THE EXPENSE MARGIN IN LIFE INSURANCE.

The principle of mutuality requires that the burden of expense in life insurance should be borne by all the members equally; but, even with the most careful adjustment, the allowance usually made is considerably in excess of what is needed in the regular companies doing business on the "level premium" plan.

It is customary in these companies to add to the net premium a percentage thereof to cover the expense account. This practice, though in harmony with the "commission system," is so clearly defective and so far removed from the spirit of life insurance mathematics, that it scarcely deserves even this passing notice.

It is generally understood that these corporations combine the functions of the savings bank and life insurance company, and it is only by separating the two in our minds as far as possible that we can obtain a clear conception of the laws that should govern the apportionment of the expenses among the great variety of policies.

While it is a comparatively simple matter to state the amount of either the insurance or savings bank element in a single policy, it is by no means easy, as things go, to classify the company's actual expenses on this basis.

Fortunately, we can pretty accurately determine what these amounts should be in any particular case.

In the first place, there are institutions in our midst devoted solely to receiving and conserving small sums of money; doing, in fact, exactly what our insurance companies are undertaking to do with the reserve and contributions thereto. These savings banks are required by law to make returns to the State commissioner, from whose official report we can get a very good idea of the expense attendant on doing this business.

Confining ourselves to the city banks, where the conditions more nearly resemble those of the insurance companies, we find in thirty-eight combined institutions for saving in the State of Massachusetts a deposit in 1888 of $192,174,566, taken care of at an aggregate cost of $455,387, or about 24-100 of one per cent.

The same ratio carried out for all the savings banks in Massachusetts gives a trifle over 25-100 of one per cent.; we may, therefore, consider ¼ of one per cent. as expressing pretty nearly the cost of receiving, paying out, and investing the savings of the people.

We must remember in this connection that in the popular estimation, the savings bank is an important factor in the public welfare, and in the towns and smaller cities there are often found public spirited men willing to give their services to encourage this mode of saving; but public sentiment has not yet given to life insurance the place which it is destined, sooner or later, to occupy by the side of the savings bank. Hence the services of able managers can only be obtained by a liberal outlay of the corporate funds. A satisfactory adjustment of the matter of expenses will, perhaps, do more than anything else to bring about this recognition on the part of the public.

In the case of the savings bank it is safe to say that for double the present outlay a liberal salary could be paid to all the officers. Following the analogy, we are led to infer that if this be the case in savings banks, then ½ of one per cent. of the reserve should be an ample allowance for the special labor required in the purely banking portion of the business.

In this we have the concurrence of the late Elizur Wright. In an essay on this subject he says:

"The expenses of the five largest savings banks in Boston, in 1869, did not exceed 4-10 of one per cent. on $28,000,000 deposited in them. They certainly had twice as many transactions, in proportion to the deposits, as any life insurance company could have with the same amount of reserve, so that ½ of one per cent. on the reserve seems to be ample for all working expenses save those of maintaining the agencies and collecting the premiums."

This need hardly be looked upon as an admission that it costs twice as much to care for the funds of a life insurance company as for those of a savings bank. A liberal expense allowance must be made at the outset, seeing that an error in this particular cannot easily be rectified after the policy is issued. The dividend, or, to speak more correctly, the annual return of surplus, will correct any overpayment on this account.

There is another expense which seems inevitable. This is the government tax on insurance companies, amounting in the aggregate to nearly 1/3 of one per cent. on the reserve.

When we consider that these institutions are intended to encourage thrift and to relieve the community from the care of numberless widows and orphans, it seems a clear violation of the principles of political economy to levy a tax on this business; still, whatever our opinion may be as to the justice or injustice of the imposition, the tax is maintained and must be provided for. Consequently a further allowance of ½ of one per cent. must be added to the net premium to cover the same, making a total of 1 per cent. of the reserve for banking expenses and taxes. Considering this point as settled for the time being, let us proceed to investigate the insurance expenses.

Here, again, we are fortunate in being able to refer to the official reports of a class of corporations doing nearly, if not quite pure insurance.

