#147 | The Inconvenient Truth About Term Profitability
The pricing for term insurance is notoriously tight. Looking at quotes for a recent client of mine, the gap between the cheapest product and the 5th cheapest was just 2%. First to 20th required just a 9% change in premium. In other words, there is a significant market consensus around the price of term insurance for this particular client – and why wouldn’t there be? Compensation for all of these products is basically the same. Mortality estimates for a client like this, young and in good health, should be pretty uniform. All of the companies are likely using similar earned rate projections over the next 10 years. They all have similar capital structures and reserve requirements. At the end of the day, the competitive angle in Term appears to be which company will take lowest profits.
But that doesn’t really line up with how the market for term insurance actually appears to operate. If it was just about profit margin, then you’d see the term market more or less bouncing around with the pricing inputs. But, instead, prices just keep falling. Companies that had the cheapest products across the board 5 years ago are now middle of the pack with the same pricing. Profitability isn’t big enough to explain that. And if profitability really was the competitive angle, the companies that would have competitive term insurance would be the ones who have relatively low return hurdles – in other words, mutual companies. But their pricing is the same as their stock peers, if not significantly higher in the case of the Big 4 Mutuals.
The dirty little secret about term insurance is that profitability is not the issue because virtually all competitively priced term insurance products are unprofitable. On a Term 10 product, the life insurer basically washes out on mortality and expenses over the 10 year guaranteed level premium period but has a loss at the end that is roughly equal to the initial first year compensation. In other words, the Term 10 market is extremely efficient. Clients are paying for the true costs of their coverage and the insurer is paying for the commission out of its own pocket.
And yet, life insurers will tell you that term insurance is profitable. This is not the paradox that it seems. Recall that term insurance doesn’t actually end when the level premium period expires. Instead, the client has the ability to continue to pay ever-increasing premiums to maintain the coverage, what we call post-level term premiums. These premiums are extremely high which also makes them extremely, unbelievably profitable for the life insurer. It’s not unusual for a life insurer to recoup all of their losses from the level premium period and turn a profit big enough to meet their return hurdle even if just a small percentage of policyholders actually pay post-level premiums. They completely dominate the profitability equation. In theory, one might even argue that term insurance could be free if the life insurer was willing to make sufficiently aggressive assumptions about persistency into post-level term premiums. That’s how impactful post-level term profits are.
Pricing term insurance this way has obvious downsides. First, it’s not a great shareholder story. Relying on post-level term profits is speculative. Some companies have an internal edict not to even look at post-level term profits in their pricing and, consequently, their term insurance products are not competitive. Second, it creates a system where the smart policyholders convert or lapse and the ill-informed policyholders subsidize profitability for the entire block by paying the egregiously high post-level term premiums. But, on the flip side, policyholders who buy cheap term insurance are undeniably getting a very efficiently priced product during the guaranteed level period. And who’s on the hook if post-level term profits don’t pan out? That’s right – the insurer. Sounds like a pretty good deal for consumers to me, even if it’s risky and speculative for the insurer. This is one of the many examples in our industry where the insurer is willing to take a meaningful amount of risk in order to win in a commodity war while still convincing themselves that they are making money even though they probably aren’t. Most clients would be well-advised to take advantage of cheap term insurance, especially from a strong carrier with tight term conversion language. It probably won’t last forever.