Combination products: Are they worth a look?

October 19, 2008 (original: January 24, 2007)

"In theory, all insurable risks should be covered by a single contract, with a single deductible on the aggregate loss. It is a puzzle that such umbrella policies are not offered in practice."

Christian Gollier, "To Insure or Not to Insure?: An Insurance Puzzle,"
Geneva Papers on Risk and Insurance Theory, June 2003

(Notes and references are at the end.)

A combination product is an insurance policy that provides two or more different types of insurance in one package.

Combination products have been around for a long time. You may already have one. Does your life insurance policy contain a waiver-of-premium for disability rider, an accelerated death benefit for terminal illness, or guaranteed life annuity rates? Does your auto insurance policy have a medical payments provision? These are not usually thought of as combination products, but they do fit the definition.

On the property/casualty side of the insurance industry, combination products often include homeowners, auto and liability insurance. On the life/health side, combination products often use life insurance, deferred annuities, immediate annuities or disability income insurance as the base policy, and then they add long-term care or critical illness insurance. The Pension Protection Act of 2006 is creating more interest in combination products, because it provides favorable income tax treatment for long-term care benefits that are provided by life insurance and annuity contracts. Many combination products will continue to exist only in imagination, because they would violate current laws that govern insurance. However, creative product designers have many opportunities to invent new products even with today's constraints. (Note 1)

The theory of combination products

Combination products can provide greater consumer value than standalone policies in several ways:

Combination products can be more efficient.

Economists have used the analytical tools of their discipline to explore the optimal design of insurance policies. Raviv (1979) showed that when individuals face multiple risks, they should buy a single policy that has a deductible and coinsurance in relation to the sum of the losses. Large corporations can create this type of coverage by setting up a captive insurer and buying stop-loss reinsurance, but this solution isn't practical for individuals. Gollier and Schlesinger (1995) analyzed the decrease in efficiency that occurs when consumers are forced to buy separate policies with separate deductibles. (Note 2)

Zweifel and Eisen (1996) analyzed combination products from the perspective of portfolio theory. They posited that the individual's lifetime goal is to manage three assets — health, wealth and wisdom — and they explained how to identify combinations of life, health, disability, accident and general liability insurance that could reduce the variability of those assets.

Sharpe (2006) argued that combination products, such as variable annuities combined with long-term care insurance, could be more efficient than standalone products at providing benefits that match individual preferences. Sharpe (2007) laid out an analytical framework — state-dependent utility maximization — that can be applied to combination products.

Churchill (2007) noted that the efficiency of combination products could lead to suitable designs for developing countries, where people have a need for insurance but little money to pay premiums.

Combination products can have pricing advantages over multiple standalone policies.

Here's the abstract of a patent application for a product that combines homeowner's insurance and pet health insurance:

Method and apparatus for bundling insurance coverages in order to gain a pricing advantage
A method for reducing the lapse rate of a first insurance policy comprises the step of offering to sell a rider to said first insurance policy, said rider comprising benefit features, said benefit features configured such that the combination of said rider and said first insurance policy has a higher switching cost than the switching cost of said first insurance policy alone and said rider is constructively attached to said first insurance policy, whereby said step of offering to sell is at least in part performed by technological means. The first insurance policy may be a homeowner's policy. The rider may be a pet health insurance rider.

The idea here is that the insurer makes more money if more people renew their policies, so it can reduce the cost of coverage as a reward.

Pricing advantages can also occur in distribution, underwriting and administrative costs, and in claims experience (due to reduced adverse selection). If the combination product contains offsetting risks, the insurer's hedging costs and capital charges can be lower. However, combination products can also have pricing disadvantages, such as higher corporate income taxes or more conservative pricing assumptions to reflect uncertainty. They may also require the purchase of new administrative systems.

Several researchers have argued that combinations of annuities and long-term care insurance can enhance financial security in retirement at a lower cost than standalone policies. Getzen and Hall (1987) designed a "long life insurance plan" that would provide a per-diem payment for nursing home stays, coupled with a delayed life annuity. Using Canadian mortality and morbidity data, Christopherson (1990, 1992) designed a "disability-escalating retirement annuity" that would increase the base monthly income by 20% to 70% if the annuitant could not perform specified activities of daily living (such as bathing, dressing and eating). Healthy annuitants would receive a slightly lower payment than they would with a traditional (non-escalating) life annuity.