The assessment societies, outside of the fraternal and benevolent, reporting in 1889 to the insurance commissioner of Massachusetts, show outstanding risks amounting to $733,515,366. Losses to the amount of $7,270,238 were paid during the year at a cost for transacting the business of $2,403,053, which includes among other items "agency expenses and commissions," which amount to about $1,203,000, or 17 per cent. of the cost value of the insurance actually done. It would seem as if an allowance of 20 per cent. would be a liberal one in the case of the regular companies, which surely have as good facilities for doing business as the assessment societies.

As far as insurance is concerned, there is less difference between regular and co-operative companies than is generally supposed. Regular companies assess each policy in advance for a year's insurance at a time, while co-operative societies furnish insurance only from one assessment to another. The difficulty in the way of collecting the assessment in the latter case would seem to be greater than in the former, owing to the more permanent nature of the regular insurance contract.

In compensating agents the assessment companies naturally pay in proportion to the insurance obtained, inasmuch as there is no other basis to go upon, but regular companies usually pay the agent a percentage of the premium which includes a considerable trust fund over and above the assessment for actual insurance. It is easily seen that by the last method the agent's compensation increases in proportion to the amount of savings bank business forced upon the company.

To realize how far we are from anything like a scientific, not to say common sense basis for insurance expenses, we have but to examine the following list, which gives the ratios between the expenditures for general expenses in 1889, and those for the extension of the business. For every $100 used in a general way, the different companies spend for commissions and agency expenses: $37, $66, $67, $78, $91, $106, $110, $113, $120, $140, $157, $161, $173, $175, $186, $189, $200, $202, $222, $264, $311, $346.

It will doubtless be said that I am taking a very advanced position when I say that in the ideal life insurance scheme there is no place for the commission system. Solicitors will be a necessity only so long as they are in the field, but fifty years of life insurance has taught our community its true value and, thanks to the modern press, the institution it is no more likely to fall into desuetude than is Christianity or the moral law.

For the convenience of bringing the company to the individual, the latter should be willing to pay a fee. The man who renders another a service or puts his superior knowledge at another's disposal should look to the party benefited for his remuneration. Any compensation given for such service to a go-between by a mutual company is paid by all, and the question arises, Is the advantage to the company of sufficient importance to warrant the imposition of this tax upon all its members promiscuously? The following, from the Massachusetts Insurance Commissioner's Report for 1885, leaves no doubt as to the convictions of the writer on this important matter:

"The expensiveness of the life insurance policy is not because the level net premium is too high, for the premium is absolutely just, and the policy holder gets full value; but the complaint justly applies to the excessive expense charge. A person who wants insurance, life or fire or other, should be able to buy it at first cost without paying tribute of profits to middlemen. To that complexion the matter will finally be brought by the force of intelligent opinion, whatever resistance may be opposed by persons whose thrift lies in the perpetuation of the expensive system now in fashion."

It requires but a slight degree of prophetic vision to predict that in a very few years the companies in self defense will be obliged to change their method of compensating agents.

Several companies have already begun the reform by grading commissions; granting a percentage proportional to the amount of insurance likely to be done on the policy. Other companies have simply reduced the amount of the commission rate, thus virtually withdrawing from active competition.

This will, in a certain degree, explain the wide variation in the figures given above, where it is noticed that, in five companies out of twenty-two, the total agency expenditures amount to less than the general expenses, while in six cases the companies spend more than double as much on the former as on the latter. In either class we find representatives of the five largest companies in the country.

On applying the foregoing ratios to the business of the existing companies we find that, calling the theoretical expenses $100, the actual expenditures for 1889 were as follows: $112.67, $118.34, $150.40, $194.48, $208.16, $208.53, $228.66, $235.89, $248.44, $250.79, $258.33, $258.57, $265.14, $267.19, $267.92, $274.47, $294.17, $314.96, $335.70, $377.94, $616.70.

In this discouraging exhibit there is one ray of comfort. The combined assets of the two companies heading the list amount to over $100,000,000. There is no question as to their financial standing, and both show a large increase in membership over the previous year. I may also say here that it is a difficult matter to get at the actual "cost of insurance" in the various companies. Many of them, on their own acknowledgment, do not compute the advance cost of carrying their "amount at risk," and others, for reasons of their own, do not care to state the figures. In cases where the correct figures were not obtainable, I have assumed the cost to have been 1-1/3 per cent. of the mean amount at risk.

