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Why Buy Whole Life Insurance?

One of the drawbacks of holding a modern currency is inflation. Inflation is often described as an increase in the price of goods and services, but it's really an increase in the money supply. To inflate means to increase the money supply. Specifically, it means an undue expansion of the money supply.

When the central bank inflates the money supply through the monetization of debt, it is buying up debt obligations of a government. For example, if the U.S. government needs money, it can issue debt obligations (bonds). These bonds can then be purchased by a central bank. When the bonds are purchased, the central bank uses money that it creates out of thin air. 

This eventually erodes the real value of the money you hold in your wallet or in your bank account. To overcome this effect, you'll have to purchase assets that can keep pace with the rate that the money supply is being inflated, or you need to purchase assets that are not tied to or dependent on the currency you are holding. 

For the purposes of this discussion, I'm going to focus on buying an asset that might keep pace with the rate at which the money supply is being inflated. One such asset is a properly designed dividend paying whole life insurance policy.

It's important to emphasize "properly designed". There are many whole life insurance policies on the market today. However, the most efficient policies use dividends and a limited pay structure. This means that the whole life policy generates a cash reserve based on a fixed interest rate plus a dividend that is the result of the insurance company's cash surplus generated by the insurance company's investment gains and a favorable mortality experience (fewer people die during the year than expected). 

Dividend paying whole life insurance tends to be grossly misunderstood as an expensive way to purchase life insurance. However, this assumption is largely inaccurate. The cost per thousand dollars of insurance would be the same as term life because your probability of death is the same at any given age regardless of the policy you choose to buy. The policy type doesn't determine your cost of insurance; various health and lifestyle-related factors do. What does change is how much insurance you buy over time. That will affect overall costs of the policy.

Whole life insurance, in its most basic form, is a way to purchase life insurance that allows the policyholder to self insure. A cash surplus builds up against the death benefit and decreases the net amount at risk to the insurance company. The net amount at risk represents the actual amount of life insurance you are purchasing from the insurance company. Over time, with whole life insurance, the cash surplus increases and replaces the death benefit you previously purchased. This has the net effect of reducing the overall cost of the policy because you are purchasing less death benefit over time.

This cash surplus is known as the cash value. The cash value is what most life insurance agents refer to as the "savings" portion of whole life.

A dividend paying whole life insurance policy uses two factors for interest crediting: the fixed interest rate which is guaranteed for the life of the policy and the dividend rate, which is not guaranteed. The fixed rate is highly sensitive to inflation. As inflation rises, the fixed rate in a whole life insurance policy becomes a liability because the rate at which the money supply is growing outpaces the fixed rate offered by the policy. This is fairly well known.

However, the dividend function of the policy enhances the cash value and acts to offset the effects of inflation. In an inflationary environment, companies need to offer increasing value in order to attract investment dollars. Insurance companies invest premium dollars they receive and seek out the best consistent yield given current market conditions. They then pass along the profits to their policy holders in the form of a dividend.

This explains why, historically, insurance company dividends have risen during inflationary periods and leveled off during periods of deflation. As inflation rises, the dividends tend to increase to reflect the increased profits of the insurance company. Policyholders are thus protected from the effects of inflation while earning a guaranteed rate of return.

Up to a point, this dividend is said to represent a return of premiums paid into the policy. Once the cost basis is reached, however, the dividend represents a tax-free gain in the policy.

An insurance company is willing to do all of this because, if the policy pays dividends, it is more often than not (but not always) a mutual life insurance company. A mutual insurance company is owned by its policyholders. Instead of being publicly traded, it is privately held. This also means that it works for the benefit of its policyholders and in some mutual insurance companies, high level management will own "stock" in the company (i.e. they will own whole life insurance issued by the company). This acts to further align the interests of management with the interests of policyholders.

To enhance cash values, a limited payment policy can be chosen. A limited pay policy shortens the time required to pay for the policy in full. Limited pay policies can be structured so that the policy is guaranteed to be paid up in 20, 10, or even 6 years. After the policy is paid up, no more money can be paid into the policy.

Dividends and interest accumulate and enhance the cash value. It's important to note that these limited pay policies are not policies designed to force the dividends to pay for policy premiums after a set number of years (also called "accelerated pay"-which became a common practice in the 1990s). Instead, these policies are a reflection of the old endowment contracts issued prior to the 1970s which guaranteed that the policy would be paid in full after a set number of years.

Because of the truncated payment period, cash value growth is accelerated and much higher fixed and expected interest rates are possible. To say it another way, more money is being placed on a compound growth curve in an accelerated manner relative to the death benefit. Which means, the policy becomes a virtual cash cow in very short order. These policies are not popular, nor are they widely discussed in financial literature. They are, however, simple and effective at creating incredible cash reserves with an attractive, steadily increasing, death benefit.

While a limited pay, dividend paying, whole life insurance policy may not win any investment awards for stellar double digit returns, it does provide a stable, steady, and secure foundation for consistent growth and a base from which to employ a more aggressive investment strategy. While I do not think that you can outpace inflation and experience real investment growth at the same time using this strategy, I do think this is one way to help fight the monster that is inflation.

This entry was posted on July 19th, 2010 by David C Lewis, RFC. Edits may have been made to keep this entry current. · 3 Comments · Insurance & Savings, Investing, Retirement Planning

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3 Comments so far ↓

  • In Sured

    Thanks for your article.

    Could you write a bit more about a standard WL policy vs a Custom WL Policy?

    I realize the number of payments is set with the Custom WL, but what are the other differences? I’m surprised in your article that it says that with the Custom WL, the dividends are not used to pay the premium.

    So where does the money that would have paid the premium from a standard WL come from? Are you in essence pre-paying the premiums that you would have paid until you were 100?


    • Ben

      In response to your question about dividends is that you can choose how your dividends are used. You can be paid in cash apply them toward premium payments or purchase paid up additions. Ideally you would use the dividends to purchase paid up additions on your policy, until the dividends became large enough to support your policy. In the case of buying paid up additions to your policy with dividends its similar to dividend reinvestment with stocks so that you receive compound interest.

    • David C Lewis, RFC

      The main difference is that a custom or limited pay whole life has a set payment period which isn’t affected by the dividend scale. Your dividends may be entirely devoted to building death benefit and cash value. An ordinary whole life, or any whole life, where dividends are being used to pay policy premiums is forcing the policy to try to do two things at once. With the custom or whole life policy, premiums contractually end after a set number of years. With ordinary whole life, they end at age 100 (or age 98 or 99, etc, depending on the policy).

      To answer your last question, yes, you are essentially prepaying your premiums with a limited pay or custom whole life if you want to think of it that way. You are putting up more money (up front) to pay for the death benefit. Incidentally, the money has a longer time to compound and this is why you always end up with more cash value with these policies–in many cases significantly more cash value.

Leave a Reply to Ben