Negative returns until expiry

The success of life insurance is due not least to the fact that it provides the intermediary with an interesting source of income through substantial ? often one-off ? commissions payable as soon as the contract is concluded. commissions, which can often be paid once on conclusion of the contract. However, the so-called ?Zillmerung? also harbours liability risks due to a lack of transparency.
In the 19th century, August Zillmer had ensured that life insurance policies could be sold on a full-time basis by means of the Zillmerung procedure named after him. For example, in the case of a contract with a monthly premium of EUR 250 and a term of 35 years and thus a scheduled premium expenditure of EUR 105,000 until expiry, commissions of up to about four percent of the premium sum, i.e. up to EUR 4,200, are paid. Since these amounts are ultimately repaid from the customer’s incoming premiums, they are ultimately the cause of low surrender values or meagre returns over many years when a contract is terminated.
However, proponents of zillmerisation criticise unzillmerised contracts, where the acquisition costs are retained from each premium over the entire term: The last contributions would no longer be worthwhile because they no longer lead to a positive return by the end of the term. With Zillmerisation, on the other hand, the last premiums are no longer burdened with such high costs because they are already repaid at the beginning of the contract by the Zillmer procedure. However, this argument for zillmerization is completely misguided, as the following calculations show. Endowment policies do not run for just one year, but for 12, 20 or 35 years. But then, with a four percent Zillmerung, three percent running costs and 4.5 percent total interest, a single premium of 1,000 euros results in a maturity benefit of 1,577, 2,243 or 4,341 euros; the premium yield in relation to the 1,000 euros paid in is then 3.87, 4.12 or 4.28 percent. With a longer term, the initial costs become less and less significant. However, the following fictitious example looks much less favourable: The customer pays 1,000 euros once after 34 years, but is already being charged 40 euros in acquisition costs, which will be deducted with compound interest in 34 years from the then payable premium ? in addition to at least 30 euros in administrative costs ? be deducted. Then the remainder will bear interest at an expected 4.5 percent. 40 euros over 34 years would then add up to 179 euros, plus 30 euros in administration costs would be 209 euros, leaving 791 euros from the 1,000 euros of the last annual instalment paid, which would earn interest at 4.5 percent for one year and thus result in 827 euros or a minus return of 17.3 percent on expiry. The result looks even worse if the total interest rate is six percent: Then the compounded acquisition costs of the last annual premium installment add up to 290 euros, and the negative return on the last installment is 27.9 percent. Unit-linked life or annuity insurance policies are not exempt from these effects either, and the impact can be even greater here. With a fund yield of nine per cent, only the last annual instalment of 749 euros already accrued is missing because of the initial acquisition costs of 40 euros ? their negative yield then amounts to as much as 75.9 percent. Even if unit-linked policies cannot formally be described as zillmerised, they usually also have an allocation of acquisition costs at the beginning of the contract that corresponds to zillmerisation in effect.
High burden of premiums with acquisition costs
However, the effect of such contracts is not so transparent here at first glance: A contract (again calculated in a simplified way without death benefit) with a term of 35 years and an annual premium of 1,000 euros results in ? with the same acquisition and administration costs and the same overall interest rate as in the example ? 76,075 on expiry, i.e. more than double the contributions paid ? and yet only a 3.97 percent return on premium. However, if the premium payment is limited to 34 annual instalments from the outset, the maturity benefit is calculated as 75,248 Euro ? so only 827 euros less, although 1,000 euros of contribution were saved. And if only 31 annual premiums are paid from the outset, the maturity benefit is reduced to 72,485 euros ? only 3,590 euros less than if contributions were paid until expiry. The payment of the last four annual contributions therefore results in a loss of 410 euros. The reason for this result, which is certainly unexpected by the investor, is the high burden of premiums with costs, in particular acquisition costs. This leads to a reduction in the interest-bearing actuarial reserve ? and the surrender values ? and thus not only to lower guaranteed maturity benefits but also to lower interest surpluses. This is particularly disadvantageous for those customers who subsequently terminate or repurchase their contracts. Because those from the ? not paid at all ? The acquisition costs calculated for the full premium sum of the entire term have already been offset against the premium in the first few years and lead to ? not only at the beginning, but even intensified by compound interest effects over the entire term ? at reduced surrender values. It makes no significant difference whether the acquisition costs are offset against the premiums once by Zillmerisation or spread over the first five years.
Concrete offers from life insurers show the actual effects. An offer made by a life insurer at the beginning of March 2006 provides a guaranteed maturity benefit (sum insured) of EUR 42,509 for a 30-year-old with a term of 35 years and a premium-payment period of 31 years (EUR 1,000 annual premium), including currently declared current surpluses of EUR 63,668. With a full 35-year premium-payment period (i.e. EUR 4,000 additional premium), the guaranteed maturity benefit increases by only EUR 2,863 to EUR 45,372, with regular surpluses by EUR 3,312 to EUR 66,980. The loss from the additional four years’ contributions paid is therefore expected to be 688 euros ? If the guaranteed maturity benefit is taken as a basis, this is as much as 1,137 euros. This ratio may change again as a result of terminal surpluses. But closing surpluses can be cut back until the very end, so they are very uncertain. In addition, it is precisely in the case of the final surpluses that different modalities of allocation must be expected in future due to a ruling of the Federal Constitutional Court. The same provider gives for a 30-year-old with a unit-linked pension insurance ? also 35 years term and 1,000 Euro annual premium ? a capital settlement of EUR 107,100 for six percent fund performance and EUR 206,667 for nine percent fund performance. If the premium payment period is shortened by one year, this results in a lump-sum settlement of EUR 106,544 or EUR 206,791. The last annual premium thus leads to a minus return of 44.4 percent in the first case, and even 112.4 percent in the second case, i.e. less benefit despite more premium.
