CLICK HERE to read my latest Forbes post to find out why you may not want to buy an annuity.
CLICK HERE to read my latest Forbes post to find out why you may not want to buy an annuity.
Last month, MetLife made the bombshell announcement that it will exit from the life insurance business. The company indicated it will shed its life insurance and annuity business by forming a separate company and then selling stock in the new company via an IPO; in essence selling its life insurance business to stockholders. (Most likely because MetLife knew no other company would buy it.)
For those of us in the insurance industry, this is one of those, “you’ve got to be kidding me” moments. Could you have ever imagined reading that MetLife, the very pillar of the life insurance industry, would announce that it is getting out of the business? This is akin to the New York Yankees announcing they are going to get out of the baseball business.
MetLife CEO Steven Kandarian justified the decision by blaming federal regulators for imposing the “too big to fail” tag on MetLife. The MetLife grievance is that these federal regulations would require the company to increase – to unreasonably high levels – the reserve capital it holds to support its life insurance business. (Of note, there are those in the financial and regulatory community – including the Insurance Department in New York – who have suggested that MetLife has been “playing games” in reporting its life insurance reserves.)
Blaming federal regulations for MetLife’s decision to exit the life insurance business is at best a half-truth. The new federal regulations for reserves may have been what triggered the decision, but they are being used more as a smokescreen and an excuse for doing what the company has wanted to do for a long time. MetLife acknowledged that even if the company were to prevail in its lawsuit against the federal government over its designation as too big to fail, it would still exit the life insurance business.
There is an unspoken but simple truth underlying MetLife’s decision: Life insurance and annuities are no longer “core” to the future of MetLife. It may surprise some in the insurance industry, but the retail life and annuity business now represent only about 20 percent of MetLife’s operating earnings, and it has been declining. MetLife reported that in the third quarter of 2015, operating earnings from life insurance and annuities declined by 33 percent from the previous year and growth had slowed to just 2 percent, compared to 12 percent the previous year.
Reaction by the Financial Community
When MetLife announced its decision to exit the life and annuity business, the financial community did a happy-dance. MetLife stock jumped 10 percent, right off the bat. The Wall Street Journal suggested that MetLife’s action will put pressure on the industry’s biggest companies such as Prudential and AIG to follow suit and exit from the life and annuity business. The Journal mused that MetLife’s action could trigger “a broader shake-up of the insurance industry’s biggest companies.”
The MetLife Decision in Perspective
It is difficult to argue with the MetLife CEO’s decision to exit the life insurance industry. He should be given credit for recognizing the realities of the industry now and for taking action to meet them. For a number of reasons, there has been, in effect, a “polar reversal” in the fundamentals of the life insurance industry. An industry that operated for 150 years selling products based on guarantees producing long-term value and long-term profits, has become an industry driven by fear of guarantees, short-term profits and commodity pricing. A business model predicated on long-term value and steady returns simply cannot function effectively (if at all) in a frenetic short-term world.
There is a simple factor at work here: It is expensive, in terms of capital required, to guarantee meeting the liabilities for mortality (death benefits) or longevity (income in retirement) that either may not emerge for decades or (even worse) be unpredictable. It is the cost – capital held in reserve – to provide these long-term guarantees that MetLife has decided it is not worth paying.
Driving this dynamic is the reality that many of the larger companies in the industry such as MetLife, Prudential and AIG are now public companies judged on the basis of their performance in the next calendar quarter, not the next quarter century. In this short-term world, the financial community views capital that is held in reserve against future liabilities as “dead capital,” and that is judged to be a liability in and of itself. This modern reality is at the core of MetLife’s decision not to invest its precious capital in new life insurance business.
It is of note that MetLife is not divesting its large block of in force (called a “closed block”) life insurance and annuities. This business has already had capital invested in it and is throwing off consistent profits. What MetLife is saying is, “We don’t want to invest our capital in new, long-term life and annuity policies, because we are being pressured by the financial markets to deliver short-term returns on our invested capital; returns not available from life insurance and annuities.”
There is a cruel irony in this situation: When the life insurance industry was singularly focused on guaranteed long-term products sold on the basis of value, it was awash in capital. The profits from this type of business created more capital than the industry could invest. In 1987, when I started LifeUSA as a new life insurance company, no less than seven very large companies fought over the right to provide the capital needed to write our new business. These companies literally paid us to take their capital, so they could participate in the long-term life insurance and annuity business LifeUSA was writing.
