization can sometimes lead to higher commissions).
2. I want you to look at long-term projections, but I’ll look at the first-year commission.
In 1992 a task force of the Society of Actuaries warned about the serious limitations of using sales illustrations to compare life insurance policies (see “How Should People Choose a Life Insurance Policy”). Shockingly, insurance companies and their agents did not immediately stop using illustrations to make sales.
If you go shopping for a cash value life insurance policy, you’ll receive projections of premiums, cash values and death benefits that stretch out decades. Oh, you’ll have so much money in the 22nd century!
But if you try to get the minimum-commission version of the policy (see Hypocrisy #1), the agent may complain that the commission is too low. He means the first-year commission. He isn’t looking at the present value of renewal commissions stretching into the 22nd century.
3. Cash values don’t matter, unless I can use them to replace your policy.
With fixed-premium policies, such as whole life, there is a predetermined relationship between cash values and death benefits. The cash value gradually grows until it equals the death benefit at maturity.
Whole life policies with substantial cash values are a target for agents who can earn a big commission by rolling the cash value into a universal life policy with a no-lapse guarantee. The guaranteed cost of the new policy may be lower than the projected (nonguaranteed) cost of the old policy, but this comes with two sacrifices: you lose upside potential, and you lose liquidity (cash surrender values and policy loans).
Even though it is the cash value of the old policy that makes the agent’s sales pitch for the new policy possible, the agent pivots and downplays the significance of cash values going forward.
4. I want to know what the commission is, but I don’t want you to know.
Life insurance commissions are usually not disclosed. Variable life prospectuses do provide some vague disclosure, buried toward the back. New York’s Regulation 194, which took effect in 2011 despite agents’ efforts to stop it, requires commission disclosure if you ask for it.
But most life insurance buyers have no idea what the agent’s commission is, and most agents don’t see why the buyer needs to know. The insurance company pays the commission, some agents disingenuously say, ignoring the fact that commissions must be priced into the premiums.
Or they’ll ask if you know what the salesperson’s commission is when you buy a refrigerator. (A curious analogy, inviting this question: If you take your life insurance policy to Europe, will it still work?)
Or they’ll argue that the high-minded enterprise of life insurance will be turned into a grubby focus on commissions, inevitably harming consumers. (Fun thing to do: Flip through a trade publication for agents — for example, Life Insurance Selling — and count the number of ads that are high-minded versus grubby.)
But agents do think that it is important for them to know the commission. Aside from the obvious interest in their income, agents use commission information in due diligence. Conscientious agents may be suspicious of products that offer above-average commissions, because they wonder if that will come at the expense of long-term consumer value.
5. We want to say that cash value life insurance beats every other investment, but we disagree that the tax advantages are excessive.
If you look at sales pitches for cash value policies long enough, you’ll probably see a proposal to replace anything. Low-yielding safe money, municipal bonds, stocks, annuities (presented as a “rescue” from the taxes that should have been disclosed at the time of sale), tax-deferred retirement accounts, Roth IRAs, anything.
But as soon as someone proposes cutting back on the tax advantages of cash value life insurance, the industry mobilizes to contact every politician who might have some control over legislation. The current tax treatment is appropriate and necessary, they say. Is it really national tax policy to make cash value life insurance better than every other place to put your money, and if so, should this be classified as a tax expenditure or as an entitlement program?
6. We want to be careful when we’re selling our products, but we want you to be careless when you’re buying them.
Life insurance companies do not put products into the marketplace without verifying that they will meet their profit objectives. This process, called profit testing, often uses simulation techniques to construct a probability distribution of results. For example, a 2012 survey by Milliman, a large actuarial consulting firm, found that 17 out of 23 companies used stochastic modeling in assessing the risk of no-lapse universal life products.
There is a trend toward using stochastic methods in solvency regulation as well. Some capital requirements are based on conditional tail expectation (CTE), a coherent risk measure that is equal to the average of the x% worst outcomes. For example, CTE90 means that you take the average of the 10% worst outcomes in the probability distribution, and the company should have sufficient capital to cover that shortfall.
But buyers of cash value policies have to settle for sales illustrations that do not present a realistic picture of the benefits and risks. This is especially true for indexed universal life and variable universal life, which pass significant investment risk to the policyholder.
Sales illustrations unrealistically assume a constant interest rate in all years, thereby hiding the impact of volatility on the future policy values. Even if you can accurately predict the long-term average rate of return, the periodic fluctuations in the credited rate will create a wide range of outcomes, including the possibility of having to put more money into the policy to keep it in force.
In “Policy Illustration Technology: It’s All about the ‘Ups’ and ‘Downs’,” published in the March 2014 issue of the Journal of Financial Service Professionals, Richard M. Weber and Christopher H. Hause modeled an indexed universal life policy to show the disparity between deterministic and stochastic illustrations. The deterministic illustration — what we now have — showed a 100% chance that a $5,417 premium would keep the policy in force for life, assuming an 8% constant interest rate. A stochastic illustration using historical S&P 500 returns (8.45% long-term average, without dividends) with a 0% floor and 13% cap showed that this same premium would keep the policy in force until maturity only 20% of the time. With a 10% cap, failure was almost certain.
Furthermore, if you wanted to rely on a deterministic illustration to estimate the premium that would have only a 10% chance of failure, you would have to reduce the constant interest rate to 5.2% to 6.3%. depending on the assumed cap. So it would take a downward adjustment of 1.7% to 2.8% to get a premium that might be viewed as acceptably risky by the buyer.
Deterministic illustrations are so unreliable for making policy purchase and maintenance decisions that it should be a no-brainer to ban their use and require stochastic illustrations. However, insurance companies and insurance regulators have shown no interest in doing this.
What explains this behavior?
Does the life insurance industry have more than its fair share of unethical people? I doubt it. I would look for an explanation in Blind Spots by Max H. Bazerman and Ann E. Tenbrunsel, published in 2011. They write: “Findings from the emerging field of behavioral ethics — a field that seeks to understand how people actually behave when confronted with ethical dilemmas — offer insights that can round out our understanding of why we often behave contrary to our best ethical intentions. Our ethical behavior is often inconsistent, at times even hypocritical.”
Bazerman and Tenbrunsel argue that unethical behavior is often unintentional, due to bounded ethicality (“cognitive limitations that can make us unaware of the ethical implications of our decisions”) or ethical fading (“a process by which ethical dimensions are eliminated from a decision”).
I am willing to believe that most agents just don’t see the ethical implications of their actions, even when their behavior is inconsistent with the codes of ethics of Certified Financial PlannersTM, Chartered Life Underwriters, Chartered Financial Consultants or members of the National Association of Insurance and Financial Advisors. (I have a link to these codes at glenndaily.com/links.htm.)
Consumers and their advisors will be doing the life insurance industry a favor by pushing back firmly against its ethical shortcomings. If you start with the premise that these shortcomings are due to blind spots, rather than character flaws, you may actually have an impact on future behavior.
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