This chapter covers life, property, and other insurances including lifetime pensions. I ignore social security benefits, assuming that they need to be supplemented by private benefits.
The needs are for financial security: to protect the family fortune from unexpected losses that would lead to financial hardship. The needs are perhaps not all obvious, and it can be difficult to persuade breadwinners to buy our policies. This applies not only to death cover—perhaps the only product that can only be bought as a gift—but also for disability, and some property, health and public indemnity insurance. This is why in many countries, such insurance and pension contributions are compulsory.
The chapter also covers hard selling, which is a species of over-servicing, the need for virtue in the management of moral hazards, and the role of mutual organizations.
Hard Selling
Hard selling is not purely a life insurance phenomenon, but this is perhaps where it started.
The origins of retail insurance go back at least several centuries, with—life insurance particularly—increasingly being sold by commissioned agents. Life companies may have developed the largest and most aggressive commissioned retail sales force of any industry. The hard sell leads to high lapse rates, at significant cost to those who have paid for the high commissions that typically consume most of the first 2 years’ premiums. The lapses may partly come from policyholders changing their minds once no longer exposed to the hard sell; but when I once sent letters to our policyholders asking why they had stopped their premiums, the only replies were from those who apologized because they were no longer able to afford the premiums. Policy design should allow for some flexibility in premium payments when incomes fluctuate.
The strong financial incentives are, however, not sufficient to prevent many wouldbe salespeople failing. There is a great deal of emotional rhetoric, much of which is pure manipulation. Their employers are not beyond repossessing homes to recover commissions paid in advance of premiums that are never received.
Life insurance salespeople also offer financial advice, but it is difficult to ensure that they are adequately trained, while the incentive structure is often counterproductive. Misselling scandals illustrate this the best, with the UK regulators being particularly active in forcing companies to pay billions in compensation for wrongly sold policies.
I have, however, known successful salespeople who invariably go out of their way to help their clients and believe in the products they are selling. When I was actuary of the Prudential in South Africa, I often shared lunch with salespeople in our canteen. Commission rates were a common topic of conversation. Our most popular product allowed them to dial their commissions up and down—from about 15 percent to 75 percent of the first year’s premium. I was often asked to remove this facility and set commissions at the maximum 75 percent, which was what our competitors were doing. Some of the branch managers put limits on the commissions that their staff could take. The Durban branch limit was as little as 30 percent—and it should be noted that the branch manager’s bonus was itself directly related to the commissions earned by his staff. He was a man of real virtue!
In spite of this, the industry frequently claims that people have inadequate life cover—suggesting that the system fails, in any event, to distribute to all who need it. It is a challenge to find ways to distribute insurance more effectively. There are many who think that the sales process is too expensive and too aggressive. I know of a number of people who have left the industry for this reason. I am one; although I am presently helping to get a business going that makes use of the internet’s new powers in order to reduce the costs of distribution. Much of what is currently sold on the web is even more expensive and exploitative of the gullible—as the sale of funeral policies to pensioners discussed above. It seems likely, however, that creative ways to use it will be found, and will offer good value.
If you need to address the challenge of making sales effective, and ethical, the work of Guy Oakes, and that of Donald Langevoort may be useful. They explore the emotional and ethical pressures of life insurance (and investment broker) sales from sociological and legal perspectives, respectively. They consider the extent to which individuals can deceive themselves and how company structures can facilitate this—and justify increasing levels of deception because the initial objective (benefits for widows and orphans) is socially justified. If you have been subject to, or observed, the emotional hyperbole of a life insurance sales convention, you will understand what they mean. If you have felt uncomfortable with the hyperbole, your discomfort is probably justified.
Standing against flagrant hyperbole and greed requires courage, preparation, and patience to find the right time to act. To make an impact, you will probably need the imagination and technical competence to show that:
• There is a better—more honest—way of selling.
• Acceptable levels of income can be made by the better way.
• The risks of continuing in the current direction are too great to sustain.
Over-Promising
Hard pressure sales can also lead to exaggerating potential investment returns. It is easier to resist the temptation if regulators impose maximum illustration rates. In any event, it requires courage to stand up against those who use inflated projections. Again, some creativity may be called for. One solution is to illustrate at more than one rate. This communicates the uncertainty and still allows for comparisons with competitors if they use an optimistic rate.
