Tag Archives: annuities

Hot Money May Cause the Life Insurance Industry to Crash and Burn

Cash is God in the life insurance business and some companies seem to be willing to sell their soul to the Devil to get it.

The appeal, power and profitability of the life and annuity insurance industry have eroded almost to the point that the industry has not only lost its prominence, but its very viability as an independent competitor in the Insurance_Stabilityfinancial services market also is being questioned. These dire circumstances are forcing insurance companies to seek capital infusions from sources they would never have previously considered and to take actions that are an anathema to traditional insurance financial management. Both actions may, in the end, threaten the very survival of the companies, but even worse is the risk that these activities may leave policyholders holding the bag and cost the taxpayers billions in bailout bucks.

There is no more cogent evidence of this state of affairs in the life insurance industry than a recent article in The Wall Street Journal which reported that the New York Department of Financial Services has issued subpoenas to a number of large private equity firms, seeking information about recent investments they have made in the life insurance industry. Regulators may be curious about this activity because the business model of private equity firms – relatively short term high returns – is so contrary to the business model of insurance companies. Just a few weeks later The New York Times reported that the New York Department of Insurance is investigating actions by insurance companies characterized as “shadow reinsurance” that are intended to artificially reduce the amount of capital and reserves needed by insurance companies.

In simple terms, here is the problem: The financial model for the life insurance industry is diametrically opposite to that of most industries. When a typical company makes and sells a product, it reports an immediate profit. When a life insurance company manufactures and sells a policy, it reports an immediate loss; a loss that may not be recovered for several years. As a result, for non-insurance companies, growth creates new capital, while a growing life insurance company consumes increasing amounts of capital. For most companies, a return on invested capital can be measured in a single fiscal year, while for a life insurance company a return on invested capital could take decades.

Capital Requirements Magnify the Issues

When it comes to managing capital needs, life insurance companies face still another financial complication. The nature of life insurance is an uncertain, long-term liability. Actuarial tables notwithstanding, the insurance company never really knows when it will have to pay or how much its future liability to the policyholder may be. With this in mind, state regulators require insurance companies to set aside and maintain a reserve of capital to meet these future liabilities. This requirement ties up capital for decades that further limits capital available for growth.

In the past, there were a number of strategies life insurance companies used to effectively deal with its capital requirements. For one thing, the insurance industry was sheltered from competition because banks and investment firms were prohibited from offering insurance products. This isolation allowed the insurance companies free rein to compete with each other to carve up the available business unfettered from free real competition from outside the industry. This meant that consumers could not comparison-shop for products based on price – as all products were priced on the same basis – and all products produced very high profit margins for the companies. This situation permitted insurance companies to use the profits emerging from existing business as “capital” to invest in new business.

Traditionally, the largest life insurance companies were not publicly traded, but were rather “mutual” companies, LifeInsurancetheoretically “owned” by the policyholders. This structure immunized the insurance company from any real pressure to show a return on invested capital, especially in the short term. In addition, the life insurance industry shared and passed around its capital among companies, in the form of reinsurance. Companies that had capital, but were not growing as quickly as others, would “loan” their capital to another company, in exchange for participating in the future profits of the business. This was facilitated because both companies were willing to accept a long term – maybe over decades – return on this capital.

There’s Trouble Ahead

But then, late in the 20th century, the life insurance industry experienced what was, in effect, a cataclysmic polar shift in its world. The life insurance industry was ravaged by a perfect storm when, in rapid succession, a maelstrom of events dramatically changed the insurance landscape.

First, there was a rush by the largest insurance companies to convert from a mutual to public structure. As a result, the short-term demands of the public market forced the management of these companies to shift, as never before, from long-term strategies to short-term, top-line sales and bottom-line results.

Then, another bomb shell: The restrictions keeping banks and investment firms out of the insurance industry were repealed and this opened the door to stiff new competition for insurance companies. The combination of increased competition and focus on short-term results caused insurance products to be marketed more as commodities – with price being the motivator – a change that significantly squeezed profit margins for insurance companies. On the heels of all this the financial crisis thundered in swamping insurance companies with hundreds of millions of dollars in investment losses at a time when interest rates for new investments dropped to virtually zero.

