Everything You Never Wanted to Know about Life Insurance

by Glenn J. Downing, CFP®

Part 1

The fundamental reason to buy life insurance is because someone else is depending upon you for a living.  Plain and simple.  It is risk transfer:  in exchange for premium dollars, the insurance company will make a big payout at your demise.

The life insurance industry is one that responds to market demands.  In Part I of this series I’m going to give you a little history.  What kind of policy should you buy – term?  whole life?  In subsequent entries I’ll discuss the  other jobs life insurance can do for you, and talk a little about underwriting.

Yearly Renewable Term.  Original insurance contracts were for one year only – term policies, in other words, that had to be renewed each year.  As the insured ages, year-by-year the premiums would rise, reasonably enough, as one’s mortality age comes closer.  So fundamentally we have a bet here between two parties:  you make a bet that you’ll die during the time of insurance coverage, and the insurance company will pay out big bucks.  The insurance company bets you that you won’t die and they’ll get to keep all their money plus the premium you paid them.  Over time the House always wins, of course.  Insurers employ statisticians who know with fair precision when deaths will occur, and at what rate, so they know how much to charge for their product.

Whole Life.  Yearly renewable term policy premiums would, over time, become prohibitive – so the insurance industry came up with whole life insurance, which provides a death benefit for the whole of one’s life, and at a steady even premium.  Compared to the annually increasing term policy, one pays a fixed level premium, which is more money in the early years than is strictly needed to fund the cost of insurance (COI).  The insurance company invests those dollars and credits the policy with a cash value.  The cash value increases over time, until the cash equals the death benefit, usually at age 100.  At that point the policy would endow, or pay out to the owner.

Back in the ‘70s there was a company called A. L. Williams.  Their mantra was buy term and invest the difference.  Part time people sold the policies through multi-level marketing, like soap or vitaminsIn those years you could get a CD for 16%.  Jimmy Carter was President.  I remember queueing up at 6AM in Manhattan and waiting 4 hours to buy a tank of gas, and being glad to pay what was then an astronomical sum:  $40.00.

In that interest rate environment, the A.L. Williams people had a field day.  The internal rate of return on the cash value of a whole life policy is now around 3.5%, and was probably about 5% or a little more then.  So yes – sounded like a good thing to cash in the whole life policy, invest in mutual funds, buy a term policy, and invest the premium difference in mutual funds.  But there are two failings here:  first, human nature.  If it isn’t a bill, most people aren’t going to pay it.  So those extra dollars resulting from lower insurance premiums realistically didn’t get invested.  And money market and CD rates dropped.

Universal Life.  So how did the insurance industry respond to the thumping they were taking?  They came up with Universal Life (UL).  The responsibility for guaranteeing the death benefit was now removed from the insurance company and transferred to the policy owner.  As long as the underlying COI is met, the owner is free to pay as much or as little premium as he cares to, and at whatever intervals he chooses.  To illustrate a UL policy, the agent enters an interest rate assumption – and back then 12% was used commonly.  This means that a 12% return was expected on all of the cash value of the policy consistently for all time.  All of a sudden there wasn’t so much of an incentive to surrender your whole life policy and take your business to A.L. Williams – your agent could simply sell you a different, permanent policy.  These interest crediting assumptions weren’t sustainable over time.  Most of those policies issued with 10% and 12% interest rate assumptions have lapsed by now.  Why? policies look first to premium dollars to cover the COI, and if that is not sufficient, will cannibalize cash value.  The day there is not sufficient cash value to cover the COI, the policy lapses.  The owner’s only option is to pay more money into the policy.

UL policies didn’t exactly kneecap the buy term and invest the difference crowd.  A.L. Williams was eventually bought out by Primerica, which was in turn bought by Travelers Insurance, which was in turn bought out by Citibank, which in turn sold all its shares.  Primerica is now a publicly-traded company.  As far as I know they still sell on a multi-level marketing basis, meaning one’s sales up line gets a share of the commission, with the result that their policies are, from what I’ve seen, expensive.

Variable Universal Life.  Eventually the yield curve for interest rates became more normal, and the stock market started roaring in the 80’s.  The next life insurance innovation was Variable Universal Life.  This was an innovation on UL.  Instead of the insurance company investing the policy cash value in current money market and cash-type instruments, the policy owner had a separate account into which he purchased mutual fund like subaccounts.  The policy owner could be as aggressive or conservative as he liked.  I saw policies like these earning 12% to 15% for years on end.  But eventually markets correct, and the downturn at the end of the ’80’s, early 2000’s, and 2008 hit these policies hard.  If the policy owner thought, This is great – I made 15% last year, so this year I can back off on premium payments,  he’d have found his policy lost so much cash value that it became way underfunded during these downturns.

Equity-Indexed Life.  More recently the insurance and annuity world has gone equity-indexed.  Simply put, the insurance company says that they’ll credit you a portion of the market’s upturn after a year, but not all of it.  But . . . if the market turns down, they won’t credit you any interest, but you won’t lose anything either.  The earlier indices were all to the S&P 500 in one variation or another.  Say you bought a policy when the S&P index was at 2000.  The policy had a participation rate of 100% and cap of 13%.  At the end of one year the S&P was at 2400.  That is a 20% rise.  You would be credited 100% of the rise (the participation rate) up to the 13% cap – not all the gain, but a good chunk of it.  On the other hand, if the year ended with the S&P down to 1800, you’d lose nothing, and next year’s starting point would be 1800.

Insurance companies invest largely in bonds and real estate to pay for their long term obligations.  What they’re doing here is using some of the premium dollars to purchase options on the index.  If the option at the end of the term is in the money, they have the cash to pay the additional crediting to the policy.  If the option expires worthless, no matter because the policy isn’t going to be crediting with any gain anyway.

In Part 2 I’ll go into some of the broader financial application of life policies, and how to determine how much to purchase.

In Part 3 I’ll give my personal point of view in guiding clients with insurance choices.

Glenn J. Downing, MBA, CFP®

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