Intentionally underfunded defined benefits pension schemes fall into the same category. Barton Waring has described the problems and issues in the United States, but the problem happens all over the world—in schemes that cover politicians and civil servants particularly. The costs of generous benefits have been understated, which has benefitted existing members, pensioners (especially those on large pensions who often made the decisions), and future generations will be asked to pay. Waring talks of the need for tough love, which will fall to some future generations of politicians. For them, courage and creativity will be necessary. Care will be needed to ensure that it is not the less vocal who bear a disproportionate share of the pain.
I would like to share one small contribution that I found personally gratifying. It was related to over-promising in that the actuaries concerned were, in my opinion, overestimating investment returns in their reports. I produced a number of actuarial reports for use by individuals making claims for loss of support in South African courts—using much lower real rates of return because I could not see how the individuals concerned would be able to make the returns being used. My reports were never challenged in court, but frequently led to larger settlements. The most successful, and most interesting actually had little to do with financial assumptions. It concerned a widow who had a claim for loss of support because of her husband’s wrongful death. He had worked for a farmer and been allowed to keep two cows on the farm. I had been asked to determine the present value of his income, but the question was the value of the cows’ milk. At the time as I remember, he would have been lucky to get 50c per liter from other farm workers; the farmer was receiving twice this price from the wholesalers, but his widow was paying six times at the store in the local town. The difference more than doubled her claim. Using some of my financial instincts to help in this way was particularly satisfying! You never know where some ideas will take you if you are looking for an opportunity to contribute.
Benefits that Meet Needs
The focus on sales means that the industry often seems little concerned for the real needs of its clients—as would be required by the marketing concept. The next few pages look at the inadequacy of some of its products, and how they provide creative opportunities for product development that would meet people’s needs.
One potential contribution is to work at improving the advice given by salespeople and financial planners. In particular, the calculators, proprietary or freely available on the Internet, could be made more effective in addressing people’s needs, and could provide the basis for better advice. Many of them misleadingly focus on the easy risks and avoid the more difficult: inflation, investment shortfalls, and longevity particularly.1 They also often fail to attempt to smooth consumption over the long run. There is a need to communicate the uncertainty and to steer people into appropriate products. Given the declining role of human capital (future earnings), it is agreed that lifetime consumption can be increased if investments are more aggressive when people are younger and the risk reduces with age. The aged need a harvesting plan2 to manage their declining asset balances—and declining ability to manage them.
At the other end of life, coverage for orphans is by far the greatest need. Adults without children are unlikely to require life insurance cover for themselves—as they can earn their own living.
Disability Insurance
Another area for product development is the redesign of disability insurance. The standard offering is a lump sum paid on total and permanent disability only—leaving people uncovered if they suffer from temporary or partial disability. Where there is cover for these, it is often limited to 2 or 5 years. On the claims management side, the industry has been slow to recognize that physical disabilities do not prevent people from working in what is now a knowledge economy. Huge improvements in medical technology also mean that many people, who would have been disabled in the past, can get back to work. There is much work to do to bring the best of rehabilitative medicine to the management of disability claims. This not only applies to life insurance, but also in the accident insurance schemes that provide cover for workers and road accidents. Rehabilitation and training can be painful and humiliating, but it is invariably to be preferred to the isolation and meaninglessness that otherwise may accompany unemployment.
The industry is also prepared to offer overlapping benefits: the trauma benefits, which pay significant lump sums on the diagnosis of certain critical illnesses, may be needed for rehabilitation expenses, but the medical expenses are better covered by health insurance. Recent medical advances mean that some of these policies are paying large amounts of money on the diagnosis of what have become trivial diseases since the policies were sold. While it may be difficult to persuade life insurers to drop policies that people can be persuaded to buy, there are business opportunities for health insurers to increase the cover they offer in this market.
Longer-term income payments are often not linked to inflation—or have an inflation linkage limited to a fixed percentage. These limitations are a throwback three decades to before inflation-linked bonds were widely available to provide hedges for such benefits. Inflation-linked contracts may be more of a challenge to sell, but potential customers may well appreciate genuine efforts to explain risks in a manner that clearly shows respect and care for their welfare.
