[Editor's Note: This week is going to be all about whole life insurance. Regular readers know I'm not a huge fan of whole life as an investment and generally recommend against it in most situations. However, it is not without its benefits which make it suitable on rare occasions (although far less often than it is sold). Since nearly every physician will have whole life pitched to him at some point in his life, it is important to have at least a basic understanding of how it works. There will be 5 posts this week. This first post is a guest post from Bob Whitlock, an insurance agent and regular blog reader and commenter, who does a nice job explaining how whole life insurance works. While I've never heard Bob argue that an investor should invest primarily in whole life, he does see it as having its place in a diversified portfolio. The remaining four posts in this series are written by me and will discuss the “myths” of whole life insurance, exposing the half-truths that agents use to sell it far more often than it ought to be sold.]
In my experience, there are a number of misperceptions surrounding participating Whole Life Insurance, including guaranteed rates of return, dividends, and the Internal Rate of Return. I would like to address these issues and, I hope, clarify this confusion.
Defining Whole Life
First, what is participating Whole Life? It is a permanent life insurance policy issued by an insurance company to an individual where dividends may be payable. A mutual insurance company is owned by policyholders as opposed to a stock company which is owned by stockholders. The benefit of mutuality is that the company is operated solely for the benefit of participating policyholders who share in the better than guaranteed investment earnings and mortality experience in these policies through the payment of annual dividends. Dividends are not guaranteed, they are declared annually by the insurer’s board of directors.
A Whole Life policy is a unilateral contract between the policyholder and the insurance company. It promises that if the policyholder pays the specified premium, then a specified death benefit will be paid and that the cash value within the policy will equal the death benefit at a specified age (at which point the policy is said to “endow”). This age can be as late as 121, which is the age stipulated by the 2001 Commissioners Standard Ordinary (CSO) table.
Where Do Dividends Come From?
The three variables in the dividend formula are: 1) actual mortality vs. guaranteed mortality; 2) actual investment returns vs. the guaranteed interest rate in the policy contract, and 3) expense charges. Expense charges are often negative as they reflect recovery of expenses in excess of what is covered in the guaranteed premium. The guarantee is that the policyholder will have his policy endow at the specified age regardless of these variables if he pays premiums through the length of the contract (WL99 refers to paying through age 99, for example).
The guaranteed cash values are based on a calculation involving mortality costs, expense charges, and interest. Guardian sets premiums at such a level that it can guarantee that they will be sufficient to ensure your policy will endow at the specified age. Two key assumptions backing this guarantee are the interest rate and mortality table. The interest rate is 4% and the mortality table is 2001 CSO, which has very conservative (high) mortality rates. This means that if interest rates fell below 4% or mortality experience was worse than 2001 CSO rates, Guardian cannot raise your premiums or lower your cash value. The interest rate guarantee, therefore, does not mean your cash values will increase 4% per year.
Thus, for the participating policyholder, the only non-guaranteed element is the annual dividend. As noted above, the annual dividend is determined by the actual mortality experience, expenses incurred, and investment returns. The dividend interest rate used in the dividend formula is declared annually and is stated as a percentage. The annual dividend payout is apportioned to each policyholder based on their policy values and the policy issue class. As the policy ages, the guaranteed cash value and the cash value created by prior dividends left with the policy to buy more insurance (referred to as “cash value of additions”), increase. The cash value of additions buys increased death benefit, referred to as “paid up additions.”
Offset and Overfunding
As the policy ages and its cash value increases, policy dividends during the premium paying period generally increase assuming the same dividend scale in all years. Eventually, the buildup of dividends may become sufficient to pay all future premiums, at which point a policy is said to “offset.” Every policy has a “base” premium which purchases a “base face amount” of death benefit. As noted, dividends purchase additional death benefit. The policyholder may also elect to “overfund” the policy and purchase additional death benefit through the use of “a Paid Up Additions rider,” (PUA Rider). Since PUAs are immediate, so are the cash values they generate. Typically, 95% of the PUA is added as cash value in the policy year the payment is made.
Whole Life Investment Returns
The actual cash value of the policy—determined by the combination of guaranteed basic cash value, policy dividends, and rider additions—can be compared to the premiums paid and expressed as the Internal Rate of Return (IRR). While the IRR may be negative in early years due to the amortization of sales and issuing expenses, over time it may exhibit a positive return. [Editor's Note: The IRR will certainly be negative in the early years but will almost certainly be positive, at least on a nominal basis, eventually.] For example, in a WL99 policy based on the 2013 Scale in all years, the IRR over a 25 year period is illustrated to be 4.22% for a Male 35 Preferred NT $1M face amount with dividends used to purchase paid up additions.* “Overfunding” a policy is the practice of adding PUAs with the intent of increasing cash value, increasing the IRR, and/or early offset. Overfunding is subject to IRS limitations that, if exceeded, can result in a policy becoming a “Modified Endowment Contract” (MEC) with negative tax consequences.
Death Benefit IRR
When considering the IRR, the policyholder should also consider the IRR of the death benefit. If a policyholder were to make a single monthly payment and then die, the IRR of the death benefit would be astronomical. Over time, the IRR of the cash value and the death benefit converge so that towards the end of the policy period, they are nearly the same. The flexible nature of participating WL insurance allows the policyholder to choose their desired balance (within ranges) of death benefit and cash values (should supplemental income be desired).
*A hypothetical illustration of a policy issued in 1986 with gross premium, net single premiums and guaranteed cash values taken from published rate manuals, shows an IRR of 4.83% for the 25 year-period ending in 2011. Dividends up to and including 2011 are actual historical dividends that would have been credited to this policy assuming that dividends were applied to purchase paid-up additions in all years, and that no loans or withdrawals of policy values were taken. Dividends are not guaranteed; they are declared annually by Guardian’s Board of Directors.
[Editor's Note: For whatever reason, discussions about whole life insurance tend to generate more heat than light. Let's keep comments on this post restricted to a discussion of the mechanics of whole life insurance- i.e. how it works. Ad hominem attacks will be deleted. If you wish to talk about how bad (or good) whole life insurance or those who sell it are, save it for tomorrow's post.]