Whole Life Insurance: Reaping Rewards Due to the Suffering of Others #3

Whole life insurance provides some of the best tax and financial planning benefits to the wealthy--it just comes at the expense of poorer individuals

Let’s say I told you that if you invested $100 I could give you back $105 tax-free at the end of the year with limited investment risk (realistic worst case you end up with $104). The downside is you have to keep your money invested the whole year before having access to it.

Would you make that investment?

As a diligent investor, you probably realize that you have to ask more questions.

Having read my previous post on the importance of understanding the relationship between risk and return, your first question should have to do with the risk of the investment relative to the return.

Sure, you could invest in the stock market instead and most likely end up with more than $105.

But there’s also a chance you could lose money by investing in the stock market and at the end of the year end up with less than the $100 you invested.

So while the average returns of my investment offering are lower than the stock market, they’re also a lot safer than stock market returns (i.e. less volatile).

So there’s value in having safety.

You might say that you could invest in a safe 1 year certificate of deposit (CD) from a bank and earn $105 as well. But that $5 gain is highly taxable, and you’d lose 40% of that in taxes leaving you with only $103.

So from a risk-adjusted, after-tax perspective, my investment offering sounds pretty good. It maximizes the after-tax return relative to the risk you’re taking.

At least to you.

The real downside to my investment offering is that while you invest $100 and get back $105, two other people will also invest $100 and lose money on their investment.

In fact, one of the main reasons that you are able to get the full $105 on your investment is exactly because the majority of people who invest will lose money.

If it wasn’t for them losing money, you would have to share some of your return with them. So instead of all 3 investors getting $101.66 each, 2 people will lose money on the deal just so you can get the full $105 and not have to share any of the benefits with the other two.

So you get all the benefits of the tax-free return and other people take all the risk.

The example, I just described is a microcosm of how whole life insurance works.

Whole life insurance is one of the best financial planning tools for wealthy individuals—especially since most can’t contribute to a Roth IRA. It gives them access to tax-free bonds with downside protection and guarantees that they cannot get elsewhere.

Wealthy individuals are getting 5% tax-free investment in bonds, with a tax-free death benefit for estate planning and large reserves and regulations backing their investment.

Unfortunately it comes directly at the expense of poorer, less wealthy individuals who purchase the policy and then cancel it.

In this post, I’ll do a brief overview of what whole life insurance is, how it’s priced, and then do a deep dive into the ethical ramifications of income inequality and what’s needed for a more just insurance offering.

What is Whole Life Insurance?
Whole life insurance is a form of permanent life insurance coverage that allows clients to pay a certain premium every year and get death benefit coverage for the rest of their life (as long as that premium is paid).

Since whole life insurance is more expensive than term life insurance, whole life insurance also includes a savings account type vehicle that accrues over time which clients have access to tax-free should they need it.

The insurance company provides this return to clients by investing in long-term bonds. Furthermore, if the insurance company is a mutual company, then it is sharing its profits with you in the later years via dividend payments into the policy. Both of these are tax-free since it is within a life insurance policy—(and the life insurance lobbyists were granted these tax-free benefits from Congress years ago).

So when clients pay premiums into a whole life insurance policy, expenses are first deducted from these premiums to pay the insurance company for providing the policy, and then the remainder is invested in the insurance company’s general investment account—which are primarily investment grade long-term bonds.

Every year, the insurance company credits interest and pays dividends to the policyowner’s savings account based on how large their account value is and how long they’ve had the policy.

So the more premiums you’ve paid into the policy and the longer you’ve had it, the larger your credited interest and dividend payments are.

In the early years of the policy almost no net interest and dividends are credited to the policy because the expenses are high.

While this is good for the policyowners who hold the policy for a long-time, it’s horrendous for clients who purchase the policy and then cancel it early.

And unfortunately, these are the majority of policyowners. According to Society of Actuaries’ lapse studies, around 50% of people who buy a whole life insurance policy will cancel it in the first 10 years and around 70%.

What’s even worse is that most clients are sold the high-commission version of whole life insurance instead of the low-commission version of whole life insurance.

As can be expected, high-commission whole life insurance has significantly higher expenses than its low-commission counterpart.

