The decision to buy variable corporate-owned life insurance can entail a complicated series of steps. There are many aspects, from plan design and the desire to “fund” a plan, to the use of COLI and the insurance product costs and features. As a result, it is often tempting to try to simplify the analysis.
In the past, simplification was achieved by focusing on the insurance chassis, while leaving separate the underlying investment alternatives. The rationale was that the sub-account features are “all the same.” Yet, potentially significant differences in performance, quality and fee structure need to be addressed to ensure the client makes a responsible decision based on all available information.
Comparing rates of return
Once the client decides variable COLI is an appropriate investment, the discussions may turn to comparing the products of a few carriers. Consider an example where a broker illustrates two carriers, A and B. Using a common and quick comparison method, the broker will show the client illustrations that represent how the policy will perform over its lifetime. The crux of the demonstration is generally the internal rate of return over some period. Often, a Life of Plan IRR is used.
In Figure 1, Carrier A has an IRR of 6.2% and Carrier B, 6.7%. Given the assumed gross investment return of 7.0%, the difference in IRRs implies a difference in the total insurance costs. Carrier A’s costs are 80 basis points (bps) and Carrier B’s are only 30 bps. At first blush, a higher IRR seems to be the better deal.
However, this may not be the full story. Fees are commonly buried in the underlying investment alternatives. Not only do these fees create confusion when analyzing the true costs of the plan asset; they also potentially limit the client’s investment opportunities.
Breaking down the insurance costs may explain the performance difference and indicate hidden fees. Insurance costs can include mortality and expense (M&E), cost of insurance (COI) and loads, as shown in Figure 2.
One will note a fairly large discrepancy in the M&E numbers, while other costs are similar. This discrepancy may reveal that something is going on. When two otherwise similar COLI products have significantly different M&Es, it is usually the result of participation fees, otherwise known as revenue-sharing. The fund company pays these fees to the insurance carrier.
Often a carrier will accept participation fees from the fund company. Result: fund performance is lowered and the fees are incorporated into the insurance product pricing. Generally, the fees lower a product’s M&E. For example, a 50 bps fee-sharing arrangement could have allowed Carrier A in Figure 2 to lower its M&E by the same 50 bps. Thus, a participation fee must be viewed as a product cost; and the fee must be factored into any valid variable COLI product comparison across carriers.
Figure 3 shows the impact of participation fees on product comparison.
It is apparent that there is no difference between the two carriers in total costs of the plan. This fact allows clients to look at the plan that provides the widest array of investment opportunities to meet their needs both now and in the future.
If a carrier’s product pricing assumes the carrier receives participation fees from a fund manager, that product is limited to offering funds from managers that have the assumed level of participation fees. This limitation could significantly impact performance of the product, because with variable COLI, it is the performance of the underlying funds that drives the results of the insurance product.
If the choice of funds is limited by revenue-sharing arrangements, the plan’s performance could suffer. Variable COLI is, and should be, created as a long-term investment. A client should focus on choosing a plan that provides for ongoing flexibility and performance.
Informing the client
The variable COLI asset is generally a significant cost-savings vehicle for many corporations. However, as we have seen, there can be a great deal of confusion about the true costs of the COLI product. As a result, clients need to be informed about all costs associated with this asset, including the costs of the underlying funds.
In this way, clients will be able to make a more informed choice and provide ongoing flexibility in their plans. By explaining the true costs of the plan, brokers will be providing additional value to their prospects and clients.