#267 | The Rise of the Reverse Blend
Now that the dust is starting to settle on 7702-2%, one thing is becoming abundantly clear – compensation is a real challenge, both for agents and life insurers. As I’ve written about in previous articles, the simple math for compensation on Universal Life dictates that a policy with a minimum face amount under 7702-2% will have less compensation per dollar of premium than a policy with a minimum face amount under the old 7702-4%. If the face amount drops, then so does Target and, therefore, so does compensation. Agents selling accumulation-oriented products are looking at compensation reductions in the neighborhood of 25-50%, depending on the age of the client. Left as is, the changes to 7702 could significantly change the business models of accumulation-oriented producers and distributors, particularly in the Indexed UL space.
My initial reaction to the 7702-2% changes was that life insurers would probably figure out a way to make the agent and distributor whole by increasing Targets, but that’s easier said than done. I pointed out in previous posts that increasing Targets would cause some bizarre compensation differences between different funding scenarios and product designs. Turns out, I missed another piece of the puzzle – surrender charges. Both Targets and Surrender Charges are linked to the death benefit. The DB reduction under 7702-2% means that, all else being equal, both Targets and Surrender Charges also decrease.
Increasing Targets to compensate would require a commensurate increase in Surrender Charges as well. However, maximum Surrender Charges are capped based on a formula that is based on the Standard Non-Forfeiture Rate, which isn’t dropping to 2% like the 7702 Rate did. That restricts the ability for the life insurer to dramatically increase the Target because there would be a pricing disconnect between the Surrender Charges and the Target. Many companies rely on “surrender margin” to provide a piece of product profitability. Reducing or even eliminating that margin would require them to bake it into other charges, which would decrease illustrated performance. That’s not the bargain that life insurers want.
Hence, there’s a growing consensus among carriers that the best solution, at least in the short term, is just to implement the new 7702-2% limits without significantly changing compensation. Beyond just pricing challenges, carriers are rightly concerned with the optics of increasing compensation and shifting much of the benefit of the new 7702-2% rates away from consumers and towards agents and distributors. That wouldn’t be a great public relations story. In the long run, the compensation structure for life insurance will likely change but the long run is a very long run indeed. Our industry has relied on heaped compensation for many decades. It ain’t going to change overnight.
But because of that, agents and distributors are now staring down the prospect of declines in revenue of 25-50%, depending on their business mix. Something has to be done. Even if some companies attempt a middle-ground solution, compensation is still going to drop for agents and distributors. What can be done to mitigate the damage? Enter the concept that is already being called “reverse blending.”
The idea is very simple. Compensation in UL is based on face amount. The new 7702-2% limits allow for much lower face amounts – and therefore compensation – than the old 7702-4% limits. But there is no requirement that the agent run the lowest death benefit per dollar of premium in order to maximize accumulation efficiency. The agent can pick whatever death benefit they want to sell and the Target premium comes along for the ride. Increasing the death benefit will obviously reduce accumulation performance, but the impact isn’t as big as you might initially think. Take a look at the relationship between death benefit, compensation and illustrated income, which is increasingly becoming the metric used for benchmarking in the accumulation space. For this example, I’m using a 45 year old Preferred Male with Symetra’s product illustrated at the maximum rate with all participating loans from years 21-40 and using the same maximum annual premium for 7 years:
|Initial Face||Target||Target % Increase||Distributions||Distribution % Decrease|
If you wanted to generalize, you could basically say that for every 10% increase in compensation, there’s a 1% decrease in illustrated distributions. That’s a pretty enticing relationship, but it has limits. The jump from a $2M to a $3M face pushes the ratio down to 5-to-1. But for agents who are simply trying to get back to where they were prior to the Section 7702 changes, it doesn’t take much of a face increase to do it and the impact on policy performance isn’t huge. It wouldn’t be hard for an agent to justify the face increase on the grounds that the product of choice is still “more competitive” than the next best product even if the death benefit isn’t at the absolute minimum.
None of this should be a surprise. As I wrote in the previous article on Symetra, a 40% reduction in comp yielded just a couple of percentage points increase in illustrated income. Reversing the change, therefore, shouldn’t impact performance significantly either. I have no doubt that this will strike some folks as counterintuitive. How is it that a 90% increase in compensation only results in a 10% decrease in illustrated income? Because compensation isn’t the most important piece of the puzzle for illustrated performance. I pushed this illustration to the limit – maximum AG 49-A illustrated rate and all participating loans. Those two factors, which are purely creatures of the illustration and not the real world, have a much bigger impact on performance than compensation. Hence, the incentive for the reverse blend. If you can increase your compensation by 10% for just a 1% reduction in illustrated income for a product that is already rich enough to make clients drool, then why not do it?
