Friday, October 30, 2015

Buy Term, Whole Life Insurance, or Both? Part 3: Whole Life Insurance and Economic Modeling—Enter "Buy Term and Invest the Difference"


Buy Term, Whole Life Insurance, or Both? Part 3: Whole Life Insurance and Economic Modeling—Enter "Buy Term and Invest the Difference"


This is the third in a series of articles summarizing a preeminent, recent study examining the intersection of insurance and personal savings.
In “Buy Term and Invest the Difference Revisited,” finance professors David F. Babbel from The Wharton School of the University of Pennsylvania and Oliver D. Hahl from Tepper School of Business, Carnegie Mellon University examine in detail term vs. whole life insurance in a paper published in May of this year in theJournal of Financial Service Professionals[1].
Whole Life Insurance
Babbel and Hahl define whole life insurance this way:
 “The insurance contract known as whole life differs in several respects from term life. In its classic textbook form, whole life has level premiums that are paid through life and a death benefit paid regardless of the age of the insured at death—hence the name ‘whole life’. Unlike term insurance, the whole life contract never expires, so it never has to be renewed nor be converted. The insured maintains protection against the financial consequences of death as long as he or she lives, and regardless of changes in health.
 Level premium whole life has an investment element that accumulates over time and goes to offset the higher costs of life insurance as the insured ages. This investment element provides a number of options to the insured that enhance the policy’s flexibility.”
Economic Modeling of Whole Life Contracts
Beginning in the 1960s it became popular to break down various investments into individual parts. For example, it became possible to purchase the “principal only” or “interest only” portions of mortgages or U.S. Treasuries, or even various tranches of payment streams, from years 3 to 6, for example. In this spirit, economists attempted to model whole life insurance into its component parts:
 “…early studies considered whole life insurance to be ‘a linear combination of one period (year) term life insurance and a savings plan of some sort(emphasis added)”[2] The last part of this statement is emphasized for a good reason. The ‘sort’ of savings plan assumed was not, and even today is not, available to consumers apart from what is embedded in a whole life policy, as will be discussed later.” [Emphasis added.]
 Enter Buy Term and Invest the Difference
Financial marketers eventually got a hold of this idea and decided to “unbundle” whole life insurance into its “assumed” components of term life and an investment program. This marketing campaign was titled “Buy Term and Invest the Difference” (“BTID”).
These solicitations conveniently happened to offer not only term insurance, but an assortment of mutual funds and other investments that could be purchased together with the term insurance.
One such marketing program, initiated in 1977 by a former high school football coach named A. L. Williams grew extraordinarily, exciting the surrender of many whole life policies to deliver monies to Williams and his favored companies, including his own.
 Life insurers were concerned that replacing whole life with term and a separate investment program might leave the financially inexpert consumer worse off. They felt caution should precede such decisions given the increased risks involved with inexperienced individuals making specific investment decisions in a field with which they were not commonly familiar.
To keep these articles manageably brief, I will end until the next installment: 
PART 4: Significant Behavioral Limitations to the Buy Term and Invest the Difference Model: Adverse Selection and Mental Accounting in Budgeting
                                                                                
[1] David F. Babbel and Oliver D. Hahl, “Buy Term and Invest the Difference Revisited.” Journal of Financial Service Professionals 69, No. 3 (2015), 92-103. (LINK)
[2] Scott F. Richard, “Optimal Consumption, Portfolio and Life Insurance Rules for an Uncertain Lived Individual in a Continuous Time Model.” Journal of Financial Economics 2, No. 2 (1975): p. 188.

Wednesday, October 28, 2015

Buy Term, Whole Life Insurance, or Both? Part 2: Does the Pricing of Term Insurance Actually Dictate Value, a True Cost Advantage?


Buy Term, Whole Life Insurance, or Both? Part 2: Does the Pricing of Term Insurance Actually Dictate Value, a True Cost Advantage?


