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Life Insurance Products and Consumer Information - ,. liCe Insuunce Products And Consumer Information MIchael P. Lynch and Robert J. Mackay Staff Report Bure:! u of Economics Feder:!! Trade Commission Washington, D. Novemb 1985 . Michael P. Lynch is a staff economist at the FTC. He is the author of all but one chaptcf. Chapter VIII was written by Robert Mackay, currently Visiting ofcsor of EconomiC3, School of Business, University of California at Berkeley and Visiting Scholar, Hoover Institution, and st:lff economist (part. time) at the FTC. The analyses and conclU3ions and conclusions set forth arc those of the authors and do not nccesrily reflect the views of other members of the Bureau of Economics other Commission Staff, or the Commission itself. EXECUTIVE SUMMARY The purposes of this study arc to describe the advantages and disadvantages of various type of life insurance policies and to assess the adequacy of information about them to consumers. The focus i on a comparison of two broad c!:lSSCS of life insurance products. The study s principal rese:lrcher was Dr. Michael Lynch. Dr. Robert Mackay contributed to the whole effort and produced Chapter VIII which compares life insurance policies to other financial instruments. One class of policies provides only life insurance protection. This class which we summarize undcr the tcrm annual rcnewable tcrm insurance (ART), typically involvcs a fixed face value death benefit paid for with annual premiums that rise over time, reflecting the positive relationship between mortali ty and age. These policies involve no savings component , in that benefits arc paid only in the event of death and the policies have no surrender value or end-of-term cash value. The second class of policies that we consider is a long-term contract of fixed duration that involvcs a fixed face value death benefit plus a surrender value and an end-of-term cash valuc equal 10 thc face valuc of the policy. This type of insurance typically is paid for with an annual premium that is constant over the period of the policy. This send class of policics necesarily combine insurance savings. and so we term these policies 'pay-in-advance' policies. Within the class of pay- in-advance policics there are three gcneral types that are considered in this report par and non-par Whole Life' and Universl Life. To attempt to compare different types of life insurance with cach other and with other financial instruments the Study begins by describing a simplified modcl of reality in which there is no uncertainty about interest rates. In such a simplified setting it is possiblc to describc a 'bare-bones (no special options) pay-In-advance policy as a simple combination of insurance and savings and to compare such a policy to an alternative financial strategy that we wil call ' Buy Term and Invest the Difference' (BTID). The BTID str:llegy involves buying term insurance and milking a periodic contribution to a savings plan such thl1t the cl1sh outll1Y is the sl1me under the two 111tcrnatives I1nd such that the policy s beneficil1ry receives the sl1me de:lth estate under either alternative. The implied ratc of return, or Linton yield, is that rl1te of interest that produces 11 BTID sl1vings accumull1tion at the end of the period equl1l to the savings accumulation available through the pl1y-in-advance policy. Assuming that there is no uncertl1inty about future intcrcst rates and that the pay-in-advance poliey has no specil1l options or fel1tures, it is possible to compare directly the performl1nce of a particular pay- in-advl1nce policy to the I1lternative BTID str:ltegy. Then , if interest rate uncert:linty I1nd any special fel1turcs and options in pay-in-advance policies can be argued not to have a significant effect on the costs of these policies, it is possible to compl1re the performance of pay- in-advance policies to. a BTID strategy that uses common fiRl1ncial instruments such as savings or money ml1rket accounts or bonds. Le., to compare the performl1nce of the pay-in-advance policy to viable market alternatives. Application of this method also, under the sl1me assumptions, yields some indirect implications about the adequl1cy of consumer information I1bout pl1y- in- advance policies For example, if pay-in-advance and BTID policies Cl1n be meaningfully complled, then if the rate of return on pay-in-l1dvl1nce policies is significantly below that of cquivalent BTID policies, a deficiency of consumer information may be the cause. ' Similarly, . if pay- in-advl1nce policies differ significantly Cram one another in their implied rates of return and if this cannot be explained by differences in options or special features of the policies again there are indirect implications that consumer informl1tion I1bout pay- in-advance policies may be inl1dequl1te. Recall, again, that the comparisons just qescribed depend on the vl1lidity of the assumptions permitting a mel1ningful comparison of pay- in-advance