May

6

 Does anyone understand how the gears and levers of insurance and annuities work? For me, it's a MEGO subject that I'd like to understand better. Is there a good web reference, or can someone write a brief essay that outlines the moving parts?

For instance, what are the real economic aspects life insurance products (whole/term/universal)? I vaguely understand some or all of them involve embedded optionality (since the pay-in of premia is fixed in advance) especially wrt interest rates. Is there a quick analysis of the form "product X includes embedded long-bond optionality that the buyer typically pays 2 vols vig on"?

And how best to jumble together all the tax/risk/return/optionality aspects, without doing deep financial engineering? I'd love to have a brief (but informed) soundbite I could pass on to friends/family who ask me about such things, believing (erroneously) I'm knowledgable.  

Russ Humbert responds: 

The moving parts from a insurance companies perspective: Mortality, Interest, Lapses, Expenses and profits and taxes. Its all based on the probability of surviving (both actual and as a policyholder), the time value of money. The buyer, buys because his time of death is much more a tail risk tragedy and is willing to pay more for less risk, a risk premium. But the real kicker is that any death benefit is generally tax free and any cash surrender value also accumulates tax free.

And in general it is best to have the most complete underwriting that your health can withgo without getting "dinged". You want to be the "pool" with the healthiest, least likely to die people to save mortality cost.

Generally people like to pay a level premium.

But this also means that if you lapse you probably are leaving something on the table (you paid your commission expenses early). However, this maybe really you are giving up something that would go to your beneficiary.

Term insurance is pure insurance, no cash value.

Whole life has cash value which has a margin of safety for the ins. comp. so they often share some of the "good experience" in a dividend.

Universal Life is like a saving account where they deduct your term cost monthly expenses and mortality. These often have a "back end load" I.e. an surrender charge.

One of the frustrating things is that investment for insurance companies are highly regulated, and very crazily taxed. Hence, it is hard for a insurance company to get you "efficient frontier" returns. If they are taking the investment risk the regulators see it as there duty to make sure they do things conservatively, to protect very long term policyholder. But like most regulations the definition of "conservative" must be so general as to make it highly inefficient.

This is somewhat mitigated by using "variable" products where the buyer takes the investment risk by putting the cash value into choice of mutual funds. However, these too suffer from some tougher regulations.

Further, IMHO any time taxes vehicles are involved, everyone wants more than their share of the pie. More of that tax benefits should go to the buyer.

Annuities likewise have the "tax free accumulation". A deferred annuity is a tax free build-up of a savings which you can latter "annuitize" (make it an income stream which can be a set period or for life or a combination of guaranteed payments for x year to life or lives. The payout can either be fixed dollars or fixed units per payout period (usually monthly)

PV $1 annuity = sum of Prob survive(t) X appropriate discount rate(t). Payout = Premium /PV $1 annuity.

From Anon: 

The moving parts from insurance companies' perspective: Mortality, Interest, Lapses, Expenses and profits and taxes. It's all based on the probability of surviving (both actual and as a policyholder), the time value of money. The buyer buys because his time of death is much more a tail risk tragedy and is willing to pay more for less risk, a risk premium. But the real kicker is that any death benefit is generally tax-free and any cash surrender value also accumulates tax-free.

And in general it is best to have the most complete underwriting that your health can withgo without getting "dinged". You want to be the "pool" with the healthiest, least likely to die people to save mortality cost.

Generally people like to pay a level premium.

But this also means that if you lapse you probably are leaving something on the table (you paid your commission expenses early). However, this maybe really you are giving up something that would go to your beneficiary.

Term insurance is pure insurance, no cash value.

Whole life has cash value that has a margin of safety for the insurance company, so they often share some of the "good experience" in a dividend.

Universal Life is like a saving account where they deduct your term cost monthly expenses and mortality. These often have a "back end load", i.e., a surrender charge.

One of the frustrating things is that investment for insurance companies are highly regulated, and very crazily taxed. Hence, it is hard for an insurance company to get you "efficient frontier" returns. If they are taking the investment risk the regulators see it as their duty to make sure they do things conservatively, to protect very long-term policyholder. But like most regulations the definition of "conservative" must be so general as to make it highly inefficient.

This is somewhat mitigated by using "variable" products where the buyer takes the investment risk by putting the cash value into choice of mutual funds. However, these too suffer from some tougher regulations.

Further, IMHO any time taxes vehicles are involved, everyone wants more than their share of the pie. More of that tax benefits should go to the buyer.

Annuities likewise have the "tax free accumulation". A deferred annuity is a tax free build-up of a savings which you can latter "annuitize" (make it an income stream which can be a set period or for life or a combination of guaranteed payments for x year to life or lives. The payout can either be fixed dollars or fixed units per payout period (usually monthly).

PV $1 annuity = sum of Prob survive(t) X appropriate discount rate(t). Payout = Premium /PV $1 annuity.

From Henry Gifford:

The importance of the "lapses" part of the above description is what was apparently behind the commotion last year when investors were reported to be buying old people's policies from them before they died. What the investors apparently figured out was that the expected number of policies that "lapsed," that is, the policyholders didn't keep up the payments and thereby forfeited the benefits, enabled the insurance companies to promise rather large payouts. The investors planned to maintain the payments on 100% of the policies until the people died, thereby getting handsome returns. 


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