Barnes Standard: A Numerical Example
This example was adapted from "Life Insurance Due Diligence: Finally, There Is a Way!" by Charles D. Haines, Jr., a fee-only financial planner in Birmingham, Alabama. The article was published in the July-August 1998 issue of CCH Retirement Planning.
Let's start with the basic principles of the Barnes Standard™:
- Life insurance is not a product. Life insurance is finance.
- In finance, there are two parties: the borrower and the lender.
- In life insurance financing, the buyer is the lender and the insurance company is the borrower.
- A life insurance policy is analogous to a home mortgage. You can think of it as a "mortality mortgage."
- To understand a home mortgage, you need to know the principal (how much you are borrowing), the closing costs (how much it costs to get the loan), the payments, the interest rate, and the term (how long you have to pay).
- To understand a life insurance policy, you need to know the present value of the death benefit, the acquisition costs (commissions and other expenses, determined by subtracting the present value of the death benefit from the present value of the gross premiums), the gross premiums, the interest rate (the rate used to determine guaranteed cash values), and life expectancy (the expected payment period, using guaranteed mortality rates).
Here's a Barnes Standard™ comparison of two $1,000,000 whole life policies issued to a 35-year-old man who doesn't smoke. Policy A has a lower guaranteed premium and pays lower dividends. Both companies have high financial strength ratings, so that factor can be ignored here.
| Policy A | Policy B | |
|---|---|---|
| Death benefit | $1,000,000 | $2,000,000 |
| Premium | $12,020 | $25,853 |
| Guaranteed interest rate | 5.5% | 4.5% |
| Life expectancy | 36.3 years | 35.1 years |
| Gross principal | $187,500 | $440,480 |
| Net principal | $583,230 | $796,210 |
| Acquisition costs | $815,270 | $855,270 |
| Guaranteed net benefits per dollar (death benefit divided by net principal) | $861.98 | $865.69 |
| Present value of dividends As % of gross principal |
$927,650 38.6% |
$1029,200 40.3% |
|
Notes: "Gross principal" is the present value of the guaranteed premiums, based on guaranteed interest and mortality rates. "Net principal" is the present value of the death benefit, based on guaranteed interest and mortality rates. This is also called "net single premium." |
||
A life insurance adviser who uses Barnes's method of analysis would conclude that Policy A is a better buy than Policy B, because:
- Policy A has a lower guaranteed premium.
- Company A is willing to guarantee a higher interest rate and lower insurance charges. Stated in Barnes's mortgage terms, it is paying the lender (the policy buyer) a higher interest rate, and it permits the lender to make the loans over a longer period of time on average.
- Company A is not using an inflated amount of net principal in its calculations.
- Company A's acquisition costs are lower than Company B's.
In contrast, a life insurance adviser who uses accepted methods of analysis would say that it is impossible to determine from this information which policy is the better buy, because:
- You have to take account of dividends in addition to guaranteed premiums.
- You have to evaluate the reasonableness of the assumptions that underlie the projected dividends.
- You have to investigate the past performance of the company's policies.
- You have to take account of the policy's cash values, especially the cash values in the early years.
- You have to consider that the buyer might actually prefer inferior guarantees, because that allows more money to be paid into the policy for investment purposes or to produce a rising death benefit. This is a direct result of the cash value accumulation test, guideline premium/cash value corridor test, and modified endowment contract test of Internal Revenue Code Sections 7702 and 7702A.
- The "acquisition costs" shown in the table do not tell you anything about the actual costs that the company incurs in marketing, issuing, and administering the policy. A company that is very efficient in these areas could easily appear to have high "acquisition costs," as defined by Barnes, if it has a high guaranteed premium and high dividends.