#349 | A Reckoning in Term

2/10/23 Update

On Lincoln’s Q4 2022 earnings call yesterday, analysts peppered CEO Ellen Cooper and CFO Randy Freitag about Lincoln’s position on Term, given that reserving for it has “negatively impacted free cash flow,” as one analyst put it. The message that came through loud and clear is that Lincoln wants to sell less term because it is a “pretty significant amount of capital and surplus strain for that portion of the Term Life business that doesn’t really have the margins associated with it,” as Cooper put it. Freitag followed up by saying that “the reality of a 30-year Term product sold on one of the big aggregator platforms is that the breakeven year is very, very far out there.” This, in my view, is an acknowledgement of the reality of Term economics as generally outlined in this article and an acknowledgement that the intent of Lincoln’s recent price increases is to slow sales. Both Cooper and Freitag still expressed a desire to sell Term, but “not at the same level we were in 2022” and only where it makes sense.

This article got a lot of attention, certainly more than I expected. Two criticisms came up that I want to address. First, Term pricing is as much art as science. The view expressed here is not indicative of any particular insurer’s view of profitability. It’s meant to be a general view of how an average insurer might look at it. That said, I also was a little bit suspicious about how insensitive the IRR was to price changes, so we’re digging deeper to make sure we got that right. We know PLT profits are important but we want to make sure the scale is correct.

Second, I’m not making a prediction of a reckoning in the Term market. As a matter of course, I try not to make predictions. I make logical if/then arguments about what might happen in the future. This article is a perfect case study. The last sentence of this article reads “If [PLT profit assumptions] become no longer rational, viable or justifiable, then Term prices are going to go up.” That is not a prediction. I didn’t say that it was definitely going to happen. It’s just a logical statement. Whether it actually happens or not is a different question.

Quick Take

By every account, Term is not a rational market. The companies at the bottom of the market are often separated by just pennies while others are 50% more expensive. The reason is because the things that people tend to think are the primary drivers of term pricing – mortality, expenses and even interest on capital and reserves – are all secondary to assumptions about lapse behavior once the level term period ends. Profits from the post-level term period are what can swing Term profitability from single to double digits. Given the importance, you’d think there would be a consensus at post-level term period profits. But there isn’t. Instead, there is only uncertainty and tradeoffs. And if PLT period profits become no longer justifiable, then there could be a reckoning in Term.

Full Article

Back when Brookfield acquired American National, there was a general expectation that Brookfield would do what most PE firms have done when they’ve acquired a life insurer – “optimize” the capital structure, rework the investments strategy and otherwise leave the new business franchise alone as long as it’s successful and profitable. Private equity buyers are not insurance experts. They know how to manage the asset and equity side of the balance sheet but the liability side, the product side, they tend to leave alone.

That appears to be exactly what Brookfield is doing. Brookfield acquired the company on May 25 of 2022 and shortly afterwards it executed two new reinsurance trades. The first is a $9.5B asset cede of fixed and indexed annuity reserves to to Bermuda-based captive reinsurer Freestone Re Ltd. The second is a tiny transaction to send $40M of reserves to Hannover related to term and Guaranteed UL. By the 3^rd quarter, Brookfield had scraped nearly $700 million in shareholder dividends out of the company and continued to push more flow through the new reinsurance deals. To put that into context, American National had previously paid $88 million in stockholder dividends like clockwork from 2016 until 2021, when it paid $155 million in stockholder dividends. Brookfield seems to be beginning the tried-and-true process that PE firms take to hollow out the capital structure of their newly acquired life insurers.

None of this is surprising. It’s exactly what we expect PE firms to do when they buy life insurance companies. What was not expected, however, was the announcement that came out in the latter part of last year that American National would be exiting the Term insurance market. American National wasn’t a huge Term player, to be sure, but why would any life insurer want to get out of Term? It’s life insurance’s equivalent of the peanut butter sandwich, cheap, effective, easy to assemble and loved by almost all except those who are severely allergic to it.