It has to have these high expenses to offset the high commission that was paid to the agent in the first year. After all, the insurance company has to make back their money somehow.

Below is a table of the IRRs by year for the first 15 years of a high-commission whole life insurance policy.

                     IRRs by Year of High-Commission Whole Life Insurance Policy

If you cancel a high-commission whole life insurance policy in the early years, the IRRs atrocious. Many of these policies take 12-15 years just to break even

As you can see from the table above, the high commission/high expense version of whole life insurance doesn’t even break-even until close to year 15.

And by then more than 50% of people have canceled the policy and lost money.

However, only ~30% of policyowners will keep the policy for the long-term.

And a small fraction of these policyowners will purchase the low-commission/low expense version of whole life insurance that offers greater returns.

Below is a table of the IRRs by year of ownership in years 15+ for clients who purchased a low-commission/low expense whole life policy:

                          IRRs of Low-Commission Whole Life Insurance Policy

A low-commission policy has excellent tax-free IRRs in the later years of the policy—which come as a direct result of the poor IRRs from people who cancel the policy early

As the table above shows, the tax-free IRRs from years 15+ are very high for investing in investment grade bonds without interest rate risk.

These high IRRs in the later years are largely due to the large dividend payments in those later years that the insurance company is sharing with the policyowners who kept the policy that long.

And as we mentioned before, the reason these IRRs are high is because the policyowners who keep the policy that long don’t have to share those dividends with the policyowners that canceled the policy.

Why is Whole Life Insurance Designed and Priced this Way?
After reading the above section you might be frustrated that whole life insurance is priced and designed this way.

It probably strikes you as unfair.

It will strike you as even more unfair when I tell you that the people who purchase the high commission/high expense life insurance policies and then cancel them tend to be from low and middle income socioeconomic classes while the people who buy the low-commission/low-expense whole life policies and keep the policy for the long-term tend to be from the higher income socioeconomic classes.

So in other words, poor Americans are being sold a product they don’t fully understand the value of and canceling the policy so that wealthy Americans can profit off of it.

In a typical whole life insurance policy, poorer Americans are paying into a system so that wealthier Americans can receive the bulk of the benefits

And the reason for these dynamic is entirely due to the commission structure.

When a life insurance agent sells a policy, he or she gets 80%-100% of the first year premium that the client pays if it’s a high commission policy and only 3%-5% of any premiums in the later years.

If it’s a low commission policy, which is better for the client, he or she will only get 15%-30% of the first year premium as a commission and almost nothing in the second years on of the policy.

This has 2 pronounced effects:
1) It incentivizes life insurance agents to sell large policies to poorer clients who may not be able to afford it or don’t understand how to benefit from the policy so that the agent can get the highest commission. There is no incentive to ensure that clients keep the policy for the long-term since the commissions in year 2 and onwards are so low. In fact, as long as clients keep the policy for at least one year, life insurance agents generally get to keep the full commission they earned in the first year.

Therefore in years 2 and onwards it’s more advantageous for the life insurance agent to spend his or her time trying to find a new customer to sell a new life insurance policy to so that the agent can earn 100% of the new policy premium as commission as opposed to spending that time working with an existing customer while only getting 3%-5% of that existing client’s premium as a commission.

2) It encourages life insurance agents to sell low-commission policies to wealthier clients so that they can get the case.

To break this down to you fully, imagine you’re a life insurance agent and you can either sell a policy with a $10 premium and get 100% of the premium as a commission, or a policy with $1,000 premium and get 10% of the premium as a commission.

Which policy do you sell?

Well the math here is simple. 100% of $10 is only $10. But 10% of $1,000 is $100. That’s 10 times more compensation.

The life insurance agent is better off selling the more expensive policy at a lower commission rate.

However, in order to sell the low-commission policy he or she needs to be able to find someone that can afford to pay $1,000. That’s significantly harder than finding someone who can afford to pay $10. But the life insurance agent can’t afford to stay in business by selling a low commission product to a client who doesn’t have much to pay.

So the life insurance agents that deal with the lower end of the market are forced to sell the high commission products.

