Wednesday, May 6, 2009

Life Insurance - an off topic post

So a lot of blogs talk about life insurance. There are a lot of arguments of whether you should purchase term, whole, universal or other types of insurance. I am not going to detail what you should look at to determine whether you are going to buy insurance or what type. There are several personal finance websites out there that can answer those questions. What I am going to try and explain, some of the other things to consider, that I feel never get detailed in these various posts. This will also not cover variable annuities as I don't know a lot about them. Let's start.

Regulation
One of the things I like about insurance, and life insurance in particular, is that it is regulated at the state level. When I start hearing insurance companies pushing for federal regulation to preempt state regulation it starts to scare me. But what about AIG you ask? AIG's state regulated insurance subsidiaries were all financially strong. It was their Federally Regulated subsidiary, AIG Financial Products that blew up the company.

The states do regular inspections and audits of the books and records of their regulated entities. There are limits and regulations on reserves that need to be kept, and what the entities can invest in. A good example is National Union, the property/casualty subsidiary of AIG, was invested a good chunk in municipal bonds. Not real dangerous. I have not looked at their exposure on the life insurance side as I have never bought life insurance (single with no dependents).

Most states have a reserve fund that is designed to cover (at least partially) in the event of an insolvency. This has happened in the past and it is another reason why state regulators are so tough on insurance companies, politically it is never pretty explaining to your taxpayers and voters why your reserve fund is now zero.

Most states have limits on how much surplus can be dividended back to the parent. To explain better, surplus, are essentially accumulated profits in their insurance subsidiary. Pennsylvania for example, will only allow the sub to dividend at most 10% of their surpluses a year back to the parent. The sub wants to retain those surpluses as it not only gives a cushion, but also allows them to grow and sell more insurance.

Ratings
Forget Moody's, S&P and Fitch. These are bond ratings and are only indications as to the efficy of the companies ability to repay their debt. Insurance companies are rated by AM Best. While still a rating agency, AM Best determines the CLAIMS PAYING ability of the insurance subsidiary. Again an example, while AIG is essentially bankrupt, their insurance subsidiaries have A- ratings in their claims paying ability. Most other ratings are at the parent level, AM Best at the subsidiary level.

An am Best rating is a letter and roman numeral that rates the claims paying ability and accumulated surplus. If you stay with in the A range, (A++, A+, A, A-), these are considered excellent. B++ and B+ are still considered good but anything below that AM Best considers, Vulnerable, i.e. stay away. As an example, most companies restrict them selfs to companies of at least A- or higher.

The Roman numeral rates the accumulated surplus held by the company. Again, surplus is the accumulated profits they hold at that entity. While it is different for property casualty companies, most large companies require a size rating of VII to do business with. This means 50 to 100 million in adjusted policy holder surplus.

If you want further information, you can look at AM Best's website which gives a thorough explanation of their rating process. It can be found here. http://www.ambest.com/

Mutual versus Stockholder
Most insurance companies used to be Mutual, but unfortunately that has changed over the years as greedy CEO's saw the money their banking and investment companies colleagues were making over the years. A mutual insurance company is one in which its policy holders are the owners of the company. Yes, you have an insurance policy, then you are an owner and in fact are eligible for dividends if the company does well.

A stock insurance company is, as you guessed, owned by stock holders. This means the stock holders receive the dividends, not you. This also means they participate in stock appreciation, allows CEO's to receive options and incents different behaviours. Again, they are restricted in what they can do by State regulators, but this brings up the whole agency/principal/customer conundrum again.

As you can see, I am a little biased against stock insurance companies. Go figure in my professional life its what I mostly use but again, that is on the P/C side, not so much on the life insurance side. There are several mutual companies still existing. While I do not necessarily recommend any of them, I encourage you to take a look.

Return on Investment
One nice thing about Whole and Universal life is for conservative investors, you can get a nice consistent return on your investment. My brother in law has a whole life policy that he essentially makes a nice 5% to 7% a year including the last two years when most everyone else has been down in equities. Not a bad return when you think about it.

Insurance companies have very sophisticated investment departments that in reality are only surpassed by hedge fund managers. They also have more investment options then many mutual funds. For the longest time, large office buildings were for the most part financed by insurance companies and those insurance companies still invest heavily in real estate. As you can imagine, when you have a 30 - 40 year time horizon like in life insurance, it provides more options.

Hopefully this gives you some things to think about. As I remember more things maybe I will come back and edit this post. Just as a full disclosure, I am not an insurance salesperson. I know insurance because I purchase it for large companies (Risk Manager) as well as selling to insurance companies in former lifes. Take everything I say with a grain of salt but I hope this gives you some thinking points to understand. Good Luck!

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