Protecting Troops from Insurance Scams

The New York Times broke a story on July 20, 2004, about how several insurance companies and financial firms were scamming young enlisted personnel with inappropriate insurance and investment programs. The scam went something like this.

Near the end of basic training each new military unit is required to attend a compulsory classroom briefing on personal finance. The underlying idea may have been sound, but the execution turns out to be nothing short of a scandal. Since the typical drill sergeant knows less about insurance than my pet schnauzer, the unit commander would arrange for a local insurance agent to teach the class. This is the same guy who sits outside the AAFEX or Navy Exchange Department Store on your local base selling insurance and mutual funds.

In the class, the agent makes a short and sweet presentation explaining about different kinds of insurance, and then hands out forms for the individuals soldiers to complete and sign: “Remember, guys, you’re on your way into combat. This is the best way to protect your family and loved ones in the case a bullet with your name finds a home.”

Not knowing any better, most of the recruits sign the forms. Consequently, the agents have a continuing source of fresh commissions, the commanders have met their mandatory personal finance education responsibilities, and the kids own a paltry insurance policy they don’t need and can’t afford. It’s pretty effective, especially since these kids usually know nothing about insurance. The irony is that neither do the agents nor the commanders who bring them in.

So here’s the straight skinny, right from the horse’s mouth: I am a licensed insurance agent and stockbroker for the State of California and a myriad of other states from coast to coast. Here is a fairly simple and straightforward strategy by which young military people (and their civilian counterparts) can identify and buy the actual type of insurance they need without getting ripped off.

Ask your insurance agent to explain the difference between various kinds of life insurance. He will tell you that there really are two kinds: temporary and permanent. Term insurance, he will explain, is the temporary kind, and is best suited for people who have temporary insurance needs, like protecting a house mortgage. Whole life insurance, on the other hand, is the permanent kind, and its derivatives are best suited to protect a person’s estate or to create and leave a meaningful estate for one’s heirs.

Your agent is regurgitating what he learned at insurance school. Before the state issued him his insurance license, it tested him extensively on this material, so there is a good chance he believes it.

Unfortunately, faith won’t make it so. Your agent’s justification for the existence of whole life insurance is pure, unmitigated balderdash.

To understand why this is so, let’s review some basic insurance principles. Let’s start out with pure insurance. From actuary tables representing decades of demographic observations, insurance companies can tell with a high degree of accuracy what the probable remaining lifespan is for a man or woman a given age and lifestyle. They also can determine how many men and women in a given demographic will die in one, two, or any specific number of years.

With this information, insurance companies can calculate exactly how much they must collect from a pool of living individuals over a given period of time in order to cover their overhead and pay the expected death benefits. They then reduce these numbers to the actual cost per thousand dollars of benefit, stated as a function of gender, current age, and lifestyle factors such as smoking and marriage status.

These tables make it abundantly clear that the cost per thousand for pure insurance goes up each year. This means that if an insured wishes to have $1,000 of coverage, he or she will have to pay whatever the cost per thousand is for that person’s age. If that person wishes to purchase $10,000 of coverage, then the cost is ten times as much.Since with every passing year, the insured is more and more likely to die, the cost of insurance goes up each year. At some point, the cost is exactly equal to the benefit, because it is virtually certain that the insured will die that year.

Insurance companies quickly discovered that the general public – lacking any useful background in mathematics – does not understand insurance, and tends to balk at paying an increasing annual premium for a shot at a fixed dollar reward. The argument that the value of the reward really increases every year as well – reflecting the rising odds of the insured’s family actually collecting the reward – was beyond the capacity (or interest) of the public to comprehend.

In response, insurance firms came up with a marketing solution based on the time-honored principle of telling the public what it wants to hear. They created a life insurance product with a constant annual premium, reflecting the cost per thousand dollars of coverage at the establishment of the policy. Then, every year, they reduce the coverage amount – the death benefit – so that its cost to the insurance company still works out to match the constant premium. Eventually, the odds that the insured will die in the current year approach 100 percent, meaning that the required premium equals the expected payout of the policy, and continuation of the policy becomes pointless.

This is decreasing term life insurance.

Since the effectiveness of decreasing term insurance is by definition limited by the age and demographic of the insured – in other words, since the coverage is temporary – insurance companies undertook to design a “permanent” type of life insurance. They soon found a solution.

The table that describes how a given decreasing term policy’s coverage decreases over time is called a decreasing term amortization schedule. Given such a schedule, one can determine how much additional money must be added to a fund each year so that the current insurance level, combined with the accumulated cash in the fund, exactly equals the original amount of insurance coverage. Add an amount to the decreasing term premium that constitutes a periodic deposit to this fund, invest the fund to generate a small-but-reliable interest rate, and the result is a level of coverage that remains constant over the years.

