Playing Moneyball with Life Insurance
LFG Marketing | July 2019
Uncovering hidden value can give you a competitive edge. This was the message in Michael Lewis’ 2003 best-seller, “Moneyball: The Art of Winning an Unfair Game,” and the 2011 movie of the same name starring Brad Pitt.
In Moneyball, Lewis detailed the strategies used by Billy Beane, the general manager of the Oakland A’s, to compete against major-league baseball teams with deeper pockets who could afford to pay top dollar for the best players. Using a revolutionary set of metrics, Beane identified players whose value was “hidden,” then signed them for much less than all-star free agents or high-profile draft picks.
For example, Beane found that on-base percentage, instead of batting average, was a better predictor of offensive production. A player who hit .270 but also walked a lot was just as valuable as an all-star who batted .330, but rarely got a base on balls. The all-star commanded a big salary, while the .270 hitter could be had for much less.
Beane’s approach was met with skepticism from his peers; old-school general managers said Beane’s statistical models contradicted decades of accumulated baseball knowledge. But in the late ’90s and early ’00s the A’s were consistently competitive and profitable, largely due to Beane’s commitment to statistical analysis to evaluate and price talent.
Some baseball people still resist Beane’s “analytics,” but today, teams in every professional sport use sophisticated statistical studies to shape their rosters and determine strategies. Often, these deep studies uncover new insights that change the game, such as the emphasis on three-point shooting in basketball, or the increase in passing in football.
Moneyball in Personal Finance?
In a November 2015 commentary, Jason Hull, CFP, explains the critical element in hidden value:
“Inherently, the ‘Moneyball’ approach works because it takes advantage of the behavioral quirks of other people.”
In Beane’s case, his competitors continued to rely on traditional stats and the subjective assessments of their scouts. Even after Beane’s methods produced consistent results, many remained unconvinced; it was, “Don’t confuse me with your facts. I know what I know.”
Behavioral finance studies regularly uncover quirks in consumers’ money decisions. For perceptive consumers, these inefficient or irrational behaviors can be Moneyball opportunities to gain a financial edge.
Here’s an example: Hold onto your life insurance policies.
Persistency and Life Insurance
One approach to life insurance sees it as a necessary cost that should be eliminated as soon as possible. You buy only enough to meet the perceived needs of today, then drop it as soon as you think you can get by without it. Using this model, many consumers discontinue their life insurance coverage well before the policies are designed to end; they might buy a 20-year term policy, but drop it after 8 years, or surrender a whole life policy before their death.
At first hearing, this strategy might seem plausible, especially since many people ascribe to it. But it overlooks the economic fundamentals of life insurance.
Insurance, in any form, diffuses the risk of an unfortunate incident happening to one person by spreading the financial cost across a larger group. For insurance to work, the premiums have to be low enough to be seen as affordable, but also high enough to ensure that all claims can be paid. Actuaries, similar to Billy Beane, use statistical analysis to build pricing models for life insurance. Then, like professional sports teams, insurance companies compete in the marketplace, using their unique pricing formulas to attract policyholders.
While each life insurance company has its own pricing models, these models are built on four primary components.
The Moneyball factor in this mix is persistence. A life insurance company must ensure that the premiums collected will be sufficient to pay any anticipated claims. In a term policy, this means the likelihood of a claim occurring during the term, whether it’s 10, 20 or 30 years. With a whole life policy, the premium coincides with the assumption that the likelihood of a death claim is 100 percent (because the policy will be in force for one’s “whole life”). Through regular audits, state regulators compel insurance companies to repeatedly prove their ability to pay all potential claims.
But some policyholders will not hold their policies to maturity – i.e., they do not persist in paying premiums. When they surrender a policy early, the insurance company retains the collected reserves. Since a benefit no longer has to be paid, these reserves improve the insurance company’s profits.
Where’s the “hidden value” in persistence? A 2014 white paper by Daniel Gottlieb and Kent Smetters, “Lapse-Based Insurance,” explains:
“Life insurance companies earn substantial profits on clients that lapse their policies and lose money on those that keep their policies. Insurers, however, do not earn extraordinary profits. Rather, lapsing policyholders cross-subsidize households who keep their coverage.”
That’s the Moneyball insight: Persistency profits cross-subsidize those who keep their coverage. Or, to put it more plainly, the people who surrender life insurance early make it more profitable for those who keep it.
In term life insurance policies with level premiums, policyholders overpay relative to the annual cost of insurance during the policy’s early years, then underpay toward the end of the term. In a 20-year level term policy, the cross-over from overpaying to underpaying typically occurs in the eighth or ninth year. If a policy is surrendered in the eighth year, it means the owner overpaid for the entire period the coverage was in effect, which further improves the insurance company’s profit.
In policies that accumulate cash values, persistency profits are included in the dividends1 paid to existing policyholders. And these dividends include persistency profits from surrendered term insurance as well as cash value policies.
Every company has different persistency statistics and methods to account for its value in their pricing models. In general, persistency profits are a “reward” to long-time policyholders, which means the longer you hold the policy, the greater the benefits. For this reason, even consumer advocates who are strong in the “life-insurance-as-an-expense camp” caution against surrendering cash value policies that have been in force for a long time.
There are plenty of compelling reasons to keep a life insurance policy instead of surrendering it before maturity. When integrated with other pieces of your personal finances, life insurance can do more than protect against the financial loss of a premature death. It can provide supplemental2 income, allow the spend-down of other assets, guarantee3 an inheritance, fund charitable causes, help with long-term care and end-of-life expenses, and more.
If you understand the possibilities with life insurance, persistence is a Moneyball factor that gives you an economic advantage. Consumers who surrender policies early literally give their premiums to consumers who keep their policies in force.
1 Dividends are not guaranteed. They are declared annually by the insurance company’s Board of Directors. 2 Policy benefits are reduced by any outstanding loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59½, any taxable withdrawal may also be subject to a 10% federal tax penalty. 3 All whole insurance policy guarantees are subject to the timely payment of all required premium and the claims paying ability of the issuing insurance company. Policy loans and withdrawals affect the guarantees by reducing the policy’s death benefit and cash values.
Lifetime Financial Growth, LLC is an Agency of The Guardian Life Insurance Company of America® (Guardian), New York, NY. Securities products and advisory services offered through Park Avenue Securities LLC (PAS), member FINRA, SIPC. OSJ: 244 Blvd of the Allies, Pittsburgh, PA 15222 (412) 391-6700. PAS is an indirect, wholly-owned subsidiary of Guardian. This firm is not an affiliate or subsidiary of PAS. 2019-82022 EXP 06/2021