This is the second in a series of articles summarizing a preeminent, recent study examining the intersection of insurance and personal savings.
In “Buy Term and Invest the Difference Revisited,” finance professors David F. Babbel from The Wharton School of the University of Pennsylvania and Oliver D. Hahl from Tepper School of Business, Carnegie Mellon University examine in detail term vs. whole life insurance in a paper published in May of this year in theJournal of Financial Service Professionals[1].
Term Insurance
There may be no other form of insurance available that matches the predictability of life insurance. Do we protect anything more dearly than our own life? Because of this fact, term or temporary life insurance which typically ends by the age of 85 (or earlier) can be priced quite reasonably, particularly at younger ages. Term life insurance is pure insurance, it provides no cash value and typically terminates without paying benefits, other than peace of mind, during its term.
The price of term insurance per $1000 of coverage is usually constant for its particular term, (e.g., 5, 10, 15, 20, or 30 years), then jumps precipitously in the event of renewal. This jump in premiums due at the end of the term period to renew the policy is often so abrupt that policy owners lapse their policies. These lapses are referred to as “shock lapses” and often induce more than 50 percent of policy holders to abandon their term life insurance according to an extensive study jointly sponsored by The Society of Actuaries and LIMRA[2].
In Babbel and Hahl’s analysis (above), contrary to common thought:
“People often think that term insurance is the least expensive way to purchase coverage, but this is not necessarily true. The misunderstanding can be analogized to purchasing apples at a market. One vendor may offer to sell a dozen apples for $6. Another vendor nearby may offer to sell apples for only $4. But if paying the lower prices delivers only a half dozen apples, the price per apple is actually higher. In the first case, the price is 50¢ per apple, but in the second, it is 67¢ per apple. Alternatively, the second vendor may offer a dozen apples for only $4, but they may differ in quality from those offered by the first vendor. Accordingly, when considering cost, one must also consider the benefit received. Financial economists call this the cost-benefit ratio… .”
Further, Dan M. McGill, in the classic textbook, Life Insurance, points out:
“…term insurance has a long history of being controversial. He noted as early as 1967 that “there are certain…‘consultants’ who, when they find permanent plans in an insurance program, will advise their surrender for cash and replacement with term insurance.”[3]
Superficially, the appeal is lower premiums, but does this necessarily translate into a lower cost of insurance? McGill stated:
 “…at the time of renewal…resistance to increasing premiums will cause many of those who remain in good health to fail to renew each time a premium increase takes effect, while those in poor health will tend to take advantage of the right of renewal. [This is called adverse selection.] As time goes on, the mortality experience among the surviving policy owners will become increasingly unfavorable… . As a result, each dollar of protection on the term basis tends to cost middle-aged or older policy owners more than under any other type of contract.”[3]
In addition:
“This observation regarding the high cost of term life insurance was confirmed by David F. Babbel and Kim B. Staking (“A Capital Budgeting Analysis of Life Insurance in the United States: 1950-1979,” Journal of Finance 38:1 [1983]: 149-170). Over the 30-year period examined, and assuming 15-year holding periods, individual renewable 5-year term life had average net cost-benefit ratios, or markups per dollar of insurance coverage provided, as measured in expected present value terms, much larger than whole life contracts—on the order of three to four times higher. …the additional values derived from many elements and options associated with the whole life policies were ignored… . Since that time, however, term insurance has become much more competitively priced and the authors expect that the cost advantage that whole life has vs. term over periods of 20 years or longer has diminished... . (Interestingly…over that same time period the study also found that the true cost of participating whole life over 20-year periods was only about half as much as [term insurance], owing to its dividends.)” [Emphasis added.]
McGill did discuss circumstances under which term insurance may be the best option, including when:
 “…the need for protection is purely temporary, or the need for protection is permanent, but the insured temporarily cannot afford the premiums for permanent insurance.”[3]
In the former case, the term insurance should be renewable in case the temporary need is extended. In most cases, the term insurance should be both renewable and convertible to whole life insurance as financial circumstances improve:
"For example, term insurance may be particularly important to young people who are making substantial investments in education and training that are likely to translate into an improved financial situation over time, and to growing families. In both cases, having sufficient protection over the early years is crucial.”[3]
As a young graduate student, for example, finishes his Ph.D. program his salary may increase from an 18,000 a year teaching or research assistantship stipend to 3 or more times that amount as an entry-level assistant professor.
Next, PART 3: Whole Life Insurance and Economic Modeling—Enter "Buy Term and Invest the Difference"
---------------------------------------------- 
[1] David F. Babbel and Oliver D. Hahl, “Buy Term and Invest the Difference Revisited.” Journal of Financial Service Professionals 69, No. 3 (2015), 92-103. (LINK)
[2] “U.S. Life Insurance Persistency.” The Society of Actuaries and LIMRA, 2012.
[3] Dan M. McGill, Life Insurance, Richard D. Irwin, Inc., Revised Edition 1967. Updated in McGill’s Life Insurance, Edward E. Graves, Editor, The American College, Bryn Mawr, PA, 1994 through the 9th edition, 2013.