It was only after the companies began to shift away from guarantees and long-term value, toward a focus on commodity-type products designed to generate short-term profits that their capital base began to evaporate. By looking short-term for its return on capital, the life insurance industry moved from being a capital creator to a capital eater. As a result, the life insurance industry has now become dependent on sources of capital such as the stock market and private equity funds, that demand higher returns than life insurance is designed to produce, and these returns are expected to be delivered over the short-term. Faced with this pressure, MetLife felt its only option was to get out of the life insurance business.
MetLife could take this action because life insurance is no longer a core business of the company; in fact, this action will theoretically allow the company to increase short-term profits. The real question is: What is going to happen to those companies for which the sale of life insurance and annuities is their core business? What options will they have? What cost will they have to pay just to stay in business; if they can?
MetLife’s action is not an outlier, but only the first concrete example of the long-term damage that can be inflicted on the industry when companies abandon long-term thinking for short-term results and returns. Unfortunately, the real losers will be the insurance industry itself and consumers who need, seek and are willing to pay for guaranteed long-term protection and value.
It used to be that our grandparents worried about what would happen to their kids if they died too soon. Nowadays, our kids worry about what will happen to them, if we live too long.
Extended longevity is both a blessing and a curse. The blessings are well known and innumerable. But we are also cursed with extra time to fear death and more time to worry about our added longevity stripping us of the cash required to comfortably support those “bonus” years. In short, most folks are now more concerned about the cost of living too long, than they are about the cost of dying too soon.
A New Opportunity is Waiting
The life insurance industry achieved exceptional success and became comfortable offering products that protected against the cost of dying too soon. But it has taken the industry several decades and a number of fits and failures to (grudgingly) recognize and accept this fundamental change in consumer needs.
Despite the admonitions of some within the industry, the idea of accepting – even acknowledging – change has not been easy for the life insurance industry. Historically accustomed as it was to selling the products it wanted to sell versus products the consumer sought to buy, the life insurance industry’s initial response to the threats posed by this change was a call to “get back to the basics.” The problem for the life insurance industry was that the basics had changed and clinging to the past simply exacerbated the problems.
The Writing on the Wall was not in Invisible Ink
It’s not like the life insurance industry was not warned. As long as three decades ago, the signs of change – for those who were open to seeing them – were clearly evident. Life expectancy at the start of the 20th century was a mere 42 years; by the end of the century it had dramatically increased to age 74; with predictions that it would soon extend well into the 80s.
These remarkable statistics and a number of other factors signaled the need for change, but it was this extension of longevity that led the consumer to conclude that the fundamental products offered by the life insurance industry had become outmoded.
The life insurance industry has finally been dragged kicking and screaming into the future, but because of its intransigent allegiance to the past, it may be too late to recover what it has lost. Now that the life insurance industry has accepted the premise that it must change – if it is to survive – and offer products that protect against the cost of longevity, it is struggling with just how to do so.
Many believe that the business of insurance companies is to take risks, but that is not the case. (At least that’s not the approach for those companies that survive.) The path to success in the insurance industry is not to assume the risk of loss, but to manage the risk of loss faced by others. In order to do this, the insurance company must fully understand all aspects of the risk, so it can be managed.
The life insurance industry has more than 150 years of experience designing products that cover the costs of dying. This experience enables the industry to comfortably manage the risk of dying, without assuming much risk. Given any group of insureds, the life insurance industry can forecast – with virtual prescient certainty – when and how many in that group will die during any given period of time.
On the other hand, the life insurance industry has only a smidgeon of experience understanding the risks inherent in what could be called the “longevity market”: offering income products that meet the costs of living. An insurance company can use life expectancy tables to determine when people will die, but it has no experience projecting how many individuals in a group will live beyond – and for how long – the moving target of life expectancy.
This means the insurance company is, in effect, making a guess (taking a risk) as to how many insureds will live longer than expected and what the duration of those claims – life income – will be. In addition, interest rates have a dramatic effect on the amount and cost of income benefits. And since interest rates, another moving target, cannot be predicted for even the next year, it is a significant risk for insurance companies to try to project interest rates over decades.