Murtaugh, Spillman and Warshawsky (2001) designed a life annuity that would provide a 200% to 300% higher payment triggered by the inability to perform activities of daily living. Using adjusted U.S. mortality data, they estimated that the combination policy would cost 3% to 5% less than comparable standalone policies, on a single-premium basis. The price of the combination policy would also be relatively insensitive to actual long-term care benefit payments, because of the greater importance of the life annuity payments.

Combination products can offer features that are not available in standalone policies.

For example, the combination of a deferred annuity and a long-term care rider can be the functional equivalent of a standalone long-term care insurance policy with a long waiting period. Using a probability-of-ruin measure, Goss (1990) argued that consumers would benefit from having a wide range of policy designs to choose from, including longer waiting periods than were generally available. Combination products can easily offer high-deductible insurance by combining an asset accumulation base policy (life insurance or annuity) with other insurance.

Combination products can make insurance more affordable for a wider group of consumers.

When coverage for negatively-correlated risks is provided in a single policy, insurers can relax the exclusionary underwriting standards and conservative pricing assumptions that are necessary in standalone policies to prevent higher-risk individuals from getting underpriced insurance. Murtaugh, Spillman and Warshawsky (2001) estimated that an annuity/long-term care combination could be made available to 98% of 65-year-olds, versus only 77% for traditional long-term care insurance policies.

Combination products can increase competition in the marketplace.

Insurers that do not offer standalone policies may be willing to offer combination products, which can be designed to reduce the insurer's risk of loss. This gives the insurer the opportunity to gain experience with an unfamiliar market.

Combination products can provide greater flexibility by letting you change the purpose of the policy.

The relationship between flexibility and value has been explored in other contexts using real options analysis, a powerful application of option-pricing theory. (Note 3) Kulatilaka (1993) analyzed the value of being able to run an industrial steam boiler with oil or natural gas. Imai and Nakajima (2000) analyzed the value of being able to adjust the operating processes of an oil refinery to produce different products. Nordvik (2000) analyzed the value of being able to use a building as rental or owner-occupied housing. Bengtsson and Olhager (2002) analyzed the value of being able to change the product mix of a manufacturing plant. Greden and Glicksman (2005) analyzed the value of being able to renovate office space. Nembhard, Nembhard and Qin (2005) analyzed the value of being able to cross-train workers to do multiple tasks. Sodal, Koekebakker and Aadland (2008) analyzed the value of being able to use a cargo ship to transport either liquids or solids.

In the realm of personal finance, Milevsky and Promislow (2004) analyzed the value of being able to switch between a defined benefit and a defined contribution pension plan. Biffis and Millossovich (2006) analyzed the value of being able to convert a deferred annuity into a life annuity at guaranteed rates. Ruffino and Treussard (2007) analyzed the value of being able to switch careers.

What is the value of being able to use a life insurance policy as an inheritance for one's heirs or as a long-term care financing source for oneself? That depends on the pricing of the combination policy in relation to standalone policies and non-insurance alternatives, but it is reasonable to believe that the flexibility to transform a policy from one type of insurance to another is valuable.

Value enhancement may be especially high when the combination product provides health-related benefits (long-term care, critical illness, medical expense). Nyman (2003, 2006) argues that traditional analyses understate the value of health insurance, which gives ill policyholders the ability to buy more health care than they could otherwise afford.

Combination products can be more valuable than standalone policies in the secondary market.

For example, a rider that accelerates the payment of a life insurance death benefit should increase the life settlement price of the life insurance policy in the secondary market. However, it may be hard for buyers to estimate the value of the rider, so you might not receive full value.

How to evaluate combination products

Many life insurance and annuity products do not provide good consumer value, and there's no reason to think that combination products will be different. Good ideas do not have to lead to good products.

Combination products create opportunities for insurers to use the insights of behavioral economics to influence consumer decisions. Rabin and Thaler (2001) and Mitchel and Holzworth (2005) explained how the insurance marketplace can be a laboratory for the exploitation of myopic loss aversion, regret aversion, anchoring, framing, mental accounting and subjective probability. Sales pitches that use fluffy phrases like peace of mind, use it or lose it, and double-duty dollars may be effective marketing, but they tell you nothing about the merits of the products.

The key to evaluating combination products is to look at features, flexibility and cost. Here are some interrelated questions to ask:

What are the basic features?

Tumicki (2006) provides a useful starting point with this product classification:

Either-or
There is one pool of benefits for all risks. Benefits paid for one risk reduce what is available for other risks.
Enhanced either-or
Benefits paid for one risk partially reduce what is available for other risks, but the total pool expands.
Additive
There is a separate pool of benefits for each risk.
Transformational
The risks covered by the policy change over time.

Would you buy the base policy if you didn't want the rider?

