Journal of Financial Planning: February 2019
David M. Cordell, Ph.D., CFA, CFP®, CLU®, is director of finance programs at the University of Texas at Dallas.
Do you love to gamble? Is Las Vegas your favorite city? Does the top of your dining table flip over to reveal a blackjack table? Do you watch Casablanca periodically just to see the roulette scene? (For you younger planners, Casablanca is a great movie from the early 1940s when the only colors in the film spectrum were black, white, and gray.)
Well, I am not a gambler. Most of the bets I have placed have been on golf courses, and I have lost almost all of them. Turns out that golf is a game of skill rather than a game of chance. Besides, I never even understood some of the golf bets; I only join in because of peer pressure. My playing partners tell me what the bet is and how much we are betting. I just give them the money before we tee off to get it over with. It’s worth it to me not to have to play the whole round while thinking about losing a stupid bet.
I don’t participate in casino gambling because I know the odds favor the casino. If you play long enough, you will lose. Gambling on a horse race is a little different. There is a bit of skill involved, although it isn’t a skill I possess. When I bet on horse races, I view each bet as the cost of watching beautiful horses run. That way, I don’t feel bad when I lose my bets, which is what always happens!
You may enjoy the thrill of casino gambling. You may even rationalize that the fun you have is, on an hourly basis, worth your losses. But as a profit-maximizing behavior, betting against the house isn’t very smart. I never wanted to bet against the casino. I wanted to be the casino. If you’re the casino, the odds are always in your favor. The more people play and the more often they play, the more certain that the casino will win in the long run.
The Insurance Casino?
In general, casinos set their payoffs so that the bettor’s probability of winning, multiplied by the payoff on the bet, is less than the amount of the bet. In other words, on average they pay out less than the amount of the bet. How much less they’re willing to pay out is dependent on competitive pressures, marketing, and advertising, like dancing fountains and flaming artificial volcanos. (Free alcohol and readily available ATMs are also helpful in keeping volume up.)
Now consider the humble life of an insurance company. Like the casino, it operates on the principle of large numbers and deals with mathematical odds. Casino odds are strictly mathematical. The probability of rolling a seven with two dice is exactly one-sixth, for example, and it is the same for everyone. For insurance companies, a little more effort is involved. Actuaries use historical data and projected trends to make informed estimates about future outcomes.
Insurance companies also improve their odds of winning by employing underwriting standards. Life insurance underwriting is an obvious case of improving the odds. Companies simply reject applicants whose characteristics suggest they will have shorter-than-average life spans. Alternatively, the company may “rate-up” those applicants so that premiums are higher. The dollar amount of the payoff stays the same, but the premium (the cost of the applicant’s bet) is larger. Of course, the applicant who would otherwise be rated-up can sometimes reduce the size of the bet (premium) by, for example, losing weight or improving their blood pressure and cholesterol.
With a bet on a roulette wheel, the odds are always the same and the payoffs are proportional. A successful $100 bet pays 10 times as much as a $10 bet. In contrast, the size of the potential life insurance payoff is proportional to the premium only within ranges. That is, life insurance companies employ premium structures that provide volume discounts. We get a better deal—a better proportional payout—if we buy a policy in the next higher band.
As with the casino, the odds are clearly in favor of the insurance company, but financial planners advise clients to purchase insurance because of the possibility of a potentially catastrophic outcome for the client—the bad tail of the distribution—not the expected outcome for the average policyholder. Yes, the average roll for a pair of dice is seven, but there is one chance in 36 that the roll will be snake eyes. We recommend insurance in case the client rolls snake eyes.
With the casino bets, the casino and the bettor are on opposite sides; that is, either the casino will win or the bettor will win, but not both. With insurance, policy purchasers aren’t betting— they’re hedging. They don’t really want to win because receiving an insurance payment means that something bad happened. (Collecting a death benefit would be a lot more fun if it weren’t for the death part!) Essentially, when the insurance company makes a payment, it means that both sides lost.
Also, because the insurance company wants to avoid the moral hazard that customers may intentionally do something to trigger a benefit payment, they limit the amount of insurance in a way that eliminates the possibility that the customer could profit from the benefit-triggering event. They won’t insure a house for far more than its value, for example.
At the same time, clients try to avoid the “necessity” of collecting from the insurance company by avoiding events that would trigger a payment. For example, they park in well-lit parking lots to decrease the likelihood of theft or vandalism with the realization that, even if the loss is fully covered, the hassle factor won’t be. The client and the insurance company are on the same team, along with the agent or financial planner, in trying to lessen the probability that the insurance company will ever have to make a payment.
Join Your Client’s Team
Thirty years ago, I worked in the pension department of a large insurance company. I went on sales calls with agents who typically didn’t have full understanding of the complexities of retirement plans and products. One agent was different. He knew as much as I did. The first time I went on a call with him, he placed me on one side of the table, and he sat on the other side of the table next to the client, who was the owner of a small, thriving business. I explained the differences in the plans under consideration, and the agent asked pointed questions that put me on the defensive. I was certain that the agent knew the answer to every question he asked.
If the agent felt that my response was inadequate or unhelpful to closing the sale, he would restate my response with a bit of elaboration and ask me to confirm that his explanation was correct. The client, whose name was Eric, never said a word. Gradually, the questions became less aggressive and more positive. For example, “Will this plan give Eric the largest percentage of the contributions?” The agent began making affirmations like, “OK, I see,” and “that makes sense.” He would nod and say “uh huh” to my responses. Finally, the close. The agent put his hand on the client’s shoulder, pointed to one of the plans, and proclaimed with a confident air, “This is the best plan for us.”
Us? I had thought that the agent and I were “us” and the client was “him.” After the initial shock, I realized what happened. The agent had choreographed the meeting masterfully. He helped the client understand and examine the plans in a meaningful way while establishing himself as a valuable member of the client’s team. In the process, he showed how the insurance company could provide a valuable service that improved the client’s personal and business situations. We were all on the same team. It was a win-win-win result because the agent added value, effectively distinguishing himself from his peers.
Are You a Commodity?
The lesson of value-added can be extended to other financial planning products and services. For example, everyone understands the need for insurance, but they resent paying for it and often view it as money down the drain. But insurance isn’t simply a product. It is a tool of risk management along with risk avoidance, loss prevention, loss reduction, risk retention, and non-insurance transfers. Presenting insurance within a comprehensive approach to risk management that reduces or eliminates the probability of a financial catastrophe is much more valuable than merely selling an insurance policy.
Some clients think of insurance as a commodity because it is presented as a commodity. “For this coverage, Company X has the lowest premium. Sign here.” Planners who present insurance as a commodity essentially make themselves into a commodity. Companies differ in financial stability and quality of service, and financial products can be extremely complicated. Most clients are not equipped to distinguish among them. It is the planner who must explain, for example, the importance of naming a beneficiary other than the estate, the relative advantage of high deductibles, or the advantages of a life insurance trust. That is the value added.
If there is no value added by the planner, the client may as well purchase the product on the Internet, and the planner is just a commodity.