The system is designed so that, by the time the decreasing term coverage would have run out, the cash balance in the fund will be the same amount as the original coverage, and at this point there is no more need to make any deposits. Seen over its full amortized lifetime, this “insurance coverage” is permanent, because the insurance company can pay the original coverage amount whenever the insured dies.

Furthermore, once the policy is “paid up,” the firm can retain future interest earned by the fund, and simply designate the policy as a “paid up permanent policy.” When the insured dies, the beneficiary receives the money that the insured deposited plus the associated interest earnings, which – due to the typically extreme conservatism of such investments – usually reflect an annual rate of 1 percent or less.

This is whole life insurance.

In a variation on whole life, the insured pays a lower combined premium, and – if he lives that long – continues to do so past the point where the policy described above would have been “paid up.” The insurance company uses its actuary tables to set a constant premium such that the policy will be “paid up” the very year the insured is expected to die in any case. Depending on when death occurs, the company pays the current level of insurance plus the balance in the fund, which will at least equal the original insurance amount.

In effect, a whole life policy is nothing more than the combination of a standard decreasing term policy with a very low interest savings account, paying on the order of 1 percent or less of annual return. Contrast this meager return with what the beneficiary would have earned had the same amount been deposited over the decades in a 6 percent savings account, or in mutual funds paying a long-term average of 12 percent!

The “temporary/permanent” distinction between term and whole life insurance policies has become so pervasive that nearly everyone in the industry buys into the concept without really thinking about it. It is, nevertheless, a meaningless marketing trick that lines the coffers of insurance companies while divesting millions of insurance clients of the ability to invest effectively to support their retirement years and provide for their heirs. And in the case of young soldiers, these higher premiums take a disproportionate amount of their discretionary income away at a time when they are making as little as $1,104 per month in basic pay.

The bottom line: there is no other kind of life insurance but decreasing term.

Statements to the contrary are pure fiction. Since the real purpose of life insurance is to cover the remaining earning capacity of the insured, and since this capacity decreases with age, decreasing term insurance is a very good instrument to accomplish this. It is pure insurance, with no bells and whistles.

Sometimes one hears: “Buy term and invest the difference.”

While this is not necessarily bad advice, there is no financial reason why insurance should be linked in any way to investments. Why not keep the two entirely separate? Purchase decreasing term insurance for whatever needs to be insured against your death: your family’s financial security, the mortgage, whatever. Make your investment decisions with funds you have available for investment, because the investment is a good investment. Don’t tie it to an insurance policy!

An interesting loophole appeared in the array of policies offered by many insurance companies. A legally required provision of so-called whole life policies is that the insured be able to borrow against the “cash value” of the policy, the cash value being the current amount in the fund – which really belongs to the insured anyway. It turns out that if one makes a computer analysis of all the available policies, it is possible to structure a whole life policy so that you can lower your cost per thousand for the underlying term policy by immediately borrowing the accumulating cash value and applying it to the next premium for the policy. In this manner one can actually end up paying less per thousand for a given policy than if one were to purchase the term policy directly.

This unintended consequence came as a surprise to insurance companies. A major source of income for these companies is the profits they reap from investing the money from the funds, while retaining the difference between those profits and the nominal interest rate they pay to the policy owners. Since this twist prevented them from harvesting the lucrative profits they would otherwise receive from the accumulating cash values, many companies were quick to modify their policies to eliminate this loophole.

For would-be life insurance buyers, then, the best bet is to find and purchase the cheapest available decreasing term insurance – and you can’t beat SGLI. If you can find a so-called computer policy where using the cash value to lower the premiums actually results in a lower cost per thousand, go for it.

Congress has jumped in to “solve” the problem with legislation. But these are the guys who wrote the rules in the first place that gave the scammers access to young recruits. If they must legislate, let them force insurance companies to “tell the truth” about life insurance, so that nobody, and especially our young service people, is susceptible to this kind of scam.

A final note: life has its surprises. Most term policies have a provision for converting them to “permanent” insurance without any further medical examinations. This is a good deal for insurance companies since they immediately begin to earn their much higher profits on such a conversion. Should an insured discover that he or she has a terminal illness, however, switching to a “permanent” policy will lock in the current policy face value.

The extra cost over the short haul will be the price for guaranteeing a higher payout to the heirs, since the time of death is now a known factor (at least to the insured). In this case the exception to the actuarial tables works against the insurance company and benefits the insured.

Robert G. Williscroft is DefenseWatch Navy Editor