The Unwelcome Upshot of All This
Faced with this dual conundrum, the prudent insurance company will tend to develop products for the “longevity market” that are loaded with hedges, protections and benefits for the company, but not so many for the consumer. This is to be expected, because insurance companies do not (and should not) assume risks they don’t understand or can’t manage. As a result, the tactic taken by insurance companies in the design of these first-generation longevity products is to transfer as much risk as possible to the insured. And this will continue to be the approach until the industry gains experience and confidence in the management of those risks. In the meantime, it’s buyer beware.
The concept and objective of these longevity policies is fine, but they are so loaded with protections for the insurance company, they don’t yet offer good value for the consumer and should be avoided. It’s not that these products are bad, it’s that they are not as good as they could or will be and the cost benefit for the consumer is not well balanced.
These products are the insurance industry’s first response to meet the concerns an individual may have that they will “outlive” their assets and income. They may have enough money to get to age 75, but what if they live to 95? The basic structure of “longevity insurance” is for the purchaser to deposit a lump-sum amount with the insurance company, with the understanding that no benefits will be paid unless and until a person lives to a predetermined age. For example, a 55-year-old deposits $50,000 with the insurance company to buy a longevity policy. The policy would pay no benefits whatsoever until age 85. At that time, the company would begin to pay about $50,000 a year, for as long as the insured lived.
This type of policy certainly solves the “longevity problem,” but it comes at a very high price with few options for the insured. For one thing, once the deposit is paid to the insurance company, it belongs to the insurance company and may never be returned. The insured gives up all control and access to the money and if they change their mind or have an emergency need for cash, they are out of luck.
That means an individual age 55 could deposit $50,000 or more with an insurance company and if they don’t live to age 85, they lose all the money deposited. The only chance they have to get their money back is to live. Even then, if the insured does live to 85, and dies a year or two later, the funds are lost. In fact, insurance companies anticipate that so many of those who buy the policy will not live to collect any benefits they count on using these forfeited funds to pay those who do live. (In fairness, some companies do offer the insured options that would, under certain circumstances, allow for a return of this premium, but the costs are so prohibitive they virtually eliminate the basic value of these policies.)
There are other problems with the policy as well. For one thing, benefits are set and guaranteed at the time the policy is purchased. With current interest rates at such low levels, this may be the worst time to buy a policy that locks in current rates for, what could be, 30 years or more. Any increase in investment rates between now and when benefit payments commence (if they ever do) would benefit the company, not the policyholder. Another concern for the policyholder could be inflation. A guarantee of $50,000 a year income may seem good today, but what will its value in purchasing power be in 30 years?
There is another issue a potential purchaser of these longevity policies should consider. It is what investors call the “credit risk.” When buyers deposit their funds with the insurance company, they are taking the credit risk that the company will be around in 30 years and will be able to meet its obligations. This is a relatively low risk decision, but if the insurance company mismanages the investments backing these policies, if more people live than anticipated live to receive benefits and those receiving income live longer than planned, the insurance company could be squeezed to meet its promises.
So what is someone who is concerned about the economic costs of living too long to do?
Well truth be told, these “longevity insurance” policies are not all that revolutionary and are not worth the cost or the risk the insured must assume in order to receive benefits. In effect, the core of these policies is a single premium deferred annuity. In a single premium deferred annuity the insured makes a single deposit of funds, allows those funds to accumulate over time and then, at a later date, can elect to receive an income for as long as they live. The risk the insured is taking by purchasing this type of policy is that it is impossible to know exactly what the income will be when they elect to receive it.
What makes the longevity policy unique is that the insurance company will guarantee what that income will be. That’s great. But the costs applied by the insurance company to receive this benefit are just not worth it. The insured must give up the right to get their funds refunded if their needs change. If they need cash for unexpected purchases or emergencies, they must find it elsewhere. If they die before receiving any benefits, their family receives nothing. They have only one chance to receive income and that is they must hang on until they reach 85 and if they die a month before or a month after income starts, that’s the end of the income stream. All these costs and limitations outweigh the value of the insurance company’s guarantee as to what the income will be at age 85.
In the Meantime, Here’s the Smart Choice
Until the insurance companies gain the experience and desire to develop improved iterations of longevity insurance, the consumer is better served by purchasing a traditional single premium deferred annuity. This keeps all the options on the side of the consumer, while still offering a guaranteed income to cover the cost of longevity. The only risk for the consumer has is not knowing exactly what that income will be when they elect it, but that risk is slight and is a fair exchange for the high costs of current longevity insurance policies. This is the best way, at least for now, to enjoy your longevity, for as long as it lasts.