These were catastrophic events for an industry that always needed to wisely husband its capital and sold products that were “interest sensitive.” The fallout from this chain-reaction of events also triggered a significant reduction in the valuation of insurance companies, making it even more difficult to raise capital.

Just when things couldn’t get worse . . .

In short, just when the insurance industry needed capital the most, it ran out of capital. Companies lacked the cash required to support new business, causing them to scale back on sales. At the same time, reinsurance companies exited the market; they needed to retain all available capital to support existing liabilities.

In response to this confluence of crises, insurance companies began taking one or more of three different actions:

  • Raising capital from private equity investment firms.
  • Engaging in “financial engineering” in an effort to reduce capital requirements.
  • Moving away from the very core of insurance – the guarantee that risk of loss would be covered – by offering investment-type products that transfer the risk to the policyholder.

Any one of these actions – let alone the combination of all three – has the potential to fundamentally change the very nature of the insurance industry and threaten the future of any company that employs them. And here’s why.

It may seem like a match made in heaven: Private equity firms are flush with capital to invest and the insurance Private-Equity-Firmsindustry are desperate for fresh capital. The problem is that the business model for these two groups is not a match, let alone a heavenly one. Private equity firms seek a return on invested capital that is as much as three times higher than the normal return insurance companies can expect to achieve. Even more conflicting for the insurance industry is that private equity firms seek to be in and out of their investments within a five- to seven-year time frame, while insurance products barely break even after five years.

Another challenge for insurance companies that accept private equity capital is that these firms expect to begin receiving dividends on their investment almost immediately. The management of insurance companies that accept private equity capital will soon find they are constrained to meet the requirements of private equity and take actions that are antithetical to sound insurance management. And it could be the policyholder who ends up paying the price for this arrangement.

As mentioned above, reinsurance companies have traditionally been a reliable source of long-term capital for insurance companies, but reinsurance companies are also strapped for cash and have virtually withdrawn from the life and annuity market. In response to this, as the New York Times article pointed out, many of the largest public insurance companies have discovered a “creative” way to overcome the lack of capital available from reinsurance – they have started their own reinsurance companies.

In simple terms, these companies have set up wholly-owned reinsurance companies in states that have lower capital reserve requirements or fewer investment limitations than does the company’s state of domicile. The “parent” company then transfers large blocks of business to this “captive” company; thereby reducing the amount of reserves that have to be maintained to meet future liabilities. Voilà!, with a jurisdictional sleight-of-hand, new capital is magically created out of thin air. This may be all well and good, but should the reserves being held by the “reinsurance” company be insufficient to meet future liabilities (the reserves, after all, may amount to no more than a “conditional letter of credit” from the parent company), then once again the policyholder, or ultimately the taxpayers, could be left holding the bag.

The final action that some companies are taking is, in effect, to get out of the insurance business. Companies are developing products that are more akin to investments than insurance. This is accomplished by transferring the risk for what the future benefits may be from the insurance company to the policyholder. (For example, selling variable annuities and variable life as opposed to guaranteed life or annuities.) In other instances, companies are transferring the longevity risk – how long the benefits will be paid – from the company to the policyholder. Both of these actions have the effect of reducing the amount of capital needed to write new business and the amount of capital needed to be held in reserve. In effect, we are seeing the largest life insurance companies morph into investment companies, right before our eyes.

The Moral of the Story … 

Putting it all together, it is not implausible to foresee a scenario in which the financial services industry contracts into two players – banks and investment companies, with insurance benefits sold as an ancillary benefit on the side. This may be the most logical direction, but is does not portend good things for the life insurance industry as a viable competitor in the financial services industry.


Success in a Competitive World Depends on being Creative–not Complicated

True creativity is the art of developing a simple solution for a complex problem.

The life insurance industry has been gifted with its most expansive and lucrative marketing potential since the invention of death. This opportunity is to provide products that solve the most vexing and complex problem faced by over 60 million aging baby-boomers: How to survive life. The reward for solving this consumer need is hard to exaggerate. Yet the life insurance industry is threatening to waste away its good fortune by falling prey to confusing creativity with complexity in a way that raises obfuscation to an art form.

Simple is a Simple Does

The luggage industry offers a good example off this intellectual tomfoolery. For decades, luggage manufacturers competed for market-share by concentrating on the esthetics of the product. They confused creativity with complexity by focusing on an endless variety of styles, straps, colors, fabrics, inside pockets, tie-downs, and other petty add-ons of questionable merit.