Which component of the combination product is driving your purchase - the base policy or the rider? Are you buying a high-quality base policy and then adding a rider to enhance its value, or are you buying a base policy of questionable value to gain access to the benefits provided by the rider? The answer to this question will help you think about the value of each piece of the product as well as the total package.

Does the combination product increase or decrease your flexibility?

A high-quality life insurance policy that lets you draw down the death benefit to pay long-term care expenses increases your flexibility. However, a combination policy can decrease your flexibility if you can't drop one piece without dropping the other. This type of design is like a combination TV with DVD/VCR; if one component goes bad, you may have to replace the whole thing.

What are the differences in the features between the combination product and standalone policies?

Are there differences in underwriting? Benefit triggers? Price guarantees? Risk of obsolescence? Tax treatment? Complexity?

What is the cost?

If you can add a flexibility-enhancing feature to a desired policy at a low cost, you should consider doing it. It's easy to underestimate the value of flexibility, so you should assume that a low-cost feature is worth the cost unless you have good evidence to the contrary.

Can you figure out if the combination product is a good deal?

It's hard enough to figure out if a standalone policy is a good deal. Do you have any chance of spotting a good deal in a combination policy? Here are several approaches to consider:

Peer group comparison
You may be able to do a comparison of the product's features with those of a similar product. However, there are so many possible designs for combination products that illuminative side-by-side comparisons will be difficult.
Deconstruction

You can try to compare the combination policy with standalone policies. Can you create your own combination with similar or better features at a lower price?

Try to think like an arbitrageur. Can you find a way to buy one package at a lower price, sell a similar package at a higher price, and make a fortune? (Here's an incentive: If you can make a fortune through arbitrage, you won't need to buy the insurance.)

Wherry (1999), Gluck (2000) and Lankford (2001) provide examples of deconstruction. A simple case: Suppose the combination product is a life insurance policy that provides a loan against the death benefit if you enter a nursing home or have a serious illness. How much would it cost to obtain a similar loan facility from a third party, enabling you to buy any life insurance policy?

Money's worth

"Tell us the odds," Andrew Tobias implored in The Invisible Bankers, his entertaining 1982 critique of the insurance industry (lamentably still relevant a quarter century after its publication). An updated request would be "tell us the money's worth." Money's worth is also called the expected loss ratio, or the expected present value of the benefits as a percentage of the expected present value of the premiums. This concept is familiar to actuaries and economists (although they do not always agree on the calculation), and it is important in making informed decisions about insurance. (Note 4)

Consider this: It is hard to find an economic analysis of the optimal demand for insurance that does not use money's worth as a required input — and it is equally hard to find sales materials that disclose money's worth to prospective insurance buyers. Are economists inept at thinking about insurance, or are insurance buyers missing some information that they need to make smart decisions?

Suppose you learn that the expected loss ratio of a standalone long-term care insurance policy is 60%, and the expected loss ratio of a long-term care rider attached to a high-quality life insurance policy is 85%. That would be a clue that the long-term care rider is worth considering, because it may be a more efficient way to insure against the risk of long-term care expenses.

What are the chances that you will miss out on something really good if you wait to buy?

Real options analysis offers another lesson for insurance buyers: don't be so easy to get. Many combination products lock you in with high surrender charges. If you can satisfy your insurance needs with a simple product, such as convertible term insurance, you can keep your options open to buy complicated products later. There's always a risk that you will be worse off by waiting, but there is also the possibility of being better off.

Think about your own life experiences: when you have put off doing something that cannot easily be undone, has it usually worked out well or badly for you? Let that be your guide.

Glenn S. Daily is a fee-only insurance consultant who specializes in life insurance and annuities.