Although Term represents just 12% of total industry new business premium, it accounts for 42% of policies and a whopping 72% of face amount. Even those numbers, as impressive as they are, understate the significance of Term. If you remove final expense Whole Life from the equation, which is arguably a totally different market, Term accounts for 63% of policies sold. To put it in another perspective, Term outsells Indexed UL 6-to-1 in terms of policies – and that includes all of the small-face IUL policies sold by Transamerica, National Life, Nationwide and F&G. Because of its broad appeal, a properly functioning Term market is essential to the overall health of the industry. The fact that American National decided to exit Term after Brookfield’s acquisition is surprising and troubling. What did Brookfield see that caused them to pull the plug?

One of the oft-repeated, never-proven statistics in our industry is that only [insert percentage between 1% and 4%] of Term insurance policies actually pay a claim. The insinuation is that Term is a profitable product for life insurance companies and a sucker’s bet for the insured. The reality is actually the other way around – Term is usually sucker’s bet for the life insurer and a screaming deal for the consumer. How is that possible? Because when it comes to Term, nothing is quite what it seems.

The Term market seems not to follow any rational logic. I ran a benchmark of 23 Term insurers in two cells – a 35 year old Standard Female for $500k and a 45 year old Preferred male for $1M – in 2021. I re-ran those cells in 2023 and the results were pretty interesting. Take a look at the rate actions for both cells in 10 Year Term. Gray lines are companies that stayed stable, blue lines are companies that decreased rates and red lines are companies that increased rates.

Female, 35, Standard, $500k

Male, 45, Preferred, $1 million

In general, most life insurers maintained pricing. A few, particularly those at the bottom of the market, engaged in obvious one-upsmanship and pricing warfare. The lines at the bottom actually hide the fact that there are 5 or so companies that price so closely to each other at all times that their lines overlap visually. Between 2021 and 2023,  Lincoln dramatically raised prices and essentially pulled itself out of the market, going from one of the lowest cost products to middle-of-the-pack. Prudential had been far out of the market in terms of pricing and dramatically lowered rates to move back into consideration. None of this makes any sense on the basis of mortality or macroeconomics. The Term market appears to be a sport unto itself.

The reason why, as I’ve written before, is that Term pricing fundamentally isn’t rational. Term profitability is primarily driven by assumptions about profits from the product after the guaranteed level period is over. But now it’s time to show the numbers, courtesy of an actuary on my team at Life Innovators and our own instance of Prophet, an institutional-grade life insurance pricing software used by the vast majority of insurers.

For this analysis, we looked at 45 year old Preferred male for $1 million of death benefit. We used a standard set of assumptions about reserves, capital and expenses that we believe are reasonably indicative, although obviously not accurate for any particular life insurer. We looked at 23 life insurers ranging from the most competitive products in market to the most expensive for 10 and 20 year durations. We tested the results using different assumptions about the return on reserves and capital (which has been increasing now that rates have come up), different mortality assumptions and, most importantly, different assumptions about what policyholders do when faced with post-level premiums set at 100% of the 2017 CSO, a reasonable baseline rate.

First, a baseline that assumes a 0% investment return, baseline mortality (100% Preferred VBT) and a 100% lapse rate at the end of the level guarantee period. Under these assumptions, the cheapest 10 year Term in market delivered a 4.5% IRR. The most expensive, which is 60% more expensive than the cheapest, delivered a 6.7% IRR. For 20 year Term, the range was 5.5% to 6.4% even though the price of the most expensive 20 year Term policy was 45% higher than the cheapest.

This is a shocking result. What this shows is that, essentially, Term profitability is not dramatically affected by price. How is that possible? Because Term is such a notoriously reserve and capital-intensive product. As a result, profitability is primarily driven by reserve flows. For both 10 and 20 year Term, we show the product edging into profitability only at the end of the guaranteed level period when all of the reserves and capital are released. In simple terms, think of it this way – the life insurer has to post $X in reserves and capital that will be released at the end of the guaranteed level period. The IRR is contingent on the degree to which premiums plus interest on reserves and capital exceed expenses and mortality. What this analysis shows is that mortality, expenses and commissions are factors on the margin, but not the biggest factors for profitability.

