#215 | The Fable of the Frog

What’s the best way to boil a frog? According to the fable, a frog tossed into scalding water will immediately leap out of the pan. But a frog placed into comfortably warm water that is gradually heated will eventually be boiled alive, unaware of the dramatic absolute change in temperature because each marginal change is so small. It’s a tale about time, really, about the fact that change is most felt when it occurs rapidly rather than slowly. But beyond that, it’s also a cautionary tale. No one wants to be the frog in the gently warming pan. Increasingly, though, I’m starting to have a creeping feeling that agents and distributors in our industry are the frog in the pan, seemingly unaware and accepting of gradual changes that are actually remaking the face of our industry.

Just ten years ago, the top-selling Universal Life product by a landslide was Guaranteed UL. The core story of GUL is that it is simple, cheap and entirely guaranteed. Now, the top-selling Universal Life product by a landslide is Indexed UL, which has the core story of providing non-guaranteed exposure to an external equity index that produces fantastical, but entirely and completely hypothetical, illustrated performance. It seems entirely implausible that the agents and companies who were hooked on selling Guaranteed UL a decade ago are now schilling Indexed UL, but that’s exactly what has happened. We have swung from one pole to the other and the change has been almost unnoticeable from year-to-year. The conferences still have the same people, the firms still have the same names, the “clients are still being served” – now just with entirely different solutions.

Along with the shift from Guaranteed UL to Indexed UL, our industry has also made a gradual shift from death benefit sales to accumulation sales. A decade ago, the big-ticket cases were usually the result of life insurance being used as the cornerstone of a highly complex estate or business plan for a wealthy individual. These days, the big-ticket cases are (generally) premium financed Indexed UL transactions where life insurance is being positioned as a way to get “arbitrage” that illustrates enormous streams of tax-free income. This shift is a real response to the fact that the estate tax exemption for a couple is now $20M, but it’s also an artificially created response to the changes in products that have created the ability for producers to illustrate perpetual arbitrage in a fixed life insurance product. Take away the arbitrage and you cut the legs out of Indexed UL. Isn’t it strange that we’ve come to that?

These are the big and obvious changes in our industry. A frog sitting in those pans will have the luxury of looking at the thermometer to see just how hot the water is getting, even if he continues to convince himself that he’s not being cooked alive even as the temperature rises. The more interesting story are the pans without the thermometers, the gradual changes that we can’t measure. Take, for example, changes to non-guaranteed elements in products. A decade ago, any company that changed COIs would expect to be black-balled by its distributors for violating the unspoken pact that current charges shall not be altered. And yet John Hancock and Lincoln have both changed COIs seemingly without consequence, save for the lawsuits. Agents now seem to expect that companies are going to go back and tinker with the COI charges of in-force products and that this tinkering is going to become even more prevalent in a low-rate environment. Something has changed in our psyche. We trust non-guaranteed products less – and yet, curiously, we sell a lot more of them.

The same goes for other non-guaranteed elements. When Lincoln dropped crediting rates on all of its products to the guaranteed minimums in 2011, you’d think that there would be an uproar but no one said anything. Similarly, you’d also think that there would be calls for Lincoln to increase crediting rates when earned rates actually started to go up in 2015, but no one asked for that either. So other companies have started to do basically the same thing but without the same boldness as Lincoln and have suffered the same consequences, which is to say that they’ve suffered no consequences. Carriers have realized that they can get away with almost anything once a policy has been in-force for a few years and if the changes are made gradually.

No place has this been more evident, though, than in term insurance. A decade ago, term insurance was broadly convertible to any permanent product on a given life insurer’s shelf. There was a pact that life insurers would honor the flexibility of conversion options even if the contract didn’t specifically require it. At MetLife, we called it our “current business practice” that, of course, we had no intent of changing. Until we changed it – and we were far from the only ones doing it. These days, conversion-specific products are common and companies are rolling out non-convertible term insurance in a bid to win the term price wars. I’ve argued for a long time that conversion is actually the most valuable feature of a term insurance product, even beyond the death benefit. How is it, then, that carriers have systematically eroded the value of term insurance products without significant blowback?

The same goes for life insurers themselves. Before the ill-fated demutualization craze, life insurers were generally fairly simple enterprises with bunkers full of capital to weather storms in the asset markets. Companies that blew themselves up did so by investing in risky assets and being undercapitalized. As a result, the NAIC created the Risk Based Capital framework to ensure that companies held appropriate capital for the investment risks they were taking. The idea was to make life insurers stronger and more resilient. Instead, life insurers pushed the risk to the other side of the house, where the rules were (and still are) much less clear. They wrote huge volumes of incredibly risky life insurance and annuity products predicated on assumptions about long-term interest rates and equity markets. They created dense webs of reinsurance transactions with captive insurers to fabricate capital and feed the excess to investors. They arbitraged RBC formulas for esoteric asset classes that were not contemplated by the NAIC. The list goes on.

Most life insurers are dramatically more fragile today than they have ever been, with the exception obviously being insurers that do business “the old way.” The consequence for all of this financial leverage floating around is that these businesses get bought, sold, spun off or shut down. You know the names of the companies on that list. There are a lot of them. There will be a lot more of them, some equally as shocking as when MetLife jettisoned Brighthouse Financial. Where is the uproar? Where are the producers demanding that companies not play irresponsible games with their balance sheets? When will distributors decide to not do business with a company that is clearly playing fast and loose?

The interesting bit about the fable of the frog in the pan is that actual experiments have shown that the frog doesn’t stay in the pan. At some point, the water gets hot enough that the frog jumps out, no matter how gradual the change. So here’s the question – at what point are agents going to hop out of the pan and what would that even look like? Would it look like agents saying, for example, that they’re not going to sell any product, not even a guaranteed one, from companies that have raised COI charges? Only selling term insurance products with guaranteed conversion features? Representing only the companies that don’t employ financial leverage or sell their life insurance through easily-separated, thinly capitalized subsidiaries? Demanding accountability for actual in-force performance and not just illustrated performance?

The irony is that if any of that happened, independent agents would suddenly start to look a lot more like their “captive” brethren – you know, the ones who actually do focus on selling products sold by companies that don’t raise COI charges, have guaranteed term conversion features, sport bullet-proof balance sheets and are actually held accountable for real-world performance by their agents. That would be a strange time indeed.