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Whole Life Policy Returns

February 18th, 2011 · 9 Comments · Insurance & Savings

I somehow find myself getting involved with other financial advisers and personal finance bloggers who talk about whole life insurance. It's no secret that there is a big, fat, bold line that divides the cheerleaders from those who foam at the mouth over the very mention of the product.

Whole life insurance is an insurance policy with a rich history. Originally, all life insurance policies were just term life insurance. In fact, they still are, but that's a post for another time (maybe). Whole life insurance provides death benefits that are guaranteed by the insurance company. Unless the company specifically says otherwise, the death benefit of a whole life policy stays flat. This means that when you buy $100,000 of death benefit, that's what you get for your whole life (most generally).

OK, so, back to the term life connection. Well, there was a time when all life insurance was term life insurance. Customers were kind of happy. Their families were paid a death benefit when they died. But, if they outlived the term, the family got nothing. Term life insurance only lasts for a set number of years. After the term is up, the policy has to be renewed at a higher cost or canceled.

Well, policyholders became a bit disenchanted with the fact that they would pay premiums for many years and that their term policies might never pay a claim, so some very smart actuaries (professional mathematicians who work for life insurance companies) decided that they could inflate the premium over the pure cost of insurance and level out the premium payments to age 100. The death benefit would also extend out to age 100. Vwala, the first "term to age 100" or "whole life" insurance policy was born.

This was a good move on the part of insurance companies. You see, when you sell a policy like term insurance, you can't have a majority or even a healthy minority dying on you. You wouldn't be able to invest the money long enough to pay out a death claim to each and every one of them. Term policies are so cheap because the number of claims that are settled under a term policy are low. How low? The inside industry average is thought to be about 1 percent of all term policies issued will ever pay a claim. This is very good odds for the insurer. All they have to do is make sure they have enough money to pay 1 percent all of the term policies that they issue and build in a "fudge factor" in case they're off by a few percentage points.

But, if you suddenly do have to start paying claims, above your "fudge factor", you're screwed. It's a risk, but usually a manageable one.The only risk that could be better is a risk where the insurance company's risk of losing money (by having to pay a claim) decreases over time. This is exactly what whole life insurance gives the insurer.

But, it doesn't just benefit the insurer. It also benefits the policyholder. With a whole life policy, the term is set to age 100. The premiums are scheduled so that the death benefit can be paid for for the insured individual's entire life. But, providing life insurance to someone at age 100 would be so very very expensive. There must be a way to make this practical. How about a cash reserve? A cash reserve could be set aside to offset a known future claim (the death benefit). Since the death benefit term is set to age 100, there's an excellent probability that the policy will pay a claim.

This cash reserve, called a cash value, is set aside and becomes part of the policy. As the cash value builds up in the policy, the amount of death benefit that you have to purchase is reduced. In a way, you are self-insuring. The amount of death benefit that isn't covered by the cash value reserve is called "the net amount at risk." It's called this because this is the amount of money that the insurer stands to lose if you die. The company has to pay this money out without having a reserve set aside specifically for this claim. Of course, the company does have reserves and it can pay the claim, but it must rely on the fact that not all policyholders will die at the same time (to be more exact, the insurer cannot experience death rates beyond a certain maximum percentage of current policyholders).

As you might be wondering, the cash value of a whole life policy helps to make the insurer a bit more stable, since the money represents money that actually exists, and not some future investment potentiality. This money is guaranteed because the investment returns are derived from bond holdings and other income-producing assets that can be liquidated if need be to provide the benefits outlined in the policy.

Now we come to the returns of a whole life policy. Even though the cash value was never explicitly intended to be a savings, it functions exactly like a savings because of the nature of the cash value account. As these policies have evolved over time, they have become better understood. Today, there is no question about whether the cash value represents a savings: it does. A very real one. It's a cash reserve (which is a savings) that builds up against a known future claim amount (the death benefit) which may be used during your lifetime for any reason you want to use it for. In a sense, you're taking a cash advance on your death benefit.

