Why Do We Keep Selling Insurance Products As Investments

Why Do We Keep Selling Insurance Products As Investments?

John L. Olsen, CLU, ChFC, AEP

Not long ago I gave a presentation on income annuities to a group of insurance agents. We began by considering immediate annuities (sometimes known as “payout annuities”), and the discussion turned to the pros and cons of these products. One disadvantage, cited by nearly everyone in the group, could be summarized as follows: “If I buy an immediate life annuity at a time when interest rates are low, I ‘lock in’ that low interest rate for the rest of the annuitant’s life.”

Later on, the discussion turned to longevity annuities. I summarized the operation of this product as follows: “Your client is worth $1 million and she’s about to retire. She has a lot of concerns, chief among which is the possibility that she will run out of money in her old age. Another advisor has recommended that she use one-tenth of her wealth ($100,000) to purchase a longevity annuity that will give her an income of over $100,000 per year, every year, for the rest of her life, starting on her 85th birthday. But if she dies beforehand, the annuity expires without value. What do you folks think of that recommendation?”

Just about everyone in the group hated it. “You mean if she doesn’t make it to age 85, all that money is lost?” one fellow asked. “Why would anyone buy something like that? Why would anyone ever recommend it?”

Why, indeed? Why would anyone invest a hundred grand in something that, if she doesn’t live to life expectancy (or thereabouts), she’ll lose it all? Why, for that matter, would anyone want to lock in a low interest rate on her money for the rest of her life?

These were serious inquiries, posed by serious, intelligent folks. They weren’t, and aren’t, “dumb questions.” But they reflect a fundamental misunderstanding of what immediate and longevity annuities are and what they should be expected to do.

They were investment questions regarding insurance products, and as such, they were fatally flawed. To understand why, we need to review some basic concepts.

Investment and insurance are very different things. The instruments designed to facilitate them are fundamentally different, as are the logic and math that we should employ to gauge their value.

Investment is all about profit. We buy an investment because we believe that we’ll be better off after doing so than we would be if we had not bought it. We do so with the expectation of gaining more money (whether that money is in the form of capital or income—or both).

When we grant the use of that dollar to a bank, mutual fund company, or corporation by investing it in a certificate of deposit, fund shares, or shares of the corporation’s stock, we expect that institution to pay us dividends, interest, or increased share value in return for using our money—and to give us back that original dollar when we ask for it. If it does, we will come out ahead by ending up with more than our original dollar. With some investments, of course, we don’t know for certain that this will happen. We might not get any profit or even the return of our original investment. But we expect both.

Insurance, by contrast, is all about loss. We buy insurance not because we expect to profit from owning it, but because we wish to avoid losing money by reason of experiencing a specific event (which insurance actuaries call the “covered peril”) that will cause us economic loss. In fire insurance, the covered peril is that our property will be damaged or destroyed by fire. The consequent economic loss to us is the cost of repairing or replacing that property.

We don’t know for certain that the covered peril will materialize, resulting in an economic loss, but we are unwilling to assume the risk that it will because the magnitude of that loss is too great for us to bear. If the loss does occur, the insurance company will pay us the insurance benefit amount. We will not have profited from being insured (assuming that we did not overinsure and that no chicanery was involved). We’ll have simply avoided an unbearable loss.

Of course, if the insured peril does not occur, the insurance company will not pay us a benefit. Nor will it (in most insurance contracts) give us back what we paid in premiums. Those premium dollars will be lost to us, but that’s OK, because it was worth it to us to bear the certain loss of those dollars to insure against the possibility of losing a much greater sum.

It is pretty simple, really. We’ve known all this for years. So why, then, do so many of us forget it when analyzing insurance products? We do so, in my opinion, because we’ve fallen for the fallacy that any financial instrument is necessarily an investment and may properly be measured using investment mathematics.

As we noted above, an investment aims for profit. So, if we regard an immediate life annuity as an investment, it would seem reasonable for us to note that the interest rate used to determine the amount of the annuity payments is locked in at contract inception. And it would seem just as reasonable for us to compute the return on that investment by comparing the sum of those annuity payments with the single deposit required. The resulting calculation—the internal rate of return—would, by this logic, be a measure of the profit the annuity buyer will realize.

An obvious problem with that calculation is that we don’t know the number of those annuity payments (and, thus, the total annuity payout) because we don’t know when the annuitant will die. We could assume that, of course, just as the government does, in the tables it uses to value annuity interests for tax purposes.

But that still doesn’t solve the problem. Because the profit—the real value—of an immediate life annuity is not some computed “return” on the dollars the buyer pays for it but instead is the absolute assurance that the income it produces will last as long as he or she does. It’s not about profit. It’s about avoiding loss—the covered peril of outliving his or her income.

And what about the agents’ concern that if the buyer of a longevity annuity dies before the annuity starting date all the money he or she paid into that contract will be lost? Again, the concern is misplaced because the nature of the problem is not understood.

If one buys a longevity annuity (of the usual type that provides no death benefit) and dies before the annuity starting date, has one lost one’s investment? Does the insurance company keep that money? The answer to both questions is a resounding “No.” In longevity annuities, as in all life-only annuities, if the purchaser dies before receiving through annuity payments his or her entire premium, the insurer does not keep that difference. It pays it out to those annuitants who are still living. That’s basic risk pooling.

Moreover, with longevity annuities, as with immediate life-only annuities (having no refund feature), the difference just described is never lost, because a return of principal is not a contract benefit. The covered peril in any life annuity is the economic consequence of outliving one’s income. So long as the annuitant lives, that peril remains, but at death, it expires, as does the annuity contract.

The covered peril of a longevity annuity (with no death benefit) can be perceived as slightly different. Here, it’s not just the possibility of outliving one’s income but of doing so in advanced old age. If one does not live to advanced old age, that peril will never occur, and the insurer will never have to make a payment. The insurer knows this. It knows that, in a large population of longevity annuity buyers a certain, very predictable, number will never reach the annuity starting date. Having this assurance, the insurer can apply mortality credits to each annuity contract, the effect of which is to increase the value that will inure to those members of that population who survive long enough to receive benefits—those at risk for the covered peril.

This doesn’t sound like good investment logic, and it isn’t, because investment logic doesn’t apply here. Profit isn’t a factor here. Loss, and the avoidance of loss, is what matters. It’s what these annuities are all about, and it’s how we advisors should be judging—and explaining—them.