Tags: Life Insurance, Pricing, IRFRC
More from: Alexander Braun, Lauren H. Cohen, Christopher J. Malloy, Jiahua Xu

Life insurance serves one fundamental end: to provide financial support at insureds’ death to their loved ones. Yet the industry is currently not living up to its full potential. A total face amount of $2 trillion in life insurance policies is terminated each year in the U.S. Ultimately, less than 20% of life insurance ever results in a death claim (Gottlieb and Smetters, 2016), leaving a significant portion of overall life insurance utility unrealized.

Investigating the mechanics of the current U.S. life insurance market reveals an “unhealthy” pricing dynamic. The current market equilibrium, predicated on “lapse-supported pricing”, is delicate, and carriers employing excessive lapse-supported assumptions at pricing are vulnerable to profit decline caused by unanticipated policy persistency.

Peer-subsidizing is a fundamental concept in insurance, which through pooling enables the unfortunate to be subsidized by the fortunate. However, in a lapse-based insurance context, insureds with a short life expectancy, who for whatever reason waive the death benefit through policy termination, become the subsidizer of other insureds. Termination by these insureds is essentially utilized by carriers to (i) set competitively low premiums to gain market share; and (ii) counterbalance the loss of good risks from their books, due to early termination on the part of healthy insureds.

Little known to the wider public is that the intrinsic value of a life insurance policy can be realized through a secondary sale. In pursuit of a perfect secondary market, where a policy’s intrinsic economic value is fully realizable, we suggest including the following mandatory provision in a life insurance contract: All to-be-terminated policies shall be placed in the secondary market before lapsation.

The provision would make life insurance products more attractive in several ways. For one, the policyholders’ policy value is protected, and two, potential consumers will be more willing to purchase policies knowing that they are given an additional option to forfeit their policies, and that the losses associated with early termination of policies can be mitigated.

To ensure the protection for policyholders through the suggested provision, we recommend to further discourage carriers from retroactively increasing premiums. People purchase insurance policies to gain certainty in undesired situations. However, they are often unaware of, or underestimate, the risk of a premium increase. Prohibiting premium increases of in-force policies is especially critical in the context of life settlements. When it is permissible to raise premiums of in-force policies, carriers may target policy groups most commonly seen in the life settlement market and make those policies costlier to keep in-force. This strangles the very interest in investing in life settlements. As of now, a policy’s value is completely vulnerable to such maneuvers, and policyholders’ interests are unprotected.

While mandated secondary sale helps insureds with impaired health secure their policies’ value, a fully tapped secondary market would drive the carriers’ bottom line to a deficit if no other measures were taken. Therefore, carriers must rethink their pricing strategy to ensure that the secondary market does not impose a drain on their profit.

While raising premiums of new policies altogether seems an obvious recourse, carriers may also consider augmenting policy front-loading. Carriers can advance premium charges to such an extent that, from a purely economic point of view, an insured would always be better off committing to the existing insurance contract, due to the low premium/face ratio, than terminating or switching to a new contract. Such a pricing scheme renders moot the lapse assumption, which makes accurate premium setting much easier. In reality, single premium insurance exists as an extreme form of front loaded insurance products (Gatzert, Hoermann, and Schmeiser, 2009).

Assume policies were sufficiently front-loaded under the setting of mandated secondary sale. Compared to the status quo, healthier insureds would, due to lower future premiums and the option to monetize their policies through secondary sale, stay longer in the risk pool and thus financially contribute more to the pool. On the other hand, unhealthy insureds would be more tempted to forfeit their policy for an increased cash back and would financially benefit more from the pool. In this way, peer subsidizing flows from healthy insureds to unhealthy ones, which would be more just than the present alternative as implied under lapse-supported pricing scheme.

Morbidity-contingent monetization, a key element of the proposed intervention, is not entirely unprecedented. Currently on the market are products with similar partial-to-full monetization features such as accelerated death benefits (ADB), carrier buyback, and enhanced cash surrender value, all being quasi “add-ons” that require morbidity-contingent nonforfeiture valuation. While, most of these insurance products are subject to additional charges, ADB for terminally ill is usually attached as a free rider to a life insurance policy. This is because historically, the coexistence of the viatical settlements market and ADB for the terminally-ill has ensured that the latter has become a standard feature of life insurance, with little or no surcharge.

Insurance companies that did not factor in the effect of the secondary market at pricing would be exposed to unexpected losses, and would consequently try to remedy this ex-post, i.e. by increasing the cost of insurance retrospectively. However, this would come at the cost of the potential lawsuits and reputational damage.

Through a mandated secondary sale regime, carriers internalize life settlement and foster a universal and competitive secondary market that naturally features a valuation of policies unconditionally pegged to their economic value. In anticipation of this potential ultimate equilibrium underpinned by continuous monetizability of policy value, insurance companies would need to switch lapse-supported pricing to front-loading, “mortality-focused” pricing.

A competitive secondary market as a result of such reform propels realization of the economic value of life insurance, consequently maximizing insurance utility to policyholders and augmenting the welfare of society. We suggest that life insurance carriers make a prompt business model transition to embrace and participate in the secondary sale of policies, instead of avoiding or resisting it. With increasingly more legislation getting issued in favor of life settlement (e.g. Brady, 2017), the proposed reform is a progressive rather than an aggressive one. It helps accelerate the transition into the market’s new normal. We are confident that the new equilibrium reached through the proposed paradigm shift will yield a higher market efficiency and a utility-premised wealth transfer among consumers.

The complete paper is available for download https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3179334