Companies offer benefits that leave other gaps in cover. It is common for companies to offer cover for accidental causes only (no need to ask questions about health). If a family needs cover, it needs it regardless of the cause of death or disability. I have been told that any cover is better than none, but integrity requires us to at least disclose any inadequacies. It is surely also good for sales in the long run!
As actuary to a life insurance company in South Africa in the 80s, I found that there was opportunity to be quite flexible in designing products that were more appropriate. At one point, I was put under pressure from our marketing managers to introduce a trauma product.3 I thought the amounts in insured were much too large for the need, and so designed a product that only paid a quarter of the sum insured for each disease diagnosed—and then also paid a benefit related to the number of days in hospital. This was a reasonable proxy for severity and many medical insurance policies would not have fully covered the hospital costs. I am pretty sure that most policyholders did not realize that the benefits were quite different to those offered by other companies, but also sure that most of them would not have been able to describe the competing policy benefits either. I was satisfied that we were giving good value for money and charging people less, although never had the opportunity to investigate the extent of over-servicing. A further bonus for me, though, was that we were able to remove the accident benefits from our product range. The General Manager Administration and I were able to persuade the marketing managers that we could give them their new trauma product much faster if we used the same computer code as for accident benefits. Because one could have only one product per computer code, the accident benefits would have to go, and we distinguished between the two products by date of entry.
Deductibles and Health Insurance
The industry’s obsession with easy sales, at the expense of clients, is also seen in the way that policyholders are seldom advised to increase their deductibles. There is no point in insuring for small losses: they are a waste of time and money—expensive to administer from the perspective of both policyholders and insurers. Most middle class people can afford losses of a few thousand, and should only insure for potential losses in the tens or hundreds of thousands.
I feel that this is true even in the case of medical insurance, where there is a concern that people will not go to their doctors (GPs) for preventative treatment if it is not covered by insurance. The Australian mandatory system, for instance, provides cover for visits of less than $50. Even if GP visits were subsidized, the insurance that is needed is not for a few small claims, but for situations where many claims in a short period put a strain on family finances. Modern computer technologies make this much easier to manage than previously. Incorporating this technology provides perhaps the greatest current challenge in financing medical care. Automating medical records will also allow for much better management of all medical care, and provide for huge strides in research to determine the most effective treatments. There may be some resistance by members of the medical professions who see it as a threat to their status and incomes. In this area, it may be that the financial industry has a profitable chance to be on the side of the angels.
Population ageing is a popular topic with the baby boomers entering retirement. The financing of advanced old age becomes a larger problem with increasing longevity and smaller families, which mean fewer children to care for aged parents.
By coming slower than previously, death may be easier to deny. If the aged are to live and die with dignity, addressing their problems requires careful thought, empathy, and some courage. How will we cope ourselves? We cannot address the financing of ageing without considering death. The good life includes a good death, where we acknowledge and accept our declining powers. There are consequences for our vocation. First, there is the need to develop satisfaction or contentment within ourselves. We have to befriend ourselves—because we might outlive all our friends and family. My grandfather, who lived to 102, told me that he did not like to go to the local market anymore, “because all my friends’ children are dead!” We also need reconciliation to a world where we cannot control our family or our carers.
Secondly, there is a need to make financial provision for later years when we cannot control our finances, and provision for passing on the wealth that remains. There is a period of a year or more before dementia is diagnosed where people are particularly at risk. I am doing work with Jo Earl and others that suggests that people are more gullible and therefore more susceptible to losses at this time. The need for financial advice and appropriate products is therefore much larger than previously. For those in the early stages of dementia, it may be desirable to lock financial assets away in life annuities.
There are also ways of ensuring that prevent yourself from selling your property for less than it is worth, which I have known to happen before dementia is diagnosed. Philippe Février and his colleagues describe a contract used in Europe and called viager in France. The seller gets a monthly payment and the right to occupy the property for life. It is probably better to pool your risks though:
Back in 1965, when Mrs Calment was aged 90, she sold her apartment in Arles to a 44-years old man, on contract-conditions that seemed reasonable given the value of the apartment and the life-expectancy statistics that prevailed at the time. The man turned out to be unlucky since Jeanne Calment4 lived a very long life. He died in 1995, two years before Mrs Calment, after having paid about FFr900,000 (twice the market value) for an apartment he never lived in (2004, 4).