A bigger line item is earned rate on capital and reserves. If we crank the earned rate on capital and reserves to 4.5%, then the IRRs for a 10 Year Term product jump to 6.5% for the cheapest product and to 8.74% for the most expensive product. Now we’re talking. If we push the earned rate assumption to 6%, which is probably realistic for what life insurers were seeing in Q3 of last year, then the IRRs go to 7.15% and 9.5% respectively. Note that the IRR doesn’t increase in lockstep with the earned rate. Why? Because as the IRRs increase, the net effect of the mortality margin diminishes because it’s a fixed amount. At least, that’s how the logic looks to me.

But even bigger than assumptions about mortality and earned rate is the effect of profits from the post-level term period. Going back to the baseline where cheapest 10 Year Term has a 4.5% IRR, dropping the assumed lapse rate after the post-level term (PLT) period from 100% to 80% causes a jump in the IRR to 11%. This one simple assumption change pushes Term from being unfeasible to profitable. From what I’ve seen, assumptions about PLT period behavior is the most important factor in pricing Term. Everything else is just window dressing. Here’s how the different scenarios for each Term product price in the dataset. Each dot represents the IRR for a Term product at that pricepoint. As you can see, the impact of PLT profits is massive.

For something so important, something so pivotal to the health of the Term market, you’d think that life insurers have PLT experience down to a science. But that’s not the case. PLT experience is very much the subject of ongoing research and debate. There are believers and non-believers as if PLT experience is some sort of fringe religion practiced only by actuaries. In order to bring some clarity to the situation, the Society of Actuaries has begun to publish survey results in an attempt to create more robust data and insight into industry experience. Reinsurers have also stepped in to fill the data gap. But the more they publish, the murkier the story becomes and the less certain PLT experience appears. It’s complicated. Really complicated.

Increasingly, life insurance pricing is borrowing a concept from annuities referred to as dynamic lapse behavior. The idea behind it is simple – policyholders behave differently when provided with different tradeoffs. To use PLT as an example, consider the following scenarios:

1. Policyholders experience a 15x increase in premium when the PLT period begins to maintain the same death benefit
2. Policyholders experience a 3x increase in premium when the PLT period begins to maintain the same death benefit
3. Policyholders experience an 93% reduction in death benefit when the PLT period begins but their premium remains the same

Which of these scenarios is most likely to provide the most profit to the life insurer? At first blush, the first scenario looks most likely. Premiums jump by 15x. More than 5 times more people would have to lapse as in scenario 2 in order to yield the same profit. But what if the premium jump weeds out anyone who is even remotely insurable and therefore sticks the life insurer with horrific claims experience? If that happens, then the life insurer might be better off with scenario 2. Scenario 3 presents a different tradeoff where the premium per death benefit is the same as in scenario 1 but the potential for losses due to large mortality claims is diminished. Is it the best of both worlds? Maybe, but it won’t bring as much distributable earnings as the other two if mortality doesn’t deteriorate. Choices, choices.

Life insurers have to figure out what to do and not every company comes up with the same answer. I ran illustrations for 19 life insurers in the Term market to get a feel for what they do in the PLT period. Take a look at PLT period premiums on a 45 year old Preferred Male for $1M of death benefit:

On average, life insurers caused a spike in premium from the level rate to the PLT premium of 17x. But there are a lot of stories going on in this data that need to be parsed out. Two of the companies, Lincoln and Corebridge, reduced the death benefit instead of increasing the premium. The numbers show above are the equivalent premium had they maintained the original death benefit. In reality, Corebridge reduced the death benefit at the beginning of the PLT period by nearly 95% and Lincoln reduced it by 92%. The fact that both of these companies are reducing the death benefit rather than increasing the premium out of the gate is telling. Lincoln and Corebridge have historically been two of the largest and most competitively priced Term sellers in the independent space. They take this business seriously and I have no doubt that they’ve done the work to prove (at least to themselves) that this approach is the better one to take.