And this is why you see everyone and their mother is trying to sell a life insurance policy on the internet with little to no understanding of how these products work. And their core demographic are people who can’t afford to pay much, but can easily be sold something they don’t understand.

On the opposite side of the market are life insurance agents trying to win large cases from wealthy clients.

And in order to capture these clients, these life insurance agents are selling the low-commission/low expense products in order to do so. If they didn’t, other savvy agents would clearly capture the case from them.

Income Inequality in America and Permanent Life Insurance
Rising income inequality is a topic that has garnered a lot of attention over the past several years—as it rightfully should.

The wealthy have access to numerous benefits that lower and middle income classes have limited ability to take advantage of: capital gains taxation, retirement accounts, tax deductions for businesses, real estate, investments, etc.

Permanent life insurance products like whole life are just another tool for the wealthy to grow their wealth while benefitting from the tax code.

What makes it more pernicious, however, is that the benefits accreted by the wealthy here are a direct result of individuals from lower tax brackets making poor financial decisions and being sold/buying products that they don’t fully understand or can’t afford.

It's basically like playing the role of Robin Hood but in reverse in a way that is symbolic of the plight of modern America.

Every day Americans are sold a bill of goods that if they just work hard and “do what the wealthy do” that they too can become wealthy. So they increasingly YOLO it on meme stocks, bitcoin, or whatever fad course an influencer is pitching online.

In previous generations the key to a good life was finding a good stable job in Corporate America. But today the cost of living is so high that a job in Corporate America is no longer sufficient to satisfy many Americans.

Everyone wants a way out.

Life insurance companies know human behavior and behavioral economics better than you do. They know that ~70% of people will cancel the policies they purchase and they use this knowledge to price and design life insurance policies that largely benefit the wealthy at the expense of unknowing customers who think they are making a good decision.

Policyowner behavior is a lot easier to understand and make money on than the market. I have no idea what the market will do in 10, 20, or 30 years. But I do know that people will continue to be sold bad financial products and make bad financial decisions for the next 10, 20, and 30 years. And that’s exactly what life insurance companies have built a business around for over 100 years.

In a capitalistic society it is not unheard of for benefits to be derived directly at the expense of another party.

After all, if I go to a store and am ecstatic at how cheap the goods I purchased there are relative to other stores, I shouldn’t be surprised then if I discover that the wages that store pays its labor are less than other stores providing the same goods.

The benefit I get from the low price has to come from somewhere—if it’s not due to the efficiency of the operation, then it must come from the price of labor.

But ultimately our behavior allows the store to continue to under pay its labor. If we were more concerned with the distribution of value here, we would only shop at stores that paid labor a fair wage—even if that comes at the expense of us being able to purchase goods cheaply.

In the example above, we are ok with us getting cheap goods at the expense of someone else paying the price for it in the form of cheap labor.

However, with permanent life insurance the middle class is led to believe that they are getting a fair exchange of value from it when in reality they are subsidizing the value of it for a small subset of wealthy individuals.

In reality, middle class Americans should not be touching whole life or permanent life insurance.

But if you’re wealthy, whole life insurance provides unparalleled risk-adjusted, after-tax returns for investing in bonds.

But much like other elements of American capitalism, these benefits are just coming at the expense of poorer Americans.

So if you’re wealthy, a long-term investor, investing in bonds and your advisor is not utilizing products like whole life insurance to your advantage, there are a breadth of financial planning, investment, and tax-advantaged opportunities you’re missing out on. So you may need a new advisor.

And if you’re not wealthy and an advisor is pushing permanent insurance products like whole life insurance on you, you definitely need a new advisor.

To learn more about how the wealthy properly utilize whole life insurance as financial planning tool, read our article here: Whole Life Insurance as an Investment and Financial Planning Tool - Making a 4.5% return equal to an 8%+ return for high income earners - Colva Insurance Services (colvaservices.com)

About the Author
Rajiv Rebello is the Principal and Chief Actuary of Colva Insurance Services. He helps HNW clients implement better after-tax, risk-adjusted wealth and estate solutions through the use of life insurance and annuity vehicles. He can be reached at rajiv.rebello@colvaservices.com

You can also book a call directly with him here: https://colva.youcanbook.me/