Monday, October 26, 2015

Buy Term Insurance, Whole Life Insurance, or Both? What Do Consumers Actually Buy? It Depends. (Part 1)


This is a series of articles summarizing a preeminent recent study examining the intersection of insurance and personal savings.
In “Buy Term and Invest the Difference Revisited," finance professors David F. Babbel from The Wharton School of the University of Pennsylvania and Oliver D. Hahl from Tepper School of Business, Carnegie Mellon University examine in detail term vs. whole life insurance in a paper published in May of this year in theJournal of Financial Service Professionals[1].
Making a decision between buying term, whole life, or a combination of both types of life insurance is difficult. Many advisers have previously presupposed that “buying term and investing the difference” is the right choice. Is it? A thorough analysis and revisit by two leading finance professors, Babbel and Hahl, is revealing:
This study demonstrates that financial analyses which purport to show that the Buy Term and Invest the Difference (BTID) concept dominates the combination of permanent life insurance supplemented with term life are deficient in many ways and incapable of establishing this dominance.
Furthermore, “investing the difference” is somewhat harder than it sounds. They continue:
…the assumed financial discipline necessary to successfully implement the Buy Term and Invest the Difference approach is an unrealistic expectation for many consumers.
There is no one approach that suits everyone, but let’s explore in more detail.
History of Life Insurance in the United States
Life insurance is actually as old as Roman “burial clubs” under Roman General Caius Marius in the first century B.C. In the United Kingdom, it began in London at Lloyd’s Coffee House (future Lloyd’s of London) where members of the shipping industry frequently gathered and planned. In 1759 the Presbyterian Synod of Philadelphia sponsored the first life insurance policies in America for the benefit of their minister’s families.
Interestingly in the United States by 1930, on the eve of the Great Depression,more than 120 million (whole) life insurance policies were in force, the equivalent of one policy for every man, woman, and child in the nation at that time[2].  
During this extraordinary time of economy and searching for financial safekeeping, it may be that each child “was born with a whole life policy in his or her mouth,” however modest.
In addition, because life insurers had been restricted from investing heavily in the securities market since the early 20th century (ca. 1905, after the Armstrong Investigations), they were able to provide a significant source of liquidity during the Great Depression, when such sources were severely limited because of the numerous financial institutional failures[3].
Again, you might say that whole life insurance policies partially replaced savings accounts, in some respects, due to fear of bank failures.
My question is, will this happen again? And when?
Next, PART 2:  Does the Pricing of Term Insurance, Actually Dictate Value, a True Cost Advantage?
--------------------------------------------------------- 
[1] David F. Babbel and Oliver D. Hahl, “Buy Term and Invest the Difference Revisited.” Journal of Financial Service Professionals 69, No. 3 (2015), 92-103. (LINK)
[2] Dahl, Corey, “A Brief History of Life Insurance.” LifeHealthPro.com, Sept. 9, 2013. (LINK)
[3] Anne Obersteadt, et al., “State of the Life Insurance Industry: Implications of Industry Trends.” National Association of Insurance Commissioners & The Center for Insurance Policy Research, August 2013. (LINK)

Oil: An Unstoppable Game of Chicken, Indeed?

With OPEC countries competing against each other, Russia selling aggressively to China, Iran coming on board, and the Americans fighting hard against relinquishing production--can oil prices fall further?









