A.R. Barnes, Jr., The Mortality Mortgage: Pricing Practices and Reform in the Life Insurance Industry, Quorum Books, Westport, CT, 1995. 203-226-3571. 194 pages, $55
by Glenn S. Daily
Every few years, a life insurance agent writes a forgettable exposé about the industry that has been paying his commissions. Al Barnes's The Mortality Mortgage is less forgettable than most because of the author's breathtaking agenda: he wants to show that actuarial textbooks are wrong. If he succeeds, he will also become a major contributor to the academic literature on life insurance cost disclosure. This is breathtaking because Barnes is neither an actuary nor a professor and this is his first book.
The Mortality Mortgage offers a solution to an already-solved problem: how to evaluate life insurance policies. There's no mystery to this. Life insurance products are priced using discounted cash flow techniques that are familiar to every advisor; the only difference is that determining the cash flows requires some actuarial training. To understand a product, you walk backwards from illustrations to the internal load structure to the underlying assumptions about past, present, and future pricing factors. In the corporate and private placement markets, where decision-makers have multi-million-dollar premiums at stake, this process can easily cost $30,000 in consulting fees.
That price tag is beyond the reach of most planners, but there are two solutions: pool your resources to buy serious due diligence or find acceptable substitutes. Useful tools for policy analysis include yearly and average annual rates of return, benefit/cost ratios, simplified profit testing, and an examination of publicly available documents such as the Illustration Questionnaire. An experienced analyst can use these techniques to screen out aberrant products and to raise questions for further investigation.
Barnes proposes a different approach: using a mortgage analogy in which the buyer is the lender and the insurer is the borrower. His premises are not unreasonable. The lender wants a high rate for a long time, and he doesn't want to lend more than the collateral is worth.
What is life insurance collateral worth? Barnes says that it should be valued using the most favorable interest and mortality rates prescribed for determining reserves and cash surrender values; in actuarial terminology, the lowest net single premium permitted by law. Insurers have some latitude in choosing a computation basis for their reserves and guaranteed values; a lower interest rate and a less favorable mortality table will produce a higher net single premium. Insurers also add loading to their net premiums to cover their expenses and profit.
To appraise a policy using Barnes's method, you add the first-year acquisition costs (Barnes calls them "closing costs") to the insurer's net single premium (Barnes calls it "wholesale principal"). The sum (Barnes calls it "retail principal") tells you how much you're lending to the insurer. If you're lending a lot more than the death benefit is worth (as defined by Barnes), that's bad. Quality means "principal balanced with collateral." Comparing two policies becomes easy: just compare the retail principals and then take account of other significant factors, such as the insurer's financial strength.
This approach leads to two novel conclusions:
- Dividends don't matter. Low distribution costs, high investment returns, excellent mortality experience, and administrative efficiency count for nothing. If the insurer has a high guaranteed premium (Barnes calls it a "Fat" insurer), the policy is of poor quality.
- High early cash values don't matter. A high-commission policy with a low guaranteed premium is better than a low-load policy with a high guaranteed premium.
Advisors who evaluate policies this way will want to make sure that their errors and omissions coverage stays in force.
Leaving aside Barnes's curious methodology, the book contains some basic errors.
Barnes says that life expectancy is defined as the point at which half of the original population is still alive. Not true. Life expectancy is a mean, not a median.
He implies that insurers use life expectancy for product pricing. Not true; in fact, they would eventually become insolvent if they did. (To see why, look up Jensen's Inequality in a statistics textbook.)
He says that the 1980 Commissioners Standard Ordinary (CSO) table reflects realistic mortality rates. Not true. The 1980 CSO table provides a conservative basis for determining reserves; actual mortality rates used in product pricing are typically about half of the 1980 CSO rates.
These mistakes affect most of the numerical examples in the book.
Barnes is on more solid ground when he complains about the insurance industry's lack of disclosure. Every fee-only advisor knows how infuriating it can be to deal with insurance companies and their agents. You frequently have to make special requests for basic information needed for prudent decisions.
Barnes attributes this to the industry's conspiratorial marketing strategy, but there's no need to invoke conspiracies. Life insurance is sold, not bought. Most people don't demand much information before making a purchase, so why should companies supply it? If everyone suddenly stopped sending in their premium checks, we'd have full disclosure in a few weeks. Even today, if you have a $25 million premium to invest, you can have as much disclosure as you want, within reason. It's just a question of bargaining power.
The Mortality Mortgage may appeal to people who are easily impressed by claims of revealed secrets. There are a lot of people like that, so the book could become popular. It will not appeal to knowledgeable advisors and it will not cause actuarial textbooks to be revised.
Published in the May 1996 issue of NAPFA Advisor
© Copyright 1996, NAPFA
Reprinted by permission
A Counter View
It would serve the members of NAPFA and readers of the Advisor to have another view of The Mortality Mortgage by A.R. Barnes, Jr. The conclusions drawn by Mr. Daily are by no means valid for most planners nor indicative of the opinions of many licensed insurance consultants such as myself.
His opinion on full disclosure being assured "if everyone suddenly stopped sending in their premium checks" is ridiculous. Is this how Mr. Daily suggests consumers and advisors go about obtaining policy information? Is this the only way to get this information?
How can anyone really suggest to a trustee or owner of a life insurance policy they should risk losing the coverage as a means of obtaining disclosure from a carrier?
[Webmaster's note: This is a ridiculous interpretation of what I was saying. Can you imagine any financial adviser actually telling clients to stop paying premiums and risk having their coverage lapse just to prod the life insurance industry into changing its ways? Isn't it much more reasonable to assume that I was doing a simple "thought experiment" to show that the real problem is a lack of demand for information rather than a conspiracy to withhold it? Having said that, I apologize for creating even a tiny opening for ridiculous interpretations.] Indeed, this suggests to me Mr. Daily is aware of the industry tradition and practice of non-disclosure. Should a $25 million premium be the premise for disclosure?
Why isn't every policyowner entitled to full disclosure even if the premium is $50,000, $27,500 or $275?
Mr. Daily states actuarial training is necessary to evaluate life insurance. What does this say about the agents selling the policies? Do they have this training or background? How can the carriers let people without this training represent themselves to the public as knowledgeable about insurance products? What does this say about the Illustration Questionnaire (IQ)? Does this not require an understanding of insurance pricing and assume agents have this capability and credibility?
The evaluation method of walking backwards from illustrations to internal load structures to the underlying assumptions about past, present, and future pricing is similar to walking around the world to get across the street.
The internal rate of return (IRR) method of evaluating life insurance from illustrations can be compared to evaluating the yield of a one-year CD projected over 20, 30, or 40 years — hardly an accurate procedure and dependent entirely upon the assumptions made in annual renewal rates and tax brackets.
Mr. Barnes has published the first understandable book on life insurance pricing using verifiable financial principles and formulas familiar to planners. His focus on pricing factors uses a new and different approach to evaluate life insurance — start at the beginning rather than at the end. The Mortality Mortgage presents the most direct route to full disclosure; walking across the street method vs. walking around the world methods. I highly recommend planners use this book as a blueprint for accurate policy cost disclosure.
David Bohannon, MBA, ChFC, CFP, LIC
President, Consultants Corner, Inc.