Research
There is also a challenge to research the effects of the benefits the insurance industry pays when an insurable event has occurred—and of people who have failed to take out insurance. Can too much insurance be disruptive like winning a lottery? How much income does a widow need if she has young children? If she does not? Are widowers different? Are lump sum or income streams easier to manage? What is the best way to support people after they have suffered a disability? What happens to people who are not insured when their houses are flooded? For a multi-billion dollar industry, little is known. Writing this, I have to confess to feeling that as an academic I could have done more to initiate research into this area, but there is time to do more! In fact, there is G8 initiative5 to make government data more readily available for research, and one can also argue for the need to collate private sector data. The development of knowledge is a necessary although not sufficient requirement for wisdom.
Moral Hazards in Insurance
Moral hazards increase the costs of insurance if policyholders behave more recklessly when they are insured. Anti-selection increases costs if some policyholders know more than the insurers about the claims they are likely to make—and they take out more insurance. Managing moral hazards and anti-selection is a challenge to those involved in the legal wording of contracts, marketing, underwriting, and claims management—as well as actuarial work.
Insurers do need to be cognizant of moral hazards and anti-selection. Disability income claims are, for instance, definitely higher when the replacement income is a higher proportion of what the claimant could otherwise earn. Contracts need to be designed to prevent opportunistic behavior by some policyholders at the expense of expected profits or other policyholders. The risks can however be exaggerated, partly because policyholders themselves bear the costs of recklessness. I saw this first while analyzing mortality during the Rhodesia/Zimbabwe war. The company for which I worked had increased the premium rates for term assurance—on the assumption that those most at risk in the war would take out more cover for the cheapest possible premiums. When we analyzed the experience, however, we found that term insurance mortality had in fact declined. Those prudent enough to take out term insurance were also prudent enough to stay out of trouble!
People are not all opportunistic. It would be imprudent to rely on no one taking advantage of you, but overly cynical to think everyone will. The issues can be illustrated by considering the various life insurance arrangements that offer free cover—that is free of evidence of health. This works very well when offered to large groups of employees of a company. Even if there are one or two in poor health, and even if those in poor health are instrumental in organizing the insurance, the size of the group may well dilute any excess premium that should be charged. If these arrangements have been successful for some time, however, pressure from salespeople can lead to smaller and smaller groups being accepted. This trend ends in losses once opportunistic salespeople create groups with which to cover people in poor health. Insurance companies can also apply a lower standard of underwriting when people are about to take out mortgages to buy a home. Buying a home normally indicates that they are in good health. Problems occur, however, if the underwriting becomes so limited that opportunists find death bed cases, who can take out a mortgage and then get life insurance at normal rates. Managing these hazards calls for some wisdom—and courage when your major competitors are acting recklessly. There is a great deal of merit in developing ways to offer insurance with less underwriting, but none in failing to prevent free riders creating losses.
Taking a virtue ethics approach does not mean being naïve. People can fall prey to temptation so it is prudent to design products and underwriting so that there is a cost to deception and manipulation. People are also less likely to be manipulative if they encouraged by codes of ethics as is covered later in Chapter 14. My experience is that many people respond positively to the idea that insurance contracts include the requirement of utmost good faith, which is that both parties to the contract will disclose all relevant information to the other.
It is not surprising that opportunism and fraud flourish where policyholders feel that they have been treated unfairly. Lack of candour in marketing material, particularly failure to highlight unexpected exclusions, can create such feelings. To find out, after the event, that your policy covers rain damage but not floods caused by an overflowing river can well create resentment. Policyholders will feel unfairly treated where the industry gives the impression that it does not want to pay claims. In the companies in which I started work, we emphasized that paying claims was our purpose. I cringe, therefore, when I read headlines, “victory for insurance industry” because some company has won a case against a claim by a policyholder.
