Flavors of Insurance, Part II (Life)

Life insurance probably has the most complex accounting of any of the sub-industries. Part of this comes from the complexity of the contingencies underwritten, and most of the rest from producer compensation and the length of the contracts underwritten.

Life insurance and annuities are sold, not bought. In general, people have a mental bias toward thinking that they aren’t going to die in the immediate future. Annuities are often sold to people who won’t otherwise plan for their retirement. To overcome those biases, life insurance companies pay agents handsomely to originate policies. The commission is large enough that if the company expensed it, it would lose money on a GAAP basis every time it issued a policy. That’s why policy acquisition costs are deferred, set up as an asset, and amortized in proportion to the gross profitability of the business over the life of the business.

Reserving for term policies isn’t very complex, but reserves for cash value policies are set as the expected present value of future benefits less future premiums. Small changes in interest, mortality, and lapse rates can make large changes to reserve values. Other contingencies can affect different classes of policies as well; variable and indexed contracts rely on returns of the stock and bond markets. Higher assets under management mean higher fees.

There is a second business that most life insurance companies engage in. Since the companies would not be profitable if they invested in Treasury securities, they typically invest in corporate bonds, mortgage-backed securities, and other risky forms of debt. Some also invest in commercial mortgages and real estate. When there is stress in the credit and mortgage markets, life insurance companies do poorly.

In reviewing the performance of life companies as group from March 1994 through March 2004, one can see the effect of the major drivers of profitability. Underwriting was typically profitable for companies throughout the entire decade, so that was not a differentiating factor. Most of the shifts in profitability came from investment results. The credit cycle was generally positive to the beginning of 1999, negative 1999-2002, and positive after that. The equity market supported variable life and annuity writers until the bull market peak in March 2000, punished them until March 2003, and has rewarded them since then. The only period that deviated from this description was after the bubble popped in March 2000; life companies temporarily did better as equity investors fled technology stocks for the safety of stodgy sectors like life insurance.

The outlook for life insurance is no different than the past; it is tied to the outlook for the asset markets. If the credit and equity markets do well, so will life companies.

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Bringing it to the Present

Many of the things that I wrote back in 2004 regarding life insurers have proved prescient.  Life insurers have prospered as the asset markets have prospered, and suffered during the bear markets. On average, life insurers have done better than other financials, and better than the market as a whole since 2004.

One advantage the life insurers had 1999-2003 was that they got burned on CDOs and did not get caught in the bubble.  Even with other types of structured lending, life  insurers got more conservative 2003-2005, unlike most of the rest of the financial sector.  Life insurers noticed the poor underwriting, and stayed away.

It should be noted that there are life insurers that do a lot of variable business, and those that don’t.  Those that write a lot of variable life and annuities will be more sensitive to the stock market than those that don’t write a lot of variable business.

One final squishy spot: secondary guarantees.  With Universal Life and Variable Annuities, there are secondary guarantees where the reserving is questionable.  Also true of long-dated term policies… be aware that there might be some bombs lurking there, that will manifest in severe economic scenarios.

At present, I don’t own any pure life insurers.