What the effect of early cancellation will be
If the customer waives the premium payment for the last five years with an expected fund performance of nine percent, the provider also forecasts a capital settlement of 206,313 euros. This means that the 5,000 Euro contribution of the last five years results in the end just in an additional benefit of 354 Euro, the remaining 4,646 Euro are used up because of the costs (see table on page 28). Life insurers measure their success in new business by the premium sum brokered. A contract with a monthly premium of 100 euros and premium payments for 30 years is thus worth twice as much as a contract with a monthly premium of 100 euros and premium payments for 15 years. Contracts with long premium payment periods are therefore also interesting for the insurer, even if most of them are terminated early. The effect of early encashment on surrender values for different premium payment periods is illustrated by an example. The table on page 32 compares two contracts with a premium-payment period of 35 years versus 20 years. Cost rates and zillmerization are as above, the total interest rate here is five percent; other than interest surpluses are not applied. The interest surpluses of the contract with the full premium-payment period do not exceed those of the abbreviated contract here until the end of the 30th year. Until the end of the 21st year, the actuarial reserve of the abbreviated contract is always higher than that of the contract that is continuously serviced with contributions. But even by the end of the 30th year, the actuarial reserve is only just under EUR 10,000 lower, so that it would not have been worthwhile to continue paying premiums until then. In the end, the contract with continuous premium payment yields 18,338 euros more, which is 3,338 euros more than the additional premium paid. The return on this additional benefit in relation to the additional 15 premium instalments is only 2.47 per cent, while the total return (premium yield) is 4.35 per cent over the entire term. The total return of the contract with an abbreviated premium payment period, on the other hand, is higher ? at 4.54 percent.
Additional effect Cancellation deduction
In the case of surrender values, the effects of lapse deductions are added. These are calculated, for example, as a percentage of the actuarial reserve at the lapse date plus a percentage of the scheduled premiums still outstanding up to the expiry of the contract. In the example in the table on page 32, one percent was applied to both as not unusual. This results in a much smaller impact of lapse deductions in the contract with abbreviated premium payment. This results in up to approximately 1,600 euros higher surrender values. Taking into account the further premium payment, the contract with abbreviated premium payment up to the end of the 30th year is more favourable in terms of the absolute surplus on termination, but also in terms of the return thereafter. Anyone taking out an endowment or annuity insurance policy should therefore obtain offers with a shortened premium payment period in addition to an offer with ongoing premium payment until the policy expires. For this purpose, he must demand (in an example calculation) the separate disclosure of the guaranteed maturity benefit or lump-sum settlement as well as the current and terminal bonuses ? The same applies to the projected maturity benefits and lump-sum settlements for unit-linked insurance policies. However, as a precautionary measure, the final surpluses should be disregarded in the assessment. The above-mentioned effects are all the more pronounced, however, if a contract is terminated prematurely and repurchased or made non-contributory. The acquisition costs are then already offset and reduce the surrender value or the premium-free insurance benefit. The German Association of Actuaries has determined that around three quarters of long-term policies are terminated prematurely or made non-contributory (see chart on page 31).
Transparency and broker liability
For the intermediary, the question of liability for incorrect advice arises. The Bond decision of the Federal Court of Justice is decisive here ? the advice must be suitable for the investor and the object: The product offered must therefore fit the customer and his investment objectives. With it also an information about the risks has to be connected ? according to the level of knowledge of the customer. A problem here: The security of a capital investment is usually connected with a renouncement of yields clearly above the usual capital market interest. The ?Zillmerung? leads however, for most customers at first not transparent, to a kind of total loss risk ? and such a risk is for decades to be cleared up. Liability in connection with acquisition costs can also come through the back door: Real estate, for example, is often financed through a combination of a fixed loan and the conclusion of a CLI for repayment at the end of the term. The basis for this are then model calculations with often optimistic (if not unrealistic) maturity yields ? the planned surpluses are then lower, and the acquisition costs had a greater influence on the performance of the CLI than originally planned. The broker of the model in particular is then liable for the financing gap, but not for reversal.
Johannes Fiala, lawyer, law firm Fiala, Freiesleben & Weber, Munich,
Dipl.-Math. Peter A. Schramm, actuary DAV and expert for actuarial mathematics, Diethardt
Courtesy ofwww. versicherungsmagazin.de

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Dr. Johannes Fiala
PhD, MBA, MM

Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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