If we should, in our comparison, omit the actual agency expenses and commissions, the ratios would stand as follows:

Where I would allow $100 the companies actually used: $43.17, $55.90, $65.21, $77.21, $82.39, $88.34, $91.99. $91.98. $92.19, $94.65, $97.15. $99.55. $99.11. $102.86, $109.35, $125.05, $133.03, $141.92, $195.90, $207.06, $287.72.

As might be supposed, the first two ratios are those companies before alluded to. These companies might have doubled their advertising account and expended $300,000 between them on agents' salaries, and still have kept within my allowance.

Admitting, for the present at least, the reasonableness of the proposed allowance for the expenses of the banking and insurance departments of the business, we have before us the problem how to equitably adjust the burden among the great variety of policies.

In the first place, there should be no policy in the company that does not contribute its proportionate share of the expense allowance during every year of its life. I make a special point of this, for at present the policies which have become paid up, either by the payment of a single premium at the outset or by the completion of a stipulated number of payments, contribute practically nothing to the expense account after the premium payments cease.

The following plan, I think, complies with all the requirements of the problem. By the proposed method every policy, at all stages of its existence, contributes its exact share to the expense fund, whatever its plan of payment may be.

Let us, as an illustration, examine the case of a ten year endowment policy, taken out at age 30, and consider it under three aspects, first, as paid for in advance by a single payment, second, as paid by five annual payments, and third, as paid for annually throughout the term. I have used this short term endowment policy simply for convenience, the rule applying equally to policies of longer term or to the ordinary life policy, which is, in fact, an endowment policy payable at death or age 100.¹

Taking the case of the single premium endowment policy for $1,000, we find that the following sums are required, each year to provide for the care of the reserve and to pay the government fees (1 per cent. of reserve):

1st year $6.9982 6th year $8.4136

2d " 7.2560 7th " 8.7381

3d " 7.5258 8th " 9.0781

4th " 7.8082 9th " 9.4346

5th " 8.1039 10th " 9.8086

The insurance expenses should be covered by the 20 per cent. allowance given below:

1st year $ .4422 6th year $ .2566

2d " .4100 7th " .2076

3d " .3762 8th " .1556

4th " .3402 9th " .0988

5th " .2996 10th " .0344

Consequently the total contribution required from this policy each year is:

1st year $7.4404 6th year $8.6702

2d " 7.6660 7th " 8.9457

3d " 7.9020 8th " 9.2337

4th " 8.1484 9th " 9.5334

5th " 8.4034 10th " 9.8430

The present value of all these contributions is found to be, at 4 per cent. interest, $71.6394; in other words, this sum paid at the outset, provides a fund from which we may deduct the current expenses of each year in advance, and by accumulating the balance at the assumed rate of interest from year to year, we shall have enough to pay the anticipated expenses, leaving nothing over.

In the above case the sums in hand at the beginning of the year are as follows:

1st year $71.3694 6th year $42.6981

2d " 66.7669 7th " 35.3890

3d " 61.4650 8th " 27.5009

4th " 55.7055 9th " 18.9979

5th " 49.4594 10th " 9.8430

We find a somewhat different condition existing during the first years of a 5-year endowment policy. As there is more insurance and less banking, the requirements are as follows:

1 P. Ct. on Reserve. 20 P. Ct. on Cost. Total. Initial Fund.

1st year $1.5038 $1.2572 $2.7610 $12.9769

2d " 3.0406 1.0216 4.0622 23.6015

3d " 4.6503 .7852 5.4355 33.2979

4th " 6.3367 .5378 6.8745 41.9538

5th " 8.1039 .2996 8.4035 49.4594

6th " 8.4136 .2566 8.6702 42.6981

7th " 8.7381 .2076 8.9257 35.3890

8th " 9.0781 .1556 9.2337 27.5009

9th " 9.4346 .0988 9.5334 18.9979

10th " 9.8086 .0344 9.8430 9.8430

As the premium payments extend over only five years, the expense contributions must all be paid during that time and are most conveniently made by a uniform addition to the net premium.