All the while, travelers lugged, dragged and pushed their luggage around the airports of the world to the point of frustration and exhaustion. Then someone got the idea to add small wheels and telescoping handles to luggage. This was an simple solution to a complex problem, and the rest is history. Americans need a solution to their “surviving life” issues just as elegantly simple.

Surviving Life Can be Simple, Too

The challenges associated with solving the “survive life” issue are complex and well-established and admittedly more profound than suitcases on wheels. People are living longer in retirement — decades rather than years. At the same time, corporate pension plans have been eviscerated or eliminated altogether while local, state and federal governments lack the resources to meet existing pension promises, let alone make new ones. Against this backdrop are fears that Social Security benefits will be reduced or even that the system itself will “run out of money.”

And if this were not enough, the challenge for consumers to prepare for retirement has been made more difficult because while individuals have been encouraged to systematically accumulate assets, the anticipated income from corporate pensions or government benefits seemed to eliminate the need to learn how to effectively manage the de-accumulation of those assets in the form of income.

The rewards for finding a creative solution to the income need are immense: It offers the major players in the financial services industry – banks, investment firms or insurance companies – the potential to dominate the multi-trillion dollar financial services industry. And all that needs to be done to capture this opportunity is to create understandable, value-added products that provides income to maintain an acceptable standard of living in retirement and cannot be outlived.

There is no question that the challenge to develop products that provide income that cannot be outlived is complex: How long will the individual live? What will investment returns and interest rates be in the future, especially when the future now means not years, but perhaps decades. What will be the impact of inflation? How will the longevity and/or investment risk be assumed or shared? This is where the life insurance industry can shine.

Who but the Life Insurance Industry is Better Prepared?

In reality, the complexity of the “survive life” challenge plays directly into the strengths of the life insurance industry as neatly as wheels on luggage. No other industry has the extensive, long-term experience dealing with life-expectancy, financial guarantees, long-term liabilities and managing long-duration investments. In addition, unlike banks and investment firms, the life insurance industry has well-tested and proven products – annuities – that are fundamentally designed to solve income needs. Annuities are simple products that can solve complex problems. The annuity is designed to allow an individual to accumulate funds, on a tax-deferred basis, for later payout as income; either for a specific period or for life. When kept to this simple premise, annuities are products the consumer can understand, recognize their inherent value and be motivated to purchase.

When an individual faces the prospect of retirement, the most pressing issue is: How much income will I have and will it last as long as I live? Nothing is more important than solving this concern and if that was all that was offered, it would be enough. Only the life insurance industry has the experience and proven capability to provide a concrete guaranteed answer to these specific concerns. Other retirement concerns pale by comparison, but the life insurance industry also has the advantage when it comes to meeting secondary retirement questions such as: How can I protect against inflation? What happens if I get sick? When I die, will there be something left over for my wife or family?

The advantages the life insurance industry holds in the retirement market are good things, but unfortunately they seem to also be a curse. The vast potential rewards for managing the assets of those in retirement and converting them into income has not gone unrecognized by banks and investment firms. As a result, banks and investment firms are developing and selling all types of schemes designed to mimic an annuity’s ability to guarantee lifetime income. Worse, when banks or investment firms offer such products, they must take risks they are unlikely to understand and have no successful experience managing these risks. (We all saw what happened early in this century when banks and investment firms assumed risks they did not understand and could not manage.)

The actions of banks and investment firms actually boost the opportunity for insurance companies, except for one thing:

The life insurance industry seems hell-bent on squandering this opportunity in an effort to prove that complexity is the asylum of a confused mind.

Believing that that success can be found in competition against banks and investment firms, rather than responding to the wants and needs of the consumer, insurance companies are now trying to develop products that mimic those of banks and investment firms. This is the antithesis of what insurance companies should be doing. Instead of playing to their own strengths, insurance companies are playing to the strengths of banks and investment firms.

This battle for the retirement market has led insurance companies to develop products that even under the most charitable description would be called complicated, complex, convoluted, confusing and byzantine in nature. Not only are these products mindboggling for the consumer to understand, they are so complex that the vast majority of agents commissioned who sell them have about as much chance of explaining them properly as they would explaining nuclear fusion to a third-grader. Companies are forced to spend more time explaining the process and procedures of the product to the agents, than the benefit and value. (If there is one!)