Since the savings is invested in bonds and bond-like investments, the returns tend to be low, compared to equity (stock) investments. It's not uncommon to see whole life policy returns between 1 and 2 percent. However, some life insurance companies have emphasized the strength of this kind of policy design and offered to share the profits of the company with policyholders.

These companies, called mutual life insurance companies, pay dividends to their whole life policies. These dividends may be used to purchase additional paid up life insurance death benefit, which in turn builds more cash value which generates additional dividends which buys more paid up insurance which generates more cash value which...

...anyway, the effect of a dividend-paying whole life policy is incredible. By shortening the premium paying period to just 10 years, a dividend-paying whole life policy can produce a net rate of return between 4 and 6 percent annually (this is net of all fees and expenses of the policy). At those rates of return, you'll have a hard time finding a fixed-interest investment with that kind of potential. Of course, dividends are not guaranteed to be paid, but most mutual life insurers have paid dividends every year for the last 100+ years of their operation (including tough times like the Civil War, both world wars, the great depression, and the financial crisis of 2007-2008).

It's common for financial "gurus" like Dave Ramsey, and Suze Orman to rail into financial planners who even hint at the suggestion that whole life is a significant and important part of financial planning. Usually, I find that their arguments are out of context or misleading.

Like any product, whole life is subject to some caveats. There are good product designs and there are bad ones. There are whole life policies designed primarily for death benefit protection to age 100, and then there are policies designed for cash value accumulation. Lumping them all together would be like saying "all cars are bad" or "all stocks lose money." It's ignorant at best.

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9 Comments so far ↓

  • Nick

    I’ve spent the last few hours reading over your blog, everything you have said about whole life ins just confirms what Pamela Yellen “Bank on Yourself” and Robert Nash say about it. I am in the the process of getting my own dividend paying whole life policy with a PUAR through Guardian. I;m sold on the idea to help with my retirement. For those folks that think WL insurance is expensive get some more information about what is truly available through WL don’t just listen to the so called experts do your own research.

    Have a great day everyone.

    • David C Lewis, RFC

      That’s great to hear. I like Yellen’s ideas and Nash’s, though I think I might disagree on the particular application of some of their banking policies (and specifically, what kind of whole life to buy). The Guardian is an excellent company. Good premises and I hope everything turns out great!

      • Nick

        When you have a moment to comment I would like to hear your reasons and ideas.I am always up for more education about this subject.


        • David C Lewis, RFC

          I think it’s much too technical for the blog. It has to do with how life insurance is designed. I had to do a lot of reading and talk with an actuary before I figured this out. I do offer coaching sessions for those that want financial help. I also allow people buy sessions to learn more intricate details of financial products if they are really interested in it. I think life insurance policy construction is fascinating, but most people aren’t *that* interested in it. But, I do make that available.

  • Beth Haynes

    I would love to read your thoughts on the plausibility of “whole health” for catastrophic health insurance.

  • Beth Haynes

    forgot to check the follow-up box.

  • Beth HAynes

    What I had in mind was the idea of purchasing catastrophic health care as you do whole life—so that it is permanent and portable. This would be another alternative to the idea of health status insurance. The goal is to get health insurance that has a predictable cost over a long period of time , encouraging early planning with a guaranteed coverage.

    • David C Lewis, RFC

      What I had in mind was the idea of purchasing catastrophic health care as you do whole life—so that it is permanent and portable. This would be another alternative to the idea of health status insurance. The goal is to get health insurance that has a predictable cost over a long period of time , encouraging early planning with a guaranteed coverage.

      The closest thing I can think of is high deductible health plans. Individual plans are out there, and portable within the state you live in, but the system is rigged to favor employer-based schemes. I’ve devised a way for people set up a private plan and offset the rising cost, but it requires some significant cash outlay to start and thoughtful planning. With that said, the long-term results should be fairly stable.

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