Notes

  1. For more information about past, present and future combination product designs, see Andrew Rickard, "Insurers introduce term and critical illness combos for mortgage market," The Insurance Journal, June/July 2008; Ron Panko, "To the Rescue," Best's Review, June 2008; Cary Lakenbach, "The Value Of Combining Coverages? Lifetime Protection," National Underwriter (Life & Health), October 22, 2007; Ron Panko, "Amazing Race," Best's Review, August 2007; Daisy Maxey, "The New Way to Retire," Barron's, July 16, 2007; Craig R. Springfield, Bryan W. Keene and Frederic J. Gelfond, "New Rules and Opportunities for Long-Term Care Insurance Combination Products," Taxing Times, May 2007; Robert Grubka, "What The New Annuity-LTC Combo Products Might Look Like," National Underwriter (Life & Health), March 5, 2007; Fran Matso Lysiak, "Combo Deal," Best's Review, March 2007; Cary Lakenbach, "New Life For Life/LTC Combos," National Underwriter (Life & Health), February 19, 2007; Fran Matso Lysiak, "Pension Reforms May Spur Annuity/Long-Term Care Combos," BestWeek, February 5, 2007; Cary Lakenbach, "PPA Should Boost Combination Products," National Underwriter (Life & Health), November 13, 2006; Hazel Delane, Keith Dall and Carl Friedrich, "Exciting New Opportunities In Hybrid LTC Policies," National Underwriter (Life & Health), November 13, 2006; Cary Lakenbach, "The Impact of the Pension Protection Act on the Sale of Combination Products," NAVA Outlook, November 2006; Mark Doherty, "Pension Reform Spurring Interest In Annuity/LTC Hybrids," National Underwriter (Life & Health), October 16, 2006; Carl Friedrich, "The New Combination Products Mean Seniors Get Choice," National Underwriter (Life & Health), January 9, 2006; Ron Panko, "Two for One," Best's Review, July 2005; Cheryl A. Brown, "Life and Long-Term Care Insurance Combination Products," LIMRA International, Inc., July 2005; Donald Jay Korn, "Care Packages," Financial Planning, October 2004; Carl Friedrich, "Long-Term Care Insurance - Combination Products," Research Report, Milliman USA, April 2004; "Combination Disability Products: The Urge to Merge," Record of the Society of Actuaries, Volume 28, No. 2 (June 2002); Cary Lakenbach, "CI/LTC Packages Could Spur Sales Of Both Lines of Insurance," National Underwriter (Life & Health), March 25, 2002; Linda Koco, "Transformational Products: On The Edge Of The Cutting Edge," National Underwriter (Life & Health), December 10, 2001; "Combining Long-Term-Care (LTC) Benefits With Other Products," Record of the Society of Actuaries, Volume 27, No. 3 (October 2001); "Long-Term-Care Combination Products," Record of the Society of Actuaries, Volume 26, No. 1 (May 2000); Prakash Shimpi, "Multi-Line and Multi-Trigger Products," in Prakash A. Shimpi (Editor), Integrating Corporate Risk Management, Swiss Re, 1999; John P. Mello, Jr., "Paradise, or Pipe Dream?", CFO, February 1997; Gary L. Corliss, Jean C. Gora, George D. Light, Jr., Steven E. Lippai, Lucian J. Lombardi and Robert Lombardi, Living Benefits Life Insurance Products: Practices and Challenges, Life Office Management Association, Inc., 1993; and Patricia Ancipink, "Homeowners/Auto Combination Policies - Camels or Workhorses?", Best's Review (Property/Casualty Edition), October 1978.

  2. With some complex arrangements, there may be tax-driven reasons to insure different risks separately. See Russ Alan Prince, Edward A. Renn, Arthur A. Bavelas & Mindy F. Rosenthal, Fortune's Fortress: A Primer on Wealth Preservation for Hedge Fund Professionals, MARHedge, 2007 (pp. 60-62).

  3. For more information about real options analysis, see Tom Copeland and Vladimir Antikarov, Real Options, Revised Edition: A Practitioner's Guide, Texere, 2003; and Glenn S. Daily and Laurence J. Kotlikoff, "Decision Making Under Conditions of Uncertainty: A (Second) Wakeup Call for the Financial Planning Profession," 2006 (www.glenndaily.com/documents/wakeupcall.pdf)

  4. For examples of the use of money's worth in insurance economics, see Ralph A. Winter, "On the Choice of an Index for Disclosure in the Life Insurance Market: An Axiomatic Approach," Journal of Risk and Insurance, March 1982; Olivia S. Mitchell, James M. Poterba, Mark J. Warshawsky and Jeffrey R. Brown, "New Evidence on the Money's Worth of Individual Annuities,"  American Economic Review, December 1999; Joseph G. Eisenhauer, "Relative Effects of Premium Loading and Tax Deductions on the Demand for Insurance," Journal of Insurance Issues, Spring 2002; Christian Gollier, "To Insure or Not to Insure?: An Insurance Puzzle," Geneva Papers on Risk and Insurance Theory, June 2003; Michael Braun and Alexander Muermann, "The Impact of Regret on the Demand for Insurance," Journal of Risk and Insurance, December 2004; Peng Chen, Roger G. Ibbotson, Moshe A. Milevsky and Kevin X. Zhu, "Human Capital, Asset Allocation, and Life Insurance," Financial Analysts Journal, January/February 2006; and Craig McCann and Dengpan Luo, "An Overview of Equity-Indexed Annuities," Securities Litigation & Consulting Group, February 2006.

