#261 | The Compensation Conundrum
Now that the dust is settling on the changes to Section 7702, two big questions are starting to emerge. The first is in regards the degree to which life insurers are going to take advantage of the new latitude in pricing guaranteed rates across their product lines. The second is how life insurers in the Universal Life space are going to adjust compensation to take the new 7702 maximum non-MEC limits into account. As I wrote in The Section 7702 Christmas Miracle, Universal Life has long used Target-based compensation that is linked to the as-issued death benefit. With the new 7702 limits, the historical relationship between a certain premium contribution, a certain minimum non-MEC death benefit and a certain Target compensation has been broken. What to do next requires a bit of philosophizing that the life insurance industry isn’t exactly prone to do. We need to answer a fundamental question – what’s fair compensation for selling a Universal Life policy?
Historically, the general theory has been that compensation should maintain a constant relationship with the required premium contribution for the policy. This works perfectly for Whole Life because it’s a fixed premium product. From the vantage point of the life insurer, the premium is known at issue and so, theoretically, are the anticipated cash flows from selling the product. It makes sense, therefore, that a life insurer would be willing to pay commission as a constant percentage of the required premium and anticipated cash flows. Fair compensation, in this context, is akin to gathering assets in an AUM structure. The more assets you direct towards the product, the more you get paid – regardless of whether you’re selling huge policies to young and healthy people or small policies to old and sick people. A $50,000 premium is a $50,000 premium.
Where things get murky, however, is when people start to pay non-required premiums. Think, for example, about a client overfunding a Whole Life product using a Paid-Up Additions rider or blending the death benefit with Term. In both of those cases, the premium isn’t required in the same way that it would be if policy were all base coverage. And, therefore, the life insurer doesn’t pay nearly as much for the flows. If a base Whole Life premium is 90% commissionable in the first year, then Term and PUA contributions are probably somewhere in the neighborhood of 3-5%. It seems as though an insurance agent can significantly cut their compensation simply by moving premium out of the required category (90%) and into the flexible category (3-5%).
This leads us to Universal Life, where the premium is entirely flexible. What’s fair compensation for Universal Life? We can’t, in this case, create a relationship between the required premium and the commission because there is no required premium. Instead, life insurers calculated a shadow required premium, maybe something like the premium to endow at maturity based on current rates, and used that premium to serve as the baseline for commissions. What do we call that number? The Target Premium, the key to Universal Life commissions.
In broad strokes, Target Premiums (TPs) today have maintained something of a semblance to the concept of a required premium. Targets for younger clients are lower than for older clients. Targets for accumulation products, which theoretically have higher required premiums, are higher than for death benefit-oriented products, although the relationship is completely out of whack because of competitive pressures on Targets over time.
But there’s a key difference between how compensation works in Universal Life versus Whole Life – commission recapture. For Whole Life, the company can reliably pay itself back for commission outlays from the required premium flows in the product. But for Universal Life, recapturing commission is trickier because premiums are flexible. The best course of action – and the one that the vast majority of life insurers use – is to implement an extra fixed policy charge over the first 7 to 15 years of the policy. That charge, coupled with surrender charges, ensures that the life insurer is repaid for commission outlays regardless* of the future premium flows. From a carrier’s standpoint, therefore, the commission-related cash flows for a product might look something like this:
|Target Premium||Total Payout (140%)||Year 1 Charge||Year 2 Charge||Year 3 Charge||Year 4 Charge||Year 5 Charge||Year 6 Charge||Year 7 Charge||Year 8 Charge||Year 9 Charge||Year 10 Charge|
The fact that Universal Life products clearly recapture commission through policy charges raises a pretty interesting question – what’s the actual commission in the product? From the standpoint of an insurance agent, the commission is (usually) somewhere between 90% and 100% of the Target premium, depending on the commission split that the agent has negotiated with the BGA. From the standpoint of the life insurer, the commission is the amount paid to the agent, to the distributor, to the aggregator, to the wholesaler and to sales overhead. For a life insurer, the total commission as a percentage of Target is probably in the range of 140% to 170%, depending on the company and the product.
