#49 | Free Insurance Fiction

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Richard Poundstone’s book “Priceless” recounts a study where Hershey’s Kisses were offered to students on one day for the price of 1 cent and the other day for free. Despite the fact that the prices were essentially equivalent, students took far more free candy than 1 cent candy. The observers assumed that the reason was that most students aren’t walking around with pennies in their pockets, so they placed a dish of free pennies next to the Kisses. Again, students took the free candy at a much higher rate than the 1 cent candy. Poundstone points out that getting something for free is practically irresistible – far moreso than getting something for absurdly cheap. He argues that we choose free things even if we don’t want or need them simply because they’re free. Instead of focusing on what we’re getting, we simply focus on the fact that it’s free.

Some of the more enterprising people in our business have figured out a way to create the story of free life insurance by premium financing Indexed UL. Despite numerous claims about “proprietary” strategies, all of them operate off of an assumption of arbitrage between the loan interest rate and the policy crediting rate. The old adage is that there’s no such thing as a free lunch but, of course, we’ve all had our share of “free” lunches at someone else’s expense. This isn’t a life insurance strategy where the carrier, distributor, financier or agent provides the free lunch. The life insurance still costs something, but its costs are swallowed by the gap between the bank’s charged interest rate and the earnings of the policy. The insurance is free only to the extent that the arbitrage works. The great thing about a real free lunch is that it’s over when you’re done eating. But free life insurance is like chowing down on chicken riddled with e-coli. It sure looks good on the table, it might even taste fine, but finishing the meal is really just the beginning. In fact, you’ll soon be begging to pay someone to eradicate the effects of the “free” lunch – which is exactly what has happened with premium financing Indexed UL.

This type of life insurance transaction is therefore toxic for at least two reasons. First, the proposition of anything for free totally distorts the conversation towards the idea that the insurance is free rather than the fundamental need for the product and all of the benefits it can deliver. Second, the insurance isn’t free in the same way that the researcher’s Hershey’s Kisses were. Premium financed IUL is free under a certain set of assumptions. If those are assumptions are anything other than absolutely certain, then the “free” transaction is really just one of many, many possible outcomes. The rest of the outcomes constitute risk. Free, then, isn’t really free at all. It’s just risky.

A financed IUL promoter can make all sorts of snazzy spreadsheets, write articles, give presentations and sell policies without any recourse to the truth about his assumptions. Why? Because premium financed IUL policies haven’t been around long enough to be a success. Indexed UL has only been hot since mid-2005 and financed IUL really only took off when American General sold its soul to Elite Global IUL in 2007. Given that these financing strategies are supposed to last for something like 20-50 years, we’re barely past the starting line. These IUL promoters are asking people to bet millions of dollars in exposure based on pure conjecture. Only one thing is certain – the agent is getting paid, the financing promoter is getting paid, the bank is covered and the insurer is getting its policy charges. The only one holding the bag is the policyholder. And there’s simply no historical evidence about what’s in that bag. All we know is that every incentive for the agent and promoter is to inflate the benefits of the deal because they get paid immediately and have no skin in the game.

But don’t get me wrong. 6 years has been enough time to already see evidence of some spectacular collapses. AG’s block of financed business blew up when the lender backed out, PacLife changed its premium financing guidelines as a result of poor financial results and abuses, E&O providers have started inserting clauses about not covering financed IUL because of claims experience. I’ve personally seen more than a few disasters with these arrangements.

At this point, most financing promoters backpedal and tell me that they are really all about risk disclosure, that the insurance isn’t really free and that they do some major stress testing to prove their claims. Not a smidge of their marketing materials would lead you to those conclusions, but that’s the story. Don’t believe it. These guys fundamentally believe that they are financial alchemists who can turn lead into gold through a “proprietary” strategy that only they are brilliant enough to conceive. The acid test for their concoction is really simple – run the proposal under the no-arbitrage condition that underlies damn near everything in economics and finance. What you’ll almost always find is that free insurance suddenly turns into heinously expensive and poorly designed insurance. Imagine that.

I’ll admit, there’s a chance that this stuff might work out. It’s impossible to know how small the chance is because we don’t have any empirical evidence outside of the shoddy and flawed hypothetical historical backtesting that free insurance financiers employ. My guess is that the chance is really small – as in, about the same probability as me successfully crossing the Atlantic in a pool raft. But what I think isn’t relevant. What matters is that I’m not asking people to make a bet with millions and millions of dollars on what I think about something that is impossible to predict. Free insurance promoters are being paid handsomely in the first year to do exactly that and with absolutely no financial skin in the game if it fails. If the pilot won’t get in the plane, then you probably shouldn’t either.

Fortunately, the solution is really, really simple. Plenty of life insurers simply don’t allow financing with accrued loan interest, which is the key part of the free insurance strategy. Pacific Life’s recent clamp down on financing is a bold and right move that others should follow. The buck stops at the life insurers. The ringleader in the free insurance scheme is Allianz. Virtually every free insurance deal I see uses an Allianz product and they’re publicly aligned with some of the most aggressive promoters. It’s our responsibility to regulate our industry to keep us out of the spotlight. Considering the major expenditures and high profile people involved in the free insurance financing scheme, every one of these deals represents the possibility of a public scandal. If this is unacceptable to you, feel free to send a note to Allianz, ING, PennMutual and Minnesota Life to let them know.

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