A reader wrote to me:
I periodically read your blog and it seems like you have a strong grasp of the insurance industry. As well, given your background as a life actuary I imagine you might have some valuable insights on whole-life products. I am having a baby in the late spring and have been considering the right composition of my life insurance coverage (term vs. whole life), and have thus far had a lot of trouble making sense of the whole life math and why it is a compelling option for me. I have received quite a lot of data from an insurance broker with the IRR’s, cash surrender values at different periods, etc., but unfortunately can only get this data in PDF form without really understanding the assumptions behind how the cash surrender value grows, or how the dividends get calculated. In short, I have been unable to come to a more developed thesis than the idea that whole life is just a way to lock yourself in to a middling return while the insurance company benefits from your float and makes a spread off you, while taking insurance company credit risk for decades, with some benefit in the ability to pass down a decent amount of money tax free to one’s kids when they die.
How do you view whole life, do you own any yourself? If so, I’d love to understand your logic. I recently re-read part of Buffett’s 94 letter in which he states how he buys whole life policies from people about to stop paying premiums for more than the cash surrender value and can only surmise that somehow at the point he is buying them there is probably a higher IRR than in the beginning of the policy (which makes sense given the math I have seen.)
I am skeptical because I can’t figure out the answer, which makes me not inclined to lock myself in to a life-long financial commitment with an institution that might not be around in 70 years.
For most of my life, I have had term insurance. It was cheap, and protected my wife against an untimely death of me when we were less-than-well-off. At present, we are uninsured on my life because my wife has enough assets that if I die, she can fund the educations of the remaining kids, and live thereafter, with perhaps some work on her part. She’s really bright, but who would be smart enough to hire her?
In general, I think it is smart for young people to buy 20 or 30-year term insurance. It takes care of the period where your family is most vulnerable. You get coverage when you are young and healthy, because you don’t know what tomorrow will bring. Then save and invest to build up assets to meet the needs you may have when the term policy runs out. If you still need insurance at that point, and are healthy, get underwritten again for a new policy.
There is one place where a whole life policy can make sense. Sometimes mutual insurers use a portfolio method for interest rate crediting. In an environment like this, where interest rates have fallen so much, that means they are crediting to new money the same rate that they are getting old money. That is quite a bonus, so if you can find that, it may prove to be cheaper than getting a long term insurance policy.
As for the second reason to buy life insurance, it is one of the most enduring ways to scam the taxman. Death benefits are not taxed by the states or the federal government, and unless the person dying was the policy’s owner it is immune from estate tax.
This creates a wide number of vehicles that wealthy people use together with annuities and trusts to transfer wealth out of their estate, and into death benefit proceeds that will pass to their heirs outside their estate.
This is one reason why I believe the estate tax has to go. It does not accomplish its stated ends. The wealthy find all manner of clever ways to escape it. It would be far better to eliminate the ability to shelter income from taxation while they are living. Besides, the government needs the money now.
First, don’t worry about the credit risk, within limits, the state guarantee funds stand behind the insurance companies. For most people that should be enough.
Second, as for Buffett buying life policies, this is done only when an investor buys a policy from someone who is expected to live less long than the actuarial tables would’ve predicted at the time of policy issuance. The policy is more valuable than the cash surrender value; the investor attempts to make money off the difference.
This is a controversial area, and I am generally against the practice. It should not be legal; it endangers the tax favored status of life insurance, because it allows people without an insurable interest to benefit from the proceeds of life policy. That said, the market would go away if insurers were willing to deal more favorably with those who have impaired lives, and want to cash out their insurance policy.
Third, I have run into really advanced methods for scamming the taxman that involve asset-backed securities, trusts, and what else? Life insurance. In general, I think the U.S. Treasury should use their anti-abuse rules in order to invalidate these transactions, because they lack true economic purpose. That is, even if they are structured in such a way as to give the appearance of economic purpose, there is no reason that a businessman in his right mind would structure the business in that way, except to avoid taxes.
Finally, remember that the agent has a different motive than you. He wants to earn a commission. Commissions are low, and prices are easily comparable on term policies. There are services that will even do the comparison for you. The only way that an insurance agent will earn high commission is by selling a policy that is complex, not comparable to other policies, and builds up assets. The insurance company pays a high commission on such policies because they can earn investment returns off of the excess premiums that you pay in relative to a term policy.