Tuesday, September 10, 2013

Universal Life Insurance: Imperfect Competition

How do life insurance markets operate within the classic textbook framework? Is the market perfectly competitive, or do some frictions exist that cause macro-level inefficiencies? The answer depends on what type of insurance product you are looking at, as term insurance and universal life insurance markets have drastically different competitive elements.1

Term life insurance is, all things considered, a very simple form of insurance which is consistent with other lines of insurance such as health or auto. Assuming, for example, that a 35 year old male will need coverage for 10 years, a fixed cost payable annually can cover that risk. When shopping competitively for rates, this individual has one primary element to consider: the amount of the premium. Because of the simplicity of the insurance, consumers can fairly easily compare rates to find the lowest cost policy. This is as close to a perfectly competitive market as exists in financial markets, on par with bonds and other "plain vanilla" assets.

By contrast, universal life (UL) insurance contracts can be overwhelmingly complex. Being permanent contracts instead of fixed-term, UL insurance is generally used for estate planning or tax purposes; and, since there are myriad goals related to these broad topics, different policies may be advantageous depending on the specific ends sought. Indeed, UL insurance is marketed as a highly flexible and customizable product type which can be tailored to suit the needs of the consumer.

However, unlike markets such as consumer electronics and others where products seem to be infinitely differentiable, the UL market has not approached perfect competition through the vast expansion of choices available. This comparison is not so abstract, considering that UL products have only been prominent investment vehicles for the past 30 years or so - a market still enduring growing pains, if no longer in its infancy. Consumers have little to no guidance in which product might truly be best for their needs, even if they have clearly identified what those needs are. The problem is severalfold:

  • Principal-Agent Problem. Life insurance agents are typically paid the first year of premium payments as commission. Agents therefore have incentive to promote overfunding of the policy in year 1. They may also have incentive to push products that have higher target premium. Alternately, they may be inclined to sell products which have lower initial costs or short-term guarantees without consideration of the risks beyond a certain time horizon, in order to convince the consumer that they have capacity for more insurance than they might need.
  • Asymmetric Information. UL products are vastly more complex than term or even Whole Life products, which have fixed costs that do not change. A single UL product may have 10-20 optional riders which provide contingent benefits, optionality, or guarantees, and which may or may not incur costs on the base policy. Further, even the base policy costs are more opaque than in a term policy, with adjustments for marketing and administrative costs separated from the cost of insurance. As such, it can be very difficult for consumers to determine which products are financially cost-effective given only an illustration which presents one set of assumptions.
  • Inherent Uncertainty. Unlike term policies on younger individuals, where the risk covered by the policy is very small, collecting on a UL policy is inevitable unless the coverage is no longer wanted. The collection time, and therefore future financial obligations, are uncertain, which adds to the complexity of the consumer's decision at policy issuance.

What must be done to close the gap? While the principal-agent problem may always exist, we can at least bring the market to the understanding that insurance agents are not aligned with consumers. Reducing the information gap requires a market for independent advisors dedicated to the asset class. Such advisors would presumably not suffer from the misalignment of incentives as life agents do; but nor would they necessarily compete with or otherwise harm the life insurance business. Part of the beauty of achieving a more efficient market is that it results in a more beneficial result for all parties involved, all while creating jobs and (indirectly) improving our general welfare. 

In short: There is a tremendous opportunity for a more detailed and specialized advisory of UL policies. 
These advisors would need to be fluent in the financial structure of policies, while also able to quantify and address the risks caused by uncertainty. Making this market more efficient could potentially save consumers billions of dollars each year, given the size of the underlying UL market. 

1 - For a basic description of life insurance types (including term and universal insurance), click here.

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