and BTID policies. In rel1lity, the future eourse of interest rl1tes is not known with certainty and most pay- In-advance policies hl1ve options or special features that are not easily obtained through other financil1l instruments. For eXl1mple, the typical pay- in-advance policy guarantees a minimum implicit rate of return over the life of the policy even though the sl1vings component of these policics is accomplished through annul11 increment. For eX:lmple, in non- par policies where the implicit rate of return, say X%, is fixed, the equivalent finl1ncil1l instrument would guarantee 11 rl1te of return of x% on savings made el1ch year for several yells. Ordinary bank sl1vings and money market accounts do not offer such options over a relatively long time. This suggests that a more appropriate benehmark for valul1ting the performance of Whole Life savings would be a partieular type of flexible annuity. Pay- in- advl1nce policies hl1ve other unique features. For eXl1mple , a typic:ll non- par poliey provides guaranteed cash surrender values in el1ch of the yel1rs during the tcrm of the policy. In addition, most pl1y- in-advl1 ce policies allow borrowing on the savings component of the policy at a rIte below the implicit rate of return on the policy. If interest rate uncertainty and options and special features of pl1y- in- advance policies are important determinants of the costs I1nd consumer v:lluation of these polieies, then a meaningful comparison between pay-in-advance policies load the BTID alternative cannot be made with any confidence unless the cffects '\' of thcse detcrminants on the costs and values of thesc policies cl1n be separately measured. An attempt to conduct such measurements was beyond the scope of the present study, Dr. Lynch believes thl1t thc. assumptions necessary to allow a mel1ningful comparison of pay- in-advance policies with an alternl1tive BTID strategy are approximately vl1lid, and so he argues thl1t the mel1surement of implicit ratcs of return of pay- in-advanee policies in this study cl1n bc me:lningfully comparcd to rates of return on other financial instruments. Dr. Lynch finds thl1 t the implicit rates of return on Whole Life pOlieies are" well below ' markct ' ratcs of interest for the early years of these policies. (In fact, in the first years, implicit rates of return are neg:ltive, reflecting the penl1lty for carly cancelll1tion.) In addition, appro"imately one-qul1rter of Whole Lifc policics arc canceled in the first few years of the policy, so thl1t consumers who cancel early earn a very poor return on their premiums. From this Dr. Lynch concludcs that some consumers may not be well informed about costs of cl1rly cancellation at the time they purchase a policy. The study also finds that the implicit rates of return on Whole Lifc policies held to term arc also below 'market' rates However, when correcting for differential tax tre:ltment of pay- in-advance policies relative to the BTID strategy, after-tl1x rates of return on pay- in-advance policies may be comparable. to after-tax yields on other financil1l instruments The study also compares implicit rates of return across diffcrcnt companies' policies and finds considerable variation. Dr. Lynch concludcs that consumers may be inadequately informcd about the relative mcrits of different companies' policies. Finally, the study computes implicit ratcs of return on Universal Life policics. These rates of return are much closer to market' fatcs of interest 111 though there is stil considerable variation across companies Dr. Lynch concludcs that Universal Life policies may be- an improvement over Whole Life policies but that information to provide a basis for comparison for consumers may not be adequate. The second contrihutor to this study, Dr. Mackay, foeuses on the potential differenees between pl1y- in-advance policies and alternl1tive financial Slra tegies such as BTID. Dr. Mackl1Y shows that pay- In-advance policies are long-term contracts with many unique features, and argues that these fel1tures may involve significl1nt costs for insurl1nce companies and may be of significant value to eonsumers His conclusion is that without an adequate mel1sure of the eosts and valucs of these .unique fell tu res of pl1y- in-advance policies, a meaningful compl1rison of pay- in-advl1nce policies with other finl1ncial instruments is not possible. Measurement of the value of these un ique features was beyond the scope of this study, The study consists of ten chapters The first chapter provides an introduction and overview of the study. Chapter I reports recent trends in the 'ordinary' life insurance industry (which supplies pl1y- in-advl1nce policies) and the 'group' life insurance indU3try (which supplies term insurance), focusing on the period since the 1979 FTC Staff Report. Industry aggregates sugacst that thc share of total savings accounted for by life insurance in forcc fell over the period 1978-83.
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