References

  • Bengtsson, Jens and Jan Olhager, "Valuation of product-mix flexibility using real options," International Journal of Production Economics, July 2002.
  • Biffis, Enrico and Pietro Millossovich, "The Fair Value of Guaranteed Annuity Options," Scandinavian Actuarial Journal, 2006/1.
  • Christopherson, David L., "Toward the development of disability-escalating retirement annuities," unpublished Ph.D. dissertation, University of Minnesota, 1990.
  • Christopherson, David L., "New IDEAs for Insuring Long-Term Care," Journal of the American Society of CLU & ChFC, March 1992.
  • Churchill, Craig, "Insuring the Low-Income Market: Challenges and Solutions for Commercial Insurers," Geneva Papers on Risk and Insurance - Issues and Practice, July 2007.
  • Getzen, Thomas E. and Charles P. Hall, "Achieving Financial Security Throughout Retirement: The Long Life Insurance Plan," Benefits Quarterly, Fourth Quarter 1987.
  • Gluck, Andrew, "Two for the Show," Dow Jones Investment Advisor, January 2000.
  • Gollier, Christian and Harris Schlesinger, "Second-Best Insurance Contract Design in an Incomplete Market," Scandinavian Journal of Economics, 97(1), 1995.
  • Goss, Stephen C., "Who Should Buy Long-Term Care Insurance? What Type of Policy Makes Sense?", Contingencies, July/August 1990.
  • Greden, Lara and Leon Glicksman, "A real options model for valuing flexible space," Journal of Corporate Real Estate, January 2005.
  • Imai, Junichi and Mutsumi Nakajima, "A Real Option Analysis of an Oil Refinery Project," Financial Practice and Education, Fall/Winter 2000.
  • Kulatilaka, Nalin, "The value of flexibility: The case of a dual-fuel industrial steam boiler," Financial Management, Autumn 1993.
  • Lankford, Kimberly, "The Trouble With Twofers," Bloomberg Wealth Manager, July/August 2001.
  • Milevsky, Moshe A. and S. David Promislow, "Florida's Pension Election: From DB to DC and Back," Journal of Risk and Insurance, September 2004.
  • Mitchel, James O. and R. James Holzworth, Behavioral Economics: Literature Review and Implications for Financial Services, LIMRA International, Inc., 2005.
  • Mungan, Ken, "Exponential Value Creation," LIMRA's MarketFacts Quarterly, Summer 2005.
  • Murtaugh, Christopher M., Brenda C. Spillman and Mark J. Warshawsky, "In Sickness and in Health: An Annuity Approach to Financing Long-term Care and Retirement Income," Journal of Risk and Insurance, June 2001.
  • Nembhard, David A., Harriet Black Nembhard and Ruwen Qin, "A Real Options Model for Workforce Cross-training," The Engineering Economist, 2005 (50:2).
  • Nordvik, Viggo, "Tenure flexibility and the supply of private rental housing," Regional Science and Urban Economics, January 2000.
  • Nyman, John A., The Theory of the Demand for Health Insurance, Stanford University Press, 2003.
  • Nyman, John A., "Evaluating Health Insurance: A Review of the Theoretical Foundations," Geneva Papers on Risk and Insurance - Issues and Practice, October 2006.
  • Rabin, Matthew and Richard H. Thaler, "Risk Aversion," Journal of Economic Perspectives, Winter 2001.
  • Raviv, Artur, "The Design of an Optimal Insurance Policy," American Economic Review, March 1979.
  • Ruffino, Doriana and Jonathan Treussard, “Human Capital Risk Management: The Optimal Exercise of Career Options,” working paper, Boston University, September 26, 2007.
  • Sharpe, William F., "Financing Retirement: Saving, Investing, Spending and Insuring," 2006 (www.stanford.edu/~wfsharpe/wp/finret.pdf).
  • Sharpe, William F., Investors and Markets, Princeton University Press, 2007.
  • Sodal, Sigbjorn, Steen Koekebakker and Roar Aadland, "Market switching in shipping — A real option model applied to the valuation of combination carriers," Review of Financial Economics, August 2008.
  • Tumicki, Elaine F., "Killing Two Birds With One Stone," LIMRA's MarketFacts Quarterly, Fall 2006.
  • Wherry, Rob, "Rocker-to-Grave Insurance," Forbes, November 29, 1999.
  • Zweifel, Peter and Roland Eisen, "Optimal Combination of Insurance Products," International Insurance Society, Inc. Seminar Proceedings, 1996.