How To Choose Life Insurance

How To Choose Life Insurance by David Merkel, CFA of Aleph Blog

 

This was published in the “Ask Our Pros” column at RealMoney.  I don’t know when, and I don’t have the actual question, but looking at my answer, I think I know what was asked.

I’ve been cheated in the past by insurance companies.  How can I choose an insurance company that won’t cheat me?

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This is a question after my own heart.  I worked in the life insurance business as an actuary for 17 years, serving in almost every area that life insurance companies have.

Life insurance agents and products have a bad reputation in the financial press.  Much of that bad reputation is deserved.  Products are often sold that pay agents well, but do not meet the needs of clients.  Agents influence the flow of information between the company and policyholder, and sometimes tell different stories to each side.

The life insurance industry has tried over the years to control the sales process better, so that only suitable products get sold.  Regulators have demanded it, industry groups want a better reputation, and individual companies have learned that writing bad business is unprofitable.  There are regulatory rules, industry conduct codes, etc.  It is difficult to root out bad apples among agents, which can flit from company to company; companies with bad records tend to get disciplined by the regulators and the courts.

Life insurance and annuities are products that are generally sold, not bought, excluding fancy tax reduction schemes used by high net worth individuals.  Typically, though, they get sold to people who will not plan for their own financial well-being, and would not save, invest, and protect their families on their own.  It is an expensive way to invest, but it is better than not investing at all.

There is a need for agent-sold financial products to help those that will not plan for themselves.  This provides a real service, though never as good as what an intelligent investor would do for himself, if he had the time to research everything out.

Disability and health insurance often get a bad rap over claims payment practices, often deservedly so.  Part of the reason for that is that people don’t want to pay the full price of these products; companies respond with lower priced products and get more hard-nosed about claims.  Part of the research that any person should do about an insurance company is their claims payment practices.  State insurance commissioners keep a record of which companies get complaints, and which do not.  Insurance fraud further pushes up costs, and makes companies scrutinize claims more.  Trial lawyers further push up costs by making medical malpractice expensive through exorbitant tort claims.

Auto and home insurance usually don’t draw the same level of complaints as the above areas.  There are some companies that try to be too sharp about claims practices; this is something to watch out for in any insurance company.  Auto insurance (or the equivalent) is mandatory; mortgage companies require home insurance.  The market is regulated, and usually highly competitive.

Another area of complaint is private mortgage insurance [PMI].  PMI benefits the lender, but is paid for by the homeowner.  The benefit to the homeowner is that he can buy a home, and not make a down payment of at least 20%.  The lenders require PMI when the ratio of the first mortgage to the appraised home value is greater than 80%.  New laws require PMI to go away when the ratio drops below 78%.  Homeowners can petition the lender when the ratio is at 80%.  (The lender will probably require a new appraisal.)

Now all this said, insurance companies have had a lower return on equity in the past 20 years than all other companies on average.  Insurance companies don’t make all that much money.  So where does the money go?  1) Agents.  2) Benefit payments.  3) Home office expenses.  Investment income usually subsidizes insurance companies; they lose money on underwriting on average, and when the pricing cycle is weak, they lose substantial amounts.  Since the inception of health insurance, the insurance industry may have lost money in aggregate.

In Summary:

  • Plan your investment and protection needs yourself, or find a trusted advisor to help you.  Investment knowledge pays its own dividends.
  • Study a company’s claims paying practices before buying.
  • Review expense and surrender charges and other contract terms.
  • Choose an insurance company off its reputation, and not price only.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.