But from a client’s standpoint, the commission is equal to the policy charges paid out to recapture the upfront commission. From a client’s standpoint, the commission on this product isn’t $20,945 (Target) or even $29,323 (140% of Target) – it’s $44,700, the total amount of policy charges directly related to commission payouts. Think about it this way: the salespeople want up-front commissions and the client wants to pay levelized charges. The insurance company converts the levelized policy charges into up-front commissions for a fee.
How big is the fee? Well, the IRR on the pure cash flows in the example above – which is the pricing from a real product – rings in at 8.5%. That’s the discount rate that the life insurer is using to calibrate the charges required to recapture the commission. If that strikes you as very high, then you’re right. Market loan rates are in the neighborhood of 3-4%. If the client could borrow the money to pay the commission out of pocket, the total cost to repay the loan over 10 years would be lower than by using the embedded pricing in the product to recapture the commission. But from a carrier’s standpoint, this is an even swap. Most life insurers have pricing targets for IRR in the range of 8-10%. If the carrier were to offer better amortization terms at a lower rate, then the commission recapture element of the product would be a drag on overall profitability.
I used one policy for this example where the ratio of charges related to commission is about 1.52 (representing a 52% markup for policy charges in excess of the actual first year commission paid) and the imputed discount rate was 8.5%. How can you figure that out? Simple. This policy from Pacific Life can be blended, which allows us to compare the charge structure across different compensation levels. Take a look.
|PacLife PIA 6||Total Payout||Total Charges||Payout/Charge Ratio|
There are 4 other IUL products in the marketplace that allow for blending and have a direct correlation between base policy charges and compensation. Below is a table that compares their payout/charge ratio at age 45, 55 and 65.
|Product||Age 45||Age 55||Age 65|
|PacLife PIA 6||1.52||1.47||1.39|
|PacLife PDX 2||1.62||1.63||1.63|
|Accordia Lifetime Builder Elite 2020||1.89||1.56||1.27|
|John Hancock Accumulation IUL 20||1.69||1.54||1.55|
|Symetra Accumulator IUL 3.0||1.62||1.50||1.73|
|Securian Eclipse Accumulator IUL||1.25||1.23||1.19|
If you wanted to generalize, it’s fair to say that the client pays a 50% markup to the life insurer for the service of converting levelized charges into heaped commissions. This is a real, structural problem for commissions in Universal Life. Life insurers have stepped up to provide heaped commissions for their agents at an exorbitant price to consumers. If consumers knew that they were financing agent commissions at an 8.5% discount rate that resulted in a 50% premium, they’d be furious. Isn’t there a better way?
If life insurers simply paid the cash flows related to commission recapture to their distributors, they’d increase total compensation by 50-70% right out of the gate without any adverse effects to policy performance. If a life insurance producer still wanted heaped commissions, third parties (or the life insurer itself) could step up to finance the commissions to provide a heaped payout at a more favorable discount rate than 8.5%. The current compensation model is clearly sub-optimal for all parties. It puts the life insurer in the role of transforming levelized charges into heaped commissions in a flexible premium product, which is an inherent inefficiency.
But beyond that, Target premiums are blunt-force tool for calibrating compensation. If life insurers want to pay for premium flows into a flexible premium product, then they should pay based on premium flows, not the fabricated concept of a Target premium. For example, a life insurer could skip the whole Target premium concept and simply pay a flat percentage fee for any premium paid into the product and then cover the fee with an extra premium load. This would create a 1-to-1 match for compensation payout to policy charges, eliminating the role of the life insurer as paymaster and ultimately creating either a much more efficient product or a much higher payout to the life insurance agent – or both.
The changes to Section 7702 have exposed the flaws in the Target-based compensation model. One response that life insurers will inevitably take is to play around with their Target premiums until they feel like they’ve made the best of a bad situation. A much better response would be to actually fix the problem – ditch Targets to create a better, more efficient compensation structure. And there’s never been a better time to do it.
For those of you looking for a practical application to this post, consider this – the ratios above are a guide to the “effectiveness” of blending the product. If you want to blend, or you’re in a situation where you need to blend, then you’ll get more cost-reduction bang for your commission-reduction buck by going with (at age 45) Accordia at 1.89 than Securian at 1.25.