And, that’s not the worst of it. Uppermost in the mind of most consumers today is guarantee over uncertainty and security over risk. When it comes to guarantees and security, the life insurance industry has a pristine reputation that it is putting on the line with these products. Yet, when terms such as “contingent deferred annuity,” “hybrid income annuities,” “guaranteed lifetime withdrawal benefit” enter the vernacular of annuity discussion, not only does complexity become the main ingredient of the product, but unknown crucial issues such as the risk profile, pricing adequacy, disclosure transparency, policy reserving and ultimate capital requirements all come into play in a way that culd significantly increase risk, for both the company and the consumer. It’s bad enough when neither the agent nor consumer can understand the product, but when you add to the equation the possibility that the company may not fully understand what it is selling, then you have a recipe for potential disaster.

And the Moral of the Story …

The opportunity to meet the “survive life” needs of retiring Americans presents the life insurance industry with potential to once again dominate the financial services industry. The life insurance industry has the reputation, experience, products and distribution system that is unmatched by banks and investment firms.

Meeting the need for retirement income that may span decades is a complex problem, but the solution need not be. Seeming to fear competition from banks and investment firms, more than the opportunity to meet the needs of the consumer, the life insurance industry is surrendering its strengths of guarantees and security for complexity and uncertainty. If the life insurance industry wants to prevail in the retirement market it must understand what it does best and leverage that advantage against banks and investment firms, rather than trying to mimic them.

The life insurance industry should start by recognizing that true creativity is the art of developing simple solutions to complex problems. If the life insurance industry can adopt this philosophy it has the experience and resources to develop “creative” products that safely and securely provide income while mitigating risk, for the companies and the consumer. These products can be transparent in a way that can be explained and understood and offer a recognizable value that will allow consumers to “survive life.” It may seem complex, but it is simple.



The Value of Life Should Never be Cheapened

The commoditization of its products has put the life insurance industry in a race to the bottom.

The life insurance industry is inexorably shifting – both its products and distribution – from a traditional value-oriented system to a commoditized, price-sensitive business model. If this process continues, the life insurance industry and its companies will be reduced to nothing more than an appendage of the overall financial services industry. And this is the urgent message I will be delivering at NAFA’s Insurance Marketing Advisory Committee’s annual symposium when it meets (Oct. 19-21) in Boca Raton, Fla. The IMO Summit is the largest gathering of insurance marketing organization principals and executives in the industry and they, too, need to hear this warning.

A “commodity” is a product for which there is a demand, but one that is sought without qualitative distinction as to the benefits and the provider; price and convenience, not value becomes the driver of sales. Operating in a commodity business environment pushes the product provider into a relentless reduction in costs, benefits and service; combined with the need for increased efficiency in accessing the commodity product. This is all designed to win the race to the lowest price, even at the expense of profits and long term-viability.

Frustrated by stagnant growth, cowered by the competitive intrusions of banks and investment firms and compelled to seek short-term gains, the leaders of the life insurance industry seem willing to surrender the very strength of the industry to the ill-perceived simplicities of product commoditization. This is a race to the bottom that can only be won by losing. The value of life is always reduced when it is cheapened.

The pressure to survive in a commoditized industry triggers an inevitable consolidation that puts more and more market control in the hands of fewer and fewer, causing the loss of innovation, real competition and the further degradation of service. This amalgamation of product providers ultimately causes the consumer to suffer a double-whammy in the form of even less value and increasing prices; with no guarantee of enhanced profits or the ultimate viability of the industry. Indeed, growth and profitability most often becomes even more volatile in a commoditized industry.

Commoditization is Nothing New and Never a Worthy Goal

The airlines are the archetypal example of an industry that has suffered through all the consequences of moving from a service, value-oriented approach to one offering product based on price. In the process, the airlines have been buffeted by the turbulence and painful pangs of consolidation, bankruptcy and illusive profits; along with loss of customer respect and loyalty. The airline industry is lucky and may be able to survive – if ever so tenuously – in this type of environment because it does offer a product that is needed and in demand. But for the customer, airline travel has gone from being an enjoyable experience to the exasperation of inconvenience, pitiful service and actually increasing prices. (Yet another example of being careful what you wish for!)