Protective is another highly competitive giant in the Term space that takes a markedly different approach. Their PLT premium increase is just 4x. The next lowest premium increase is Transamerica at 13x. Protective is quite obviously going for the hypothetical scenario 2, theoretically keeping more customers around and with better mortality experience than their peers. However, you’ll notice that Protective’s PLT costs meet the rest of the pack after 5 or 6 years, which mitigates more long-term mortality effects of lower PLT expenses.

At the same time, Protective also offers a Universal Life policy that essentially operates (and is marketed) as a Term policy. From what I remember, there have been periods of time when the UL product was actually cheaper than the street Term in part because of reserving differences in the products. These days under PBR, the reserves are probably somewhat similar, so we can look to other factors for reasons why the two products might be priced differently.

One factor may be that the Universal Life policy has a very different PLT behavior. Like Lincoln and Corebridge, Protective’s UL drops the death benefit at the beginning of the PLT period. But unlike those two, the reduction is marginal – just 50% or so in the first year. After that, the death benefit gradually slopes off until it hits $10,000 at age 90, at which point it stays constant and the premium begins to increase. Of these 19 products, the Protective UL is by far the most generous in terms of PLT pricing. And it also happens to be 12% more expensive than Protective’s traditional Term product.

Prudential also takes a slightly different approach. Instead of increasing the PLT premium every year, Prudential essentially flattens the slope by fixing the PLT premium for the first 5 years of the PLT period. They seem to be playing a slightly different game. At 24x, Prudential has the highest PLT premium and premium ratio of any of the insurers in the first year. There will certainly be a huge shock lapse at the beginning of the PLT period. But after that, the client will be getting a bill for the same amount each year, which theoretically might incentivize them to stay and cause lower lapse rates in immediately subsequent years. As another large and historically competitive Term player, you can bet that Prudential is doing this intentionally and has data to show the benefits of the approach.

When it comes to PLT period pricing, there isn’t a right answer. The only thing for sure is uncertainty and tradeoffs. But most uncertain of all is the question of whether attempting to optimize PLT profitability is even possible at all. In reading the SOA materials and some reinsurance commentary, there is a distinct possibility that PLT profits may be illusory, at least for most insurers. And if that’s the case, then the Term market is going to be in for a massive reset along the lines of what we’ve seen with Lincoln and Prudential taking charges on their in-force Guaranteed UL block. A reckoning, of sorts.

If you’re a producer and you’ve made it this far, then here’s what that would mean for you – Term prices would increase across the board to rates that we see from companies who, as a matter of course, do not factor PLT profits into their pricing. Ballpark, I would say that would increase Term prices by 30-50% pretty much across the board. Without PLT profits, then things like commissions, expenses, mortality and other factors will matter a lot more and will separate the competitors from the also-rans. In other words, the real factors, not just an assumption about profits that no one is really quite sure will come to pass.

In light of all of this, perhaps its not so odd that Brookfield pulled the plug on Term. Perhaps its also not so odd that other companies in the Life space have chosen not to focus on manufacturing cheap Term. Maybe even we should no longer be surprised at the graveyard of companies that attempted to sell cheap Term to underpin their business and later faced serious challenges with the block.

What is actually odd and surprising is that there is so much cheap Term on the market. Term, as I said before, looks a lot like a sucker’s bet for a life insurer and a slam dunk for a consumer. According to one industry survey I saw (but can’t cite because it’s an internal carrier thing), somewhere around 70% of companies price assuming profits from the PLT period. If that becomes no longer rational, viable or justifiable, then Term prices are going to go up. We may very well be in the waning days of the good ‘ol days of cheap Term.