A closer look at whole life insurance |

A Closer Look at Whole Life Insurance

Posted February 10, 2012 by thomas

Here’s a little-known story: You ever heard of the expression “bought the farm?” When you say so-and-so “bought the farm,” or “bought it,” it means he died. The term comes from agricultural communities. Here’s how it came about: Farming has always been a debt-intensive business. Farmers traditionally borrow money from bankers to live on and plant in the spring, and pay off the loan with harvests in the fall. Their farms, of course, were the collateral on the loan. If the farmer died, though, the family risked losing the farm to the bank when the bank foreclosed it. This was an economic catastrophe for families, though – you couldn’t always just get a job in the big city in those days. So farmers worked to protect themselves.

How? They would buy life insurance policies, large enough to buy their farms back from the bank. The family would literally “buy the farm” with the proceeds from a life insurance policy. And so the term “bought the farm” became a euphemism for death – but also for renewal, because the family was able to keep the farm going.

In those days, term insurance as we know it today was comparatively rare. Farmers didn’t really “retire,” and needed to buy their farms back from the insurance company no matter how long they lived. The preferred mechanism was whole life insurance. Why? Because whole life insurance is permanent. And over time, as the farmers got older and paid into their policies longer, they were able to use their life insurance cash values to finance their farming. They didn’t need good credit with the bank – the life insurance company knows the policy owner will die someday, so they can cover the loan out of the death benefit. So it was the safest loan going. They didn’t need to fill out lengthy applications. They could contact their hometown agent, and the agent could issue a check on behalf of the life insurance company.

Farming has changed quite a bit, since the 1850s. But whole life insurance hasn’t changed much. It’s still built pretty much the same way as it was a century and a half ago:

Everyone dies.
All permanent life insurance policies will therefore eventually pay a death benefit, if they are kept in force long enough.
The insurance company must maintain a cash reserve at least equal to the probability of having to pay a death benefit in a given year.
The older the insured, the higher the likelihood of death.
The higher the likelihood of death, the greater the cash reserves against the policy have to be.
The insurance company can invest these cash reserves, and earn money on them.
The cash value grows over time, as the insured gets older. It earns money. Eventually, the cash value will reach the death benefit. At that point, the policy is said to “endow,” and the life insurance company just cuts a check for the cash value. You win! There’s no point in letting your cash value get larger than the death benefit. Enjoy the money! (Currently, whole life policies are designed to “endow” at age 121.
The policy owner can borrow against the cash reserves.
Because eventual death is a sure thing, so is the loan – the insurance company knows it can eventually take the balance due out of the death benefit before it sends the rest on to the family or other beneficiary.
Because eventual repayment is a sure thing, the insurance company doesn’t need to do any underwriting on the loan. They don’t care what your income is. They don’t care what you use it for. You can spend it on hookers and cocaine in Las Vegas if you want. Or you can just waste it! It doesn’t matter to the insurance company.
Because of this, cash value life insurance is a popular place for cash reserves. You can get at it pretty quickly – in a few days now, with modern communications. It’s much faster than most bank loans – and approval is guaranteed.
Meanwhile, your money in the policy earns a guaranteed rate of interest in a whole life policy. This isn’t going to be very aggressive – it’s a safe, guaranteed rate of return, roughly comparable to a CD or money market-type rate of return, except it’s usually free of income tax.
Most important of all, if you die prematurely, your family gets an immediate tax-free death benefit: The whole point of life insurance!

I can’t emphasize this enough – the main reason to own life insurance is for the death benefit. The fact that you can borrow against the cash value is a happy coincidence, and that privilege is there because of the death benefits. Life insurance also enjoys very favorable tax treatment under the law: Tax free growth in cash values, tax-free withdrawals or loans against policies, and tax-free death benefits – precisely because Congress recognizes the importance of the death benefits. Essentially, the tax-advantaged structure of life insurance policies equates to a tax subsidy for widows and orphans. Who are much more deserving of them than most, in our book.

Now, there are two basic ways life insurance companies can be structured – and that affects a whole life policy owner quite a bit. Stock companies are owned by their shareholders. Typically, they are publicly traded companies on Wall Street, though that’s not always the case. If the company’s investments do better than expected, or they pay less in death claims, or they can reduce operating expenses, the company will send a dividend to their stockholders.

With a mutual life insurance company, though, the corporation isn’t owned by stockholders, but by policy owners. The company will still try to make profits. And when it makes profits, it will also issue a dividend. But the dividend doesn’t go to stockholders; it goes to policy owners!

Although the source of that money is usually investment income, the IRS technically considers dividends to be returns of an overpayment in premium, and so dividends are tax free. If you let cash value accumulate for years, you can start pulling that money out, tax free, for whatever you like. You can make tax-free withdrawals of all the money your policy has earned – then start taking tax free loans against the policy past that point.

Considerations

Whole life insurance is great for those who have enough cash flow to aggressively contribute premium to the policy, and who need or want a permanent death benefit. If you are barely getting by each month, though, stick to term insurance for now. Since the whole point of life insurance is the death benefit, it doesn’t make much sense to get less death benefit than you really need to make the policy permanent.

If you have some money to save, though, and you want a solid, safe place for guaranteed safe money, and a cash reserve, life insurance can be a great match for some.

You do need a longer-term time horizon for whole life insurance to make sense. These are “front-end-loaded” products. The agent gets paid out of the first years’ premiums, so it can take time for the cash value in the policy to equal what you paid for it.

If you have a very long term time horizon, or you can fund the policy aggressively, though, you can get to the point where dividends in a mutual life insurance company pays your premiums for you! When this happens, your life insurance policy will stay in force, and maybe even grow, and you have no more premiums due. Once you get to this point, whole life insurance can become an extremely effective place to park savings, reserves, business cash flow, etc. More on that approach in a future article.

Tags: financial planner, insurance, risk management

Financial Planning, Insurance | thomas | 8:00 am

3 Comments

By Evan @ smartwealth, February 11, 2012 @ 10:05 am

my wife and I often pondered term or whole life, we decided on “longer” term life, getting us to retirement, and at that point we have 401k/IRA to fall back on.
By Andy Hough, February 19, 2012 @ 10:46 am

Interesting. I always wondered where the phrase “bought the farm” came from.

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