At this point, I would anticipate that folks reading this might have two responses. The first is that agents won’t actually do anything like this because they’re either fine, upstanding people who put their clients’ interests ahead of their own or, less nobly, they don’t want to get caught red handed in a competitive situation. To be sure, a lot of agents won’t utilize this “reverse blending” strategy. But some will. We know that they will because we saw something similar happen when PacLife PDX was originally released on the market. The product was heads-and-shoulders more competitive than other products and agents decided to take some of that illustrated benefit for themselves by reducing the blend of the product and, therefore, dramatically increasing their own compensation and the policy charges. I heard that this was happening on a wide scale and I’ve seen so many unblended PDX policies at this point that I think the stories are true. Agents took an advantage that was meant for their clients and diverted it into their own pocket. It happened once, it will happen again.
The second response is that the concept of a “reverse blend” is a travesty and is exactly the sort of behavior that warrants the application of a fiduciary or best interest standard for life insurance. It seems like a natural argument – doesn’t the agent have an obligation to sell the “most efficient” policy to the client? I want to say yes. I want to agree. But the more I think about it, the more difficult it seems to answer.
Imagine that every life insurer just increased the Target premiums to “make the agent whole” even at the lower death benefits. The policy performance under that scenario would be just a hair worse than under the reverse blend concept. The only difference would be the COI charges during the initial period of time before the face amount would be reduced in either case to the GPT corridor (in the examples above). Reverse blending essentially takes the decision about fair compensation out of the carrier’s hands and puts it into the hands of the agent. And if I was running product development, that’s exactly what I’d want to have happen if for no other reason than to avoid the optics of increasing compensation after the change to 7702. No one wants that news to go to Capitol Hill.
If the decision is left in the hands of the agent, then the question is what is “in the best interest of the client.” This, again, is trickier than it seems. What is the obligation of the agent to sell a product with the minimum death benefit in order to maximize accumulation? I’m not sure. The problem is that from a tax and legal standpoint, overfunding a life insurance policy isn’t even a reason to buy the contract. The reason why life insurance has cash value is to support the death benefit. That’s why we have the 7702 limits and tax incidence deferral to begin with. Using life insurance for accumulation and distribution was never intended to be the primary purpose for any life insurance product.
One might even argue that the agent is obligated to sell the client the appropriate amount of life insurance coverage and the client should fund the policy as needed. Chances are good that a client buying life insurance for accumulation purposes could probably justify having more life insurance rather than less. So isn’t it actually in the client’s best interest, from the pure standpoint of using life insurance for its intended use, to sell a higher death benefit?
There are other reasons a higher death benefit might be a fit as well. You could argue that the client might want more funding flexibility in the future. You might say that it’s a hedge against the client deciding that, actually, death benefit is the primary focus of the sale and it hedges future insurability. There are all sorts of reasons you could put forth without even the slightest hint of a compensation differential.
And to make things even more complicated, there are already numerous products in the market that allow for blending that reduces compensation and policy charges. The fact that this strategy is called a “reverse blend” is a nod to traditional blending. Are agents required to blend coverage to reduce compensation? No, they’re not. Are agents who don’t blend raked over the coals by state regulators, class action lawyers or their BD’s compliance department? No, they’re not. Our industry has never taken the position that agents are required to reduce compensation for the benefit of their clients. Why would reverse blending be held to a different standard?
From my view, it would be extremely difficult and nigh impossible for there to be any sort of regulatory, compliance or even carrier-driven prohibition on reverse blending. The fact is that life insurance is not an investment. It is not meant to be a vehicle for accumulation and distribution. It is insurance. Fighting against the “reverse blend” requires a belief that the accumulation benefits of life insurance outweigh the benefits of death benefit coverage. That’s an untenable position for life insurers to take as a matter of policy, especially considering that a fairly large percentage of sales in the accumulation market (higher than 50% at some carriers) already use death benefits that are higher than the absolute minimums.
I’m not in favor of the reverse blend. I think it’s bad form and exactly the kind of behavior that gives our industry a black eye. But it would be highly hypocritical for life insurers, distributors and agents to turn up their noses at it considering the practices regarding compensation that are already prevalent in our industry. The reality is that the reverse blend may actually represent the most elegant solution to the problem of compensation posed by the changes to 7702 by pushing the decision about compensation to the person closest to the sale and the one who bears the greatest reputational risk for being greedy – the agent.