The present value of the amounts in column 3 is $60.0819, and the equivalent annuity for five years is $12.9769. This amount, received for five consecutive years, will put the company in funds to pay current expenses and leave a reserve of $42.6981 at the beginning of the sixth year, which, as we have seen in the analysis of the single-premium policy, is the sum required for future expenses on the paid up basis.

In like manner we find that the 10-year annuity equivalent to the present value of the annual contributions in the case of an annual-payment policy is $5.534, thus:

1 P. Ct. on Reserve. 20 P. Ct. on Cost. Total. Initial Fund.

1st year $.8234 $1.3514 $2.1748 $ 5.5340

2d " 1.6473 1.2478 2.8951 9.0275

3d " 2.5096 1.1388 3.6484 11.9116

4th " 3.4124 1.0210 4.4334 14.1277

5th " 4.3572 .8916 5.2488 15.6161

6th " 5.3479 .7534 6.1013 16.3160

7th " 6.3853 .5966 6.9819 16.1572

8th " 7.4726 .4270 7.8996 15.0763

9th " 8.6127 .2418 8.8545 12.9977

10th " 9.8086 .0344 9.8430 9.8430

The present value of the ten yearly expense items given in the "total" column above is $46.6812, which is equal to a ten-year annuity of $5.534. The several premiums stand now as follows:

ENDOWMENT: $1,000, AGE 30, PAYABLE AT DEATH OR 40

Net Prem.² Margin. Total.

At single premium. $687.228 $71.6394 $758.8674

At five premiums. 150.615 12.9769 163.5939

At annual premiums. 84.172 5.5340 89.7060

By the actuaries' rate we have, with the customary loading for expense:

Single premium: $721.66 (loaded, $34.36). Five premiums, $188.70 (loaded $37.78). Annual premium, $105.65 (loaded $21.11).

Admitting the correctness of the new method, we must conclude that the present single premium is not sufficiently loaded to cover its own expenses, while the annual payment policy pays more than its just share. A prominent and thoroughly informed life insurance president says in this connection: "Many of the policies, particularly the short term endowments, are charged with too high a percentage of expenses to prove a good investment at maturity or profitable to the insured in case of surrender." This is not to be wondered at when the applicant for a 10-year endowment policy sees at a glance that he must pay, in the gross, more than is returned unless he should die in the interim, in which case a plain "life" or "term" policy would have answered the purpose. Under the new system of assessing expenses one form is as desirable as another, from the standpoint of the insured or the company.

The new premium for the 10-year endowment policy, $89.71, commends itself at once to the applicant, who can easily see that his total outlay must fall short of the amount ultimately to be realized, of course, disregarding interest and probable dividends in both cases.

In discounting the future expense contributions I have not taken the chances of dying into account. Hence the expense reserve in any instance applies only to that individual case, and, in the event of death or surrender before the maturity of the policy, the amount of the expense fund not used would naturally revert to the insured.

The scheme of expense assessment outlined above will doubtless be pronounced impracticable by the majority of insurance men.

Such a far reaching reform is too much to hope for, at least in the immediate future.

No well informed life insurance expert will deny that there are opportunities for improvement in the business, but to graft new methods on old companies is a hopeless undertaking.

It is well, however, to have new methods well matured in advance of the public demand, and I feel convinced that the ideas here set forth are in the line of the reform which, before long, must be instituted by the companies if they would retain the confidence and patronage of the community.

Doubtless many insurance presidents could tell of suggestions which have impressed them favorably and which they would gladly have adopted were it not for the injustice done thereby to older members and the changes necessary to bring existing contracts into conformity with the new system. Similar objections may be urged against the ideas here advanced, and I must confess I hardly see a way by which the present suggestions can be utilized by existing companies. We can only hope that sooner or later some of the new theories may be practically tested. Meanwhile the companies at present in the field are doing a great work for the good of humanity, even though their methods may be, in some particulars, more practical than scientific.

Winchester, Mass. FRANK J. WILLS.

[1]

The expense allowance on a plain life policy for $1,000, taken at age 33, would be about $5.29; net premium (com. ex. 4 per cent.), $18.04; total office premium, $23.33; present rate $24.10.

[2]

Thirty American offices. Discount from middle of year, Vx-½ or (M x 1.01961) / Dx.