A Principal-Agent Model of Optimal Search Effort in Life Insurance Policy Replacement

1. A Principal-Agent Model of Optimal Search Effort in Life Insurance Policy Replacement James M. Carson William R. Cupach David T. Russell Presentation for the 2007 ARIA Meeting Quebec City

2. Motivation and Background of Discussion • “Policyholder Surrender Activity” (Russell) • Principal – Agent Issues (Ross) • Agent and “Agent” • Here: Agent as Representing Consumer • P-C Ins: Comp / Contingent Commission (Spitzer) • Cummins and Doherty (2006) • Cooper (2004, 2006) • Carson, Dumm, and Hoyt (2007) • Life Ins: Consumer Losses Linked to Misalignment of Interests • Compensation / Commissions—1st Year • The Insurance Forum (Belth) • Number One Factor (Skipper) • Effect of Compensation / Commissions…

3. Life Insurance Replacements • Surrender One Policy in Favor of New One (1035) • ~ Up To 1/3 of Sales • Agent Represents New Product as Superior • Also With Annuity Products, Etc. • Comp / Commission Perhaps  Misalignment(later) • Replacement May in Fact Be Good Idea: • Lower Mortality / Improved Pricing (Brown, 2002) • Higher Net Crediting Rates or Dividends • Availability of New, More Suitable Product • New Combination of Investments (Such as Mutual Funds) • But, When Inappropriate or Malicious ”Churning” or Moral Hazard of Agent

4. Footnote:Comparison with a “Refi” • Surrendering a Life Ins Policy Similar to Refinancing a Mortgage • Allegedly Superior Terms (lower cost) in Return for a Fee • Closing Costs in the Refi = Surrender Charge / Loads • Term Replacement Very Similar to Refi • Comparison of Old vs. New Payments is Relatively Easy • CV Replacement Somewhat Similar to Refi • Many Options Lost or Reduced in Value • Surrender Charge / Loads May Be Incurred Twice • Crediting Rate Comparisons and Premiums are Only Part of the Story

5. Factors Increasing The Principal-Agent Problem • CV Life Ins is Difficult, But Quite Rewarding, to Sell • Generally, Comm Only if Sale / Replacement • For CV Products, Commissions Can Be 50-125% of Base Premium, and 2-6% or More of “Pour-In” Premiums; These Premiums Can Be > $25,000 • For “Seasoned” Policies with $CV, Replacements = Big $$$ • Information Asymmetry: Agents Armed with Superior Information (Usually) Against Someone Who Has Already Bought the Product • Attractiveness of Replacement Sensitive to Assumptions

6. Factors Increasing The Principal-Agent Problem… • Policyholder Often Has Same or Lower Premiums, But Coverage and CV Growth May Differ Substantially Good Replacement?? • *In addition to serving two principals (IR and ID), agent acts to maximize own expected utility, causing the agent’s interests “to differ from those of the insurer and the policyholder” (Skipper) • Judging a “Successful” Replacement Might Take Time to Reveal Itself • If new insurer becomes insolvent—bad replacement?

7. Current Protections • Disclosure of Contract Terms • Replacement Questionnaire • Regulatory Scrutiny / License Revocation • Scrutiny of Agents by Insurer • Bad Publicity (Word of Mouth, New Websites Listing Complaints) • Threat of Private Lawsuits • But, can we improve, in particular, in the area of compensation? …….

8. Principal-Agent Model • Examine Properties of Optimal Compensation Contract Between Consumer (Principal) and Insurance Agent (Agent) • Level of Search for Superior Replacement Policy is Unobservable by Policyholder • Replacement Decision Differs From Classical Problem in that: • Comp Determined by Other Party (IR), besides Consumer • Consumer Doesn’t Know Type / Amount of Comp • Since Compensation Not Negotiated, No Opportunity for Consumer to Design Comp Schedule to Encourage Optimal Agent Behavior

9. Agent’s Objective Function

10. Case 1: Agents Suffer No Consequences from Failed Replacements If penalty function (R) is assumed to be zero for all levels of effort, the maximization problem becomes: Now, since search is costly and benefits accrue to policyholder, agent will minimize search effort:

11. Case 2: Agents Suffer Penalties That Do Not Benefit the Victim Let PDF of regulatory action be as in eq. (5), where: gamma is intercept term and higher values reduce chance of any reg. action Beta parameter such that more search effort reduces chance of reg. action Both depend on regulatory environment for the jurisdiction in question. For a given state of the world: Thus, if R >= 0, agents have incentive to expend at least some search, and consumers prefer strong regulatory environment to encourage agent diligence.

12. Help on the Way? • In Early 2006, the NAIC and ACLI Announced Some Headway in the Development of a Model Act for Suitability • Any Transaction in Life Insurance or Annuities To Be Subject to Suitability Standards • Iowa Passed Such a Law in 1997 • ALL Customers Included, Not Just Seniors • Without Financial Recourse for the Insured, Will More Regulation and IMSA Press Be Enough?

13. Implications of Our Work • While Regulatory Sanctions and Class Action Judgments Reduce Churning, It is Not Enough • Deceptive Practices Continue, Despite Signed Suitability Documents Required from Agents (LIMRA: Total Volume Approximately $25b) • Problem: Competition in the Market for Agents and Past Industry Practice Dictates Heaped Commissions

14. Alternatives to Heaped Commissions in Life Ins Replacement Transactions • Some Component of Commission Must Be “At Risk” (Held in Escrow or Recoverable) • “Contingent” or “Retrospective” Compensation • Salaried Employees……. • Insurer-Driven Replacements (Cannibalizing) • Agent Purchases Insurance Coverage or a Bond to Indemnify Policyholders Who Suffer Failed Replacements (Similar to 401(k) Trustees)