However, the life insurance industry may not be as lucky as the airline industry, because it has one noteworthy disadvantage if it is to function in a commodity environment; that being it does not offer a demand product. Life insurance and annuities have always been products that are sold not sought and have been based on the value of life, not the price of life.

There is another problem for the life insurance industry if it operates with a commodity mentality. Life Insurance and annuities have always been a long term proposition – for both the companies and the consumer. Both the profits and the benefits of the products sold were designed to emerge over a lifetime. This is the antithesis of a commodity product that is intended to be offered, purchased and used in an incident in time; the commodity sale is over and done with, with the results quickly delivered and known. Life insurance and annuities do not work that way and to sell them in that fashion is a disaster in the making for both the company and the consumer.

There is abundant evidence that the life insurance industry has begun to commoditize its business model.

More and more the products offered – especially term insurance and annuities – are developed to meet a “spread-sheet” mentality. Even the largest and most traditional companies have begun to develop products and lend their credibility to a widening array of television and Internet sales efforts. These sales are based on price, not value because value does not spread-sheet well.

If an industry is focused on reducing cost so as to base sales on price rather than value, there are no margins or need to invest in a distribution system schooled in explaining and selling value. (Note that the airline industry reduced costs by virtually eliminating – first by reducing fees and ultimately by eradicating them altogether – the travel agent; sending the customer online to spread-sheet the cost of tickets.) Consistent with this approach, the insurance industry has systematically reduced its investment – recruiting and training – in the agent distribution system. At the same time, the insurance companies have begun a process of reducing commissions to agents (and especially those paid to independent marketing companies) that if continued will ultimately reduce operating margins for agents and marketing companies to the point of extinction. (Companies will loudly proclaim that they do invest in agent training, but a close examination of this “training” will reveal that it revolves around “product technicalities” and navigating regulatory and suitability requirements; not in learning how to identify and deliver value in the sales process.)

With fewer and fewer companies competing in the market, there is no doubt that consolidation has taken firm hold in the life insurance and annuity industry. This situation lessens the motivation to innovate, freezes out competition (other than by price alone which is prohibitive for all but the largest companies) and this, in turn, reduces options for both the consumer and the distribution system. When consolidation occurs, as it has in the life insurance industry, products lose differentiation across the market and the creativity needed to survive in a diffused market is lost.  The DNA evidence of this happening is found when the new products being introduced are little more than copies of products offered by other companies, with differentiation based only on price (sometimes reflected as a higher bonus or interest rate) or a new “bell or whistle” added. Indeed, in such an environment the margins needed in order to deliver value are lost and there is no choice but for the products to be marketed as a commodity.

The tragic irony in the commoditization of life insurance and annuity products is that not only will the consumer and the distribution system be losers, but by trying to sell products intended to be long term and value-oriented as a commodity, the industry itself will be the ultimate loser.

But this does not have to be the death of life. The need for the value-oriented benefits and long-term financial security that can be provided only by life insurance and annuities is more obvious now more than ever, and the consumer is still willing to pay the price to get it. It is the life insurance industry that has clouded its vision and reduced its time-frame for profits that has caused the industry to go awry. Clinging too long to the products it wants to sell and failing to respond with products the consumer is willing to buy has lured the industry into the deceiving illusion that price and price alone is the solution to their challenges. It is a false promise for which the life insurance industry will pay a high price.

And the Moral of the story …

If the life insurance industry is to retain a dominant role in the financial services sector, it is appropriate – dare say essential – for the industry to refocus on delivering long-term value at a fair price. But, the effort will be futile unless and until it is based upon creating new products that offer the best value for living well, rather than the cheapest price for dying.

The life insurance industry is alone in its ability to develop financial products that can protect and enhance the full life cycle of financial challenges that confront every individual. In simple terms, based upon today’s consumer needs and interests, if the industry wants to stimulate real growth and fuel long-term profitability, it must sell value, not price. The history of the life insurance industry is a clear demonstration that “value sells.” Yes, value is a long term proposition, but isn’t that the essence of the life insurance industry itself? If the life insurance industry can remain true to the value oriented, long-term essence of its products, it will once again lead the parade to the top, rather than be mired in a race to the bottom.