Monday, February 6, 2012

The Limitations of Magic Factories

What Insurance Companies Can and Cannot Offer Investors

As many investors cast about for a way to generate returns and stretch their assets as far as possible amid ultra-low interest rates and a “lost decade” in the US equity market, the insurance industry has responded with a dizzying array of product offerings. Many of these products seem to offer returns unobtainable elsewhere and “have your cake and eat it, too” options. While many insurance products offer significant value and can materially improve an investor’s finances and risk profile, there are also a plethora of insurance products that are long on the “sizzle” and short on the “steak.” Considering that a number of insurance products amount to giving away 10% or more of the money you put into them, investors need to be wary. In order to figure out which products genuinely offer value and which are merely a way to generate salesmen’s commissions and insurers’ profits, it is helpful to understand the environment in which insurers operate and how they manufacture their products. This post discusses how to evaluate whether an insurance product is genuinely valuable and when you can probably get the same thing elsewhere for a fraction of the cost.

Despite what an insurance salesman might have you believe, insurers face pretty much the same capital markets that retail investors, banks, mutual funds and other participants do. They can trade the same yield curve, invest in the same equity markets and trade the same futures and options you and I can access. There are a few opportunities insurers have that most retail investors cannot access, such as commercial mortgages, non-registered bonds, hedge funds, and the like, but most other types of financial product manufacturers (banks, brokers, mutual fund families, etc.) do have access to these instruments and can use them to offer products to investors. It would be nice if the insurance industry had a magical source of returns to offer investors a leg up, but the world is simply not built that way.

Insurers also labor under a number of constraints which do not affect retain investors. Insurers must pay significant commissions to the people and organizations who sell their products, and these commissions can be quite hefty (up to 10% of your investment or more). Insurers must cover their generally quite significant overhead costs. Insurers must also adhere to very substantial regulatory requirements (all 50 states have their own independent insurance regulatory machinery) and put up quite significant amounts of capital against the products they sell. Capital is a scarce commodity and insurers generally wish to show a strong balance sheet, so a return must be extracted on the capital employed when an insurer sells a product. Investors putting up this capital generally demand a double digit expected return and that has to come out of the policyholder’s pocket. Finally, insurers must pay a percentage of revenues in excise taxes to their home state. These “premium taxes” are built into the price of insurance products and (again) come out of the policyholder’s pocket.

Given the above realities (i.e. insurers have to live with the same capital markets as everyone else and have a host of constraints peculiar to their industry), it is clear that one should evaluate the sales pitch for any insurance product carefully. If an insurance product promises returns that are way above what you can get elsewhere, be very suspicious. It is likely that you are being enticed with the sizzle and the steak may be small, overcooked and full of gristle. There are a lot of VERY motivated salespeople and agents who would love to earn a nice commission by selling you an overhyped product. Even worse, these products are usually quite difficult to evaluate (even if your brain is not fogged up by the thought of outsized, risk free returns). The insurance industry loves product complexity and the bells and whistles on otherwise straightforward policies increase with every passing years. A prospectus for a variable annuity can easily stretch into the hundreds of pages.

So with all these impediments and potential snares, is the insurance industry just a big machine to vacuum cash out of retail investors who should know better? Happily this is not the case. There are a number of products which insurers offer that allow investors (for a fee) to transfer very material risks to a creditworthy counterparty. Some of these products can be bought elsewhere (possibly for less), but some products are available only from insurers. I believe that insurance products fall into three broad categories: commodity products; complex investment products; and unique risk transfer products.

Commodity products:

These are products manufactured by the insurance industry which are either copies of products offered by other financial institutions or collections of simple financial instruments which are widely available. An example of a “copy” product is the deferred fixed annuity which offers a fixed interest rate for a specified number of years and then matures. This product is economically almost identical to a CD or a bond issued by the insurer. An example of a product that is simply a collection of financial instruments that are widely available is an equity indexed annuity as detailed in this post: Commodity products are typically fairly simple to recreate and therefore can be pulled apart and compared to similar alternatives relatively easily. Commodity products may or may not offer value, but they are frequently overpriced.

Complex investment products:

 The classic example of this type of product is the variable annuity with some sort of guarantee, which routinely have prospectuses that run into the hundreds of pages. These products are generally very complex yet usually get boiled down to a simplistic sales pitch which frequently fails to mention all of the catches embedded in the fine print. Many complex investment products are also rather expensive (guaranteed variable annuities commonly have expense ratios north of 3% annually, or over 20 times the cost of an index fund). While these products may offer some value, their complexity makes it difficult to tell whether the investor is getting something worthwhile and their high cost makes mistakes very expensive. Tread carefully when offered one of these types of products.

Unique risk transfer products:

There are some products offered by the insurance industry which offer investors the opportunity to transfer a risk to the insurer and generally are not available from any other type of financial institution. Risk transfer products may be very simple or fairly complex and they may be expensive, so it is important to fully evaluate all the details (read the fine print) and get competitive quotes. Examples of risk transfer products include term life insurance, single premium immediate annuities (payout annuities) and disability income insurance. The common thread through most such products is that the investor is paying the insurer to accept risks the investor cannot individually afford to bear, such as the risk of dying young, living longer than one’s assets will last in retirement, or becoming too sick to work. Risk transfer products usually offer significant value to the investor, but should still be evaluated carefully and competitive quotes are a must. There are some cases where risk transfer products have significant shortcomings, so a careful examination of the fine print is important. For example, long term care insurance is in principle a very attractive product that seems to allow an investor to buy protection against a very costly possible life event (a prolonged stay in in a nursing home costing hundreds of thousands of dollars). However, very few long term care insurance policies guarantee a set price. Many policyholders are finding out that insurers can and do raise the annual premium by double digit percentage increases (and premiums can increase year after year) if the original pricing did not turn out to be adequate. Caveat emptor, even with products that are unique to the insurance industry.

As always, do your due diligence, consult your advisors, and be careful.

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