Sunday, October 25, 2015

Seattle Housing Bubble Twice the Previous?

"At 81.8, the latest King County heat index is nearly double the average during the last bubble (42.6). As with the last bubble, the condo heat index is even more out of control, coming in at 115.6 in the third quarter (88 percent higher than the 61.4 average during the last bubble)."

King County Residential Real Estate Heat Index




Thursday, October 22, 2015

"Would life insurance companies that pay returns likely go under if bond yields go down--some have already dipped into negative territory?"

Good question! Shows thoughtfulness.

Given the average maturity of a major life insurer's bond portfolio of 8-10 years, this would take some time. Most likely scenario, would be "Japanese" style life insurance returns of lower and lower yields, decreasing cash value growth, but preserving death benefits given the highly accurate actuarial probabilities in predicting loss of life from a given large pool of individuals. (Think about it, most people strive much harder to preserve their life, than a dent in their car, for example.)

But, let's look at history--with a focus on what has happened to life insurers under great and lengthy duress. Are they safe? Relative to whom?

In the 1930's Great Depression, interest rates were similarly low. ~20 life insurers went into receivership, all of them purchased by other insurers. Virtually all of their claims, however, were paid by solvent reinsurers.

In "stark contrast" to life insurance companies, more than 4000 bank failures occurred between 1929-1933, losing  ~$1.3 billion of depositors money. (See:http://www.naic.org/documents/ci...)

It's too bad more life insurers don't open up checking accounts!

Actually, despite the economic difficulties during the Great Depression, and some of the life insurer's difficulties, the life insurance industry provided a critical source of liquidity (many partially liquidated their policies for the cash values) upholding the economy during a time when other sources of liquidity were limited.

Even Hollywood will remind you, if you remember the banker in "It's a Wonderful Life". Knowing everyone had lost their savings and home values (extending into WWII times--stock market took until about 1954 to recover), and that "everyone" owned life insurance, he asked Jimmy Stewart, "What about your life insurance?", when looking for his remaining assets.

The size of the available liquidity in life insurance policies can be somewhat imagined by the fact that people had developed a strong habit of entrusting their savings to life insurers after the Armstrong Investigations (see below) had strengthened them considerably through regulation. In 1930, about 120 million whole life insurance policies existed, the equivalent of one policy for every man, woman, and child in the nation.

After the Armstrong Investigations in 1905, much stricter regulation of life insurers occurred, not allowing them to own common stock, underwrite securities, etc., eventually increasing public trust enormously. (See 1930, 120M policies, above.)

Those days of saving in life insurance policies may well return, when the generations alive today who do not remember the 1930's also come to realize that "other" savings vehicles, may not be as trustworthy or as predictable as previously believed, after the next major downturn(?).

Life insurance companies have been conservatively regulated to avoid excessive equity risk and leverage since the 1905 Armstrong Investigations. This has essentially made them stable, steadily growing cash cows, with a line of buyers waiting for an opportunity to buy them, e.g., AIG history/selloff of parts of their (wholly solvent) life insurance units in 2008-9 crisis.

Furthermore, the primary assets of life insurance companies, tier 1 investment grade bonds and U.S. Treasuries, probably doubled in value during the 2008-9 crisis. Why? When markets are fearful, people (institutions) run for the safest, most liquid instruments available, U.S. Treasuries and tier 1 investment grade bonds and drive their prices higher. So insurers are often quite confident in meeting their obligations during stock market/banking crises.

Anyway, I suspect the life insurers will again be the most likely financial institutions to survive this next major downturn unscathed. A very low yield would certainly be preferable to an ultimate 89% loss in the securities market (1930's), for example. Still having all your principle with no gain (or even minor loss) at that time would be enormously beneficial (see Kennedy family history Mention, etc.).

We may know the answer to this question in the next number of years or even sooner...(?).

Sincerely,

Robert S. Park, M.D.
Life Insurance+
Seattle, Washington
(206) 395-9501
wealth | estate | business planning

“Twenty years from now you will be more disappointed by the things you didn’t do than by the ones you did.” Mark Twain

Preserving your Savings in Safety

Wednesday, October 21, 2015