Sunday, November 18, 2012

Why Insurance Products Can Make Lousy Investments

If you're considering an insurance product that includes an investment feature, consider the following two examples of why you might want to say no.

Mass Mutual.  On Nov. 15, 2012, the SEC sued Massachusetts Mutual Life Insurance Company in an administrative proceeding (an agency process somewhat like a court case, although conducted within the SEC instead of in a court).  Mass Mutual settled without admitting or denying the SEC's charges.  The essential accusation the agency leveled against Mass Mutual was that it didn't adequately explain to customers how withdrawals from variable annuities under certain circumstances could drain their accounts of value.  (See the SEC's press release at

Variable annuities involve the customer making periodic payments for a number of years and directing how the money is invested in a tax sheltered annuity. Eventually, the invested amounts can be used to purchase an income stream from the insurance company. The investments may do well or poorly.  To ameliorate the potential for poor investment returns, Mass Mutual offered an optional rider that, for an additional premium, gave customers a GMIB, or Guaranteed Minimum Income Benefit.  The GMIB guaranteed a minimum value that customers could use eventually to purchase an income stream, regardless of how poorly their investments did.

The GMIB could increase by 5% or 6%, depending on the rider.  Mass Mutual capped the level of the GMIB (through a somewhat complex formula).  Once the cap was reached, the GMIB wouldn't increase.  Mass Mutual also allowed customers to make withdrawals from their annuities before they converted the investment value into an income stream.  If they made a withdrawal before the GMIB reached its cap, the withdrawal would reduce the GMIB value (and the value of the invested assets as well), but wouldn't prevent the GMIB from continuing to increase.  However, after the GMIB reached its cap, withdrawals would decrease the GMIB and it wouldn't increase the next year.  Thus, making withdrawals after the GMIB reached its cap could permanently shrink the GMIB--under some potential circumstances, to zero.  According to the SEC, Mass Mutual didn't clearly explain how the GMIB, which might be thought by customers to be a guaranteed minimum value, wasn't guaranteed if the customer made withdrawals after it reached its cap.

Got it?  Pretty simple, right?  To be sure, after it was nabbed by the SEC, Mass Mutual did the right thing and eliminated the cap on the GMIB.  But if you furrowed your brow over the details of this annuity (and we've just summarized them--read the SEC's press release and order cited above for a gorier rendition), you should think twice--and then three times--and then four times--and then five, six, seven and many more times before investing in a variable annuity.

Universal Life.  The other example is in today's Wall Street Journal (Nov. 17-18, 2012, P. B9), which reports that low interest rates may require universal life insurance policy holders to pay higher premiums or face the cancellation of their policies.  Universal life is a form of permanent life insurance that allows customers to have life insurance coverage for long periods of time (i.e., longer than the perhaps 20 years allowed in term life coverage), often with flexibility in the amounts of the premiums paid.  Universal life also has an investment feature, and customers can use money from the investment account to help cover the cost of their life insurance.  As customers age, the cost of life insurance coverage naturally increases.  But today's low interest rate environment has been detrimental to investment returns, including those of universal life policies.  Many universal life customers are facing the need to pay increased premiums, or see a reduction of their life insurance coverage or even the cancellation of their policies.  Large numbers of universal life policies were sold years ago, before the Federal Reserve declared war on positive interest rates.  So the current low rate environment and its consequences for universal life policies probably come as a surprise to many customers. 

Insurance products like variable annuities and permanent life insurance can sometimes put customers into the middle of the complexities of the financial markets.  You're subject to many of the same risks as professional investors and traders.  But you probably don't have the same level of knowledge, experience, and information as they do.  Sophisticated insurance products can be labyrinthine mazes of risk shifting, and it's possible to run into the Minotaur.  Traditional insurance, which consists of the pooling of risks, can offer sensible protections.  But stick to policies that are easy to understand, because then you'll know what you're getting into.  Term life and fixed annuities can be useful for many people. Super dooper, turbo-charged complex insurance products that also invest your savings, pick up your dry cleaning and get the oil changed in your car are to be viewed cautiously, and then skeptically.

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