Sunday, September 5, 2010

(No.112) Gaming the system in hotels & life insurance

An article I saw in an economics journal looked at how companies hide fees and costs. The two authors (economists) concluded that sophisticated consumers have learned how to 'game the system' by having enough consumers around to subsidize them.

For example: you are attracted by an offer for a room at Hotel Nirvana for $75 a night, a room which costs the hotel $100 to provide. The person checking in behind you will rack up $70 in fees from the mini-bar, the phone and hotel parking (all of which cost the hotel $20 to provide). You used none of these. Hence the other person subsidized your room.

But getting cheaper goods and services subsidized by the uninformed consumer works as long as the sophisticated consumer knows what he or she could be charged. And it does not pay if too many people know the same thing.

But that may not be as big a problem as one might think since research has shown that even the most knowledgeable people can make dumb decisions although they have been provided with all the information they need to avoid doing so.

How does gaming the system play out in the life insurance business? Let's use first generation Term-to-100 policies as a case in point.

When T-100 policies based on lapse-supported pricing were introduced in Canada, the pricing badly over-estimated the level and rate of policy lapses that would occur. These policies were sold on the basis of offering lifetime protection but assumed -- indeed demanded from the perspective of the issuing life insurance company's financial interests -- that many Term-to-100 policyholders lose their lifetime protection and the sooner they lost it the better.

The sophisticated consumer held on to these policies -- and if you dear reader have an early Term-to-100 policy, hold on to it; it is worthy of Mark Twain's advice about land ("they are not making any more"). This created real challenges for those life insurance companies which had jumped into this market with what turned out to be seriously under-priced policies and thus tried to promote lapses of these policies or had to increase reserves on them or both.

Who were the life insurance consumers most likely to have held on to these policies, to have been sufficiently sophisticated to have refused to replace or lapse them? In my experience it was most likely to have been those policyholders who had career agents and brokers who were not only professional and gave good advice to clients but who themselves were sophisticated enough to appreciate what was happening with the companies and these policies.

In terms of this under-priced first generation T-100 business the better-managed companies pulled back. Great-West Life even pulled out of T-100 altogether providing an admirably frank explanation to their sales people of why the action was being taken.

A few companies tried to address insufficient lapses of their policies by going beyond promoting replacement of their T-100 policies by sales intermediaries to a tactic such as failing to send out an annual premium notice/reminder in the hope that the policy would lapse for lack of a timely payment of the annual premium.

A very successful and experienced Toronto life insurance broker, the late David Cowper, told me of a case where a client had a large T-100 policy (one sold to him by another broker). Cowper advised him to diarize when his policy anniversary date was and be sure to pay the annual premium promptly since he might not receive a timely premium notice if the company sought to have him (inadvertently) lapse his policy. Sure enough the policyholder received no notice but, thanks to Cowper's warning and advice, paid his premium on time anyway.

In this example, in terms of gaming the system -- and dealing with a company trying to game the system in its own interests -- both the policyholder and the broker understood that the price of this particular policy would have to be subsidized by other policyholders of the company and therefore that the company might seek to generate relief for itself.

And this fact underlines a reality of the life insurance market-place as real today as ever it was: some of the policies sold by life companies designed and priced to compete for market share and impress the financial services paparazzi with the company's volume of new business actually return low or no profit.

The premiums charged for such policies are, like the hotel room in my example, subsidized by (among others) the purchasers of life insurance policies priced by the company to actually return an adequate profit, say, a 15% ROE.


Alastair Rickard