Mutuals
Mutual societies, owned by their customers, can be successful competitors to shareholder-owned companies—in the finance sector particularly. They play a role in the market by discouraging price gouging, and may address moral hazards because they remove the conflict between shareholders and customers, making the arrangements seem fairer. In Australia, industry superannuation funds are effectively mutuals and their slogan of “all profits to members” addresses both these issues.
Some of the older mutuals were set up before corporate law was fully developed. Since then, it has been much easier to set up a company than a mutual organization. If share prices fall below book value, however, it may make sense for the policyholders or depositors to buy out the shareholders.
Having spent a decade of my life sponsored by, and then working for, a mutual insurer, I prefer their ethos. My view is that the demutualization of the past 30 years had its origins in greed rather than any inherent structural disadvantages. The senior management of the mutuals wanted the profits from the share options that could not be given to them until demutualization. Consultants and merchant banks, which made huge fees from the transactions, aided and abetted the process.
Mutuals need a different approach to capital if they are to survive. The capital providers need to benefit directly from the capital. If not, then the organizations will be vulnerable to opportunistic takeover. Those organizations that demutualized paid members significant sums for the sale of their capital, which the opportunists said had been tied up in the organizations. Frank Redington, a leading British actuary had, however, indicated the solution in his essay, The Flock and the Sheep. There are two alternative perspectives, both of which can be valid. The organization view, legally correct, is that all the assets of the company belong to the legal entity that is the company. The sheep analogy recognizes that the personality of the corporation is a legal construct, and that the capital, like the fat on a sheep, can potentially be taken by the capital providers when they leave the flock. Members can therefore bring capital into an organization when they become customers, and take it when they leave. There is a need to prevent too much mobility—members like sheep may need to be corralled for their own sake! Nevertheless, with some creativity, they can bring the fat in by an extra loading on their premiums or adding shares to their deposits. It was a great pity that the Equitable, the strongest advocate of the mutual model in the United Kingdom, was led to ruin by a dominant CEO who made impossible promises to policyholders.
In an idealistic youth, I was particularly attracted by the Mondragon cooperatives of Spain, and the Yugoslav model of worker ownership. The ideas of employee share-ownership schemes also had some attraction. Having more experience of business risks, I now think that it is unreasonable to give workers a significant interest in the profits of their employer. There is too much downside risk in that they may lose both job and savings in companies that make losses. There is also too much upside benefit in companies that turn out to be hugely profitable—especially if they are capital intensive and provide disproportionate rewards to their employees. Workers in unprofitable companies might well be resentful. I fear that this might even have played a role in the conflict in Yugoslavia. Lars–Erik Cederman and his colleagues have produced some convincing statistical evidence that inequality was a contributor to this conflict. If so, it emphasizes the importance of economic justice in keeping the peace.
The flourishing Mondragon cooperatives have modified some of their more idealistic initial principles. While the website of the Mondragon Corporation affirms that it puts workers before capital, they now raise capital on the market—without giving it control. It has expanded internationally and is recruiting associates—if you are interested!
Other types of mutuals provide social benefits to members in addition to their financial role. This often applies to the friendly societies that exist in a number of countries and to the burial societies that are common in Africa.6 The development of mutual type organizations therefore provides possible outlets for creativity in a vocation.
Chapter summary: Hard selling is a form of over-servicing that exploits customers. Over-optimistic projected investment returns are misleading and can be hurtful. The challenge is to design benefits for life, disability, and retirement that leave no gaps and create no overlaps in cover. Moral hazards can be managed by careful and scrupulously fair management. The ongoing participation of mutual firms in the market creates diversity that can encourage better value for money and corporate governance.
1Zvi Bodie and John Turner have written on these issues, and I have looked at a number myself in an attempt to find one I can recommend to people!
2This is one of the ideas about which I am personally enthusiastic, see Asher (2012).
3These had just been invented in South Africa by Marius Barnard, brother of Chris Barnard who had performed the first heart transplant.
4Who also made the Guinness book of records as the oldest person alive.
5G8 (2013) Open Data Charter. Accessed December 20, 2014. https://www.gov.uk/government/publications/open-data-charter/g8-open-data-charter-and-technical-annex.
6See Rob Thomson and Debbie Posel.