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Over the years, it has become apparent that too much “hide the ball” selling is going on in the financial services business. The NASD’s crackdown on variable annuities is but one example of how sales tactics have led regulators to conclude that many representatives need help being honest.

A looming storm cloud on the horizon variable universal life insurance sales practices will, I believe, rain tons of water on the financial services parade. Many insurance practitioners have already weathered the universal life scandal.

They have had to explain why falling interest rates have made the premium reappear and the agents disappear. How much worse will this problem be when the cyclical performance of the stock market cannot live up to the illustrations?

Many practitioners have failed to calculate the difference between an average rate of return (ROR) and an internal rate of return (IRR). As a reminder, the average is the sum of the returns divided by the number of years. So, for instance, a return of 25% each year for 4 years and a negative 30% in year five would have an average return of 14%.

But an IRR is more complicated. It is the time-adjusted rate of return. A negative return has much more impact calculated as compounded results. The IRR for this example is 11.31%. That’s a 269 basis point differential (2.69%).

Now let me ask you a question. If the illustration shows the policy earned 10%, every year for 40 years, is this realistic? Most would say, “Well, it might average that return.” Precisely, it might average 10% over 40 years. After all, the large cap market has averaged more than that over the last 50 years.

But what is the IRR? What happens when the market drops 30% a couple of times along the way, but still averages 10%? See the problem?

An illustration based on 10% assumes an IRR of 10%, not an average return. Actual market performance needs to be nearly 2% (200 basis points) higher to achieve the illustrated results. How many practitioners know that? And more important, how many are disclosing this important problem to the clients?

Let’s look at this issue more closely. Most clients do not understand life insurance. The fact is, all life insurance is term insurance. The only difference between “buy term and invest the difference” is where you invest this difference.

It can be in mutual funds, variable annuities, or in a whole or variable life fund. When you factor in the tax impact and expenses, a whole life or universal life policy will compare favorably to a term policy-plus side fund, especially when you consider the discipline required over 40 years.

How many practitioners explain this difference between term and permanent before they show an illustration? And how many point out how important the return is to the results projected in the illustration? Why not educate prospective clients instead of just trying to sell them?

To make education user-friendly, I developed what I call “the box.” It is a simple 7-minute sales track showing how all policies are a combination of mortality costs, expense assumptions and returns. By demonstrating to prospective buyers the long-term mechanics of mortality costs, it is relatively easy to prove that no one can own term insurance past life expectancy.

Why would they? The cumulative mortality costs (the incremental death benefits payable plus reserves the carrier must collect on each life annually) for term insurance at life expectancy are the same for all companies and all policies.

I call this “paying the curve.” Have you ever looked at cumulative mortality costs? At age 95, the total can exceed two times the face amount.

The industry-wide mortality costs have to be the same; this is an actuarial science. It is based on the predictable probability of death. How predictable would insurance be if everyone looked at the same data and drew different conclusions?

Granted, large companies adjust their mortality assumptions for specific experience associated with their underwriting. But these are nuanced differences. Over time, there is likely to be a regression to the mean for mortality costs as underwriting results are widely communicated.

The expense assumptions are another variable. But since they represent a relatively small portion of the total cost associated with a policy, one can easily determine which companies are the most efficient. The problem arises from lapse-supported pricing assumptions or other sophisticated pricing aberrations.

It is reasonable to conclude that mortality costs and expenses are the same regardless of the type of policy. A term policy to life expectancy has to collect the same amount of money as a whole life or universal life policy, doesn’t it?

Otherwise, the company would be creating adverse selection. Also, the expenses attributed to the policy have to be somewhat similar or the company would violate the policyholder fairness doctrine.

The only variable is the side fund. I call this the box. Premium dollars exceeding mortality costs and expense loads go into the box and grow based on some crediting mechanism. This mechanism is either based on the general account or a separate equity account.

Either way, the box is adjusted based on actual performance. If there is enough money in the box to pay the curve, then one doesn?t need to put more money into the box from an external source (i.e. new premiums). But if the box underperforms the long-term assumptions, new premiums will be required to keep the policy on target.

It is that simple. You either fill the box or pay the curve.

Should insurance agents disclose this to their prospective buyers? Is this level of disclosure an ethical business practice? I believe it is. And you know what? Buyers are grateful. They say, “This is the first time I ever understood life insurance.” What could possibly be wrong with that?

So, when discussing the mechanics of the product you are recommending, ask this simple question: “Mr. Jones, do you know how life insurance really works?” When he says no, and they always do, ask, “Would you mind if I took a few minutes to explain to you the mathematics of life insurance?”

Then give this simple 5-minute presentation. You and your clients will love the results.

, MBA, CLU, ChFC, CFP, MSFS, MSM is a 26-time life qualifier for the Million Dollar Round Tables Top of the Table. You can reach him at guy@btagroup.net.


Reproduced from National Underwriter Edition, October 28, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.