Friday, August 29, 2014

Life Insurance Myths Debunked: Whole Life

The common refrain from most mainstream financial experts is that Whole Life is too expensive, too costly, its a bad "investment", etc etc. Most of these reasons are false, as it demonstrates the lack of knowledge and understanding on how Life Insurance Contracts are engineered, constructed, and priced by Insurance Companies. This understanding does not fit into a pithy TV or Radio Soundbite, so it is understandable why there is so much confusion surrounding this topic.

I was reviewing an article titled, "5 Common Whole Life Myths, Debunked", and I also provided some replies to the posters of this article. NOTE: It is assumed that most of these posters are agents/or financial advisory types.

Here is some of the posts and my responses to those posts(The original posts are italicized):

ahardester- you have pay the salesman, the administrative costs to issue the policy and general overhead prefund reinsurance costs..

Robert Williams Jr
Ahardester's post is false. You must meet the IRS guidelines for the definition of the life insurance contract during the first several years of its existence. Placing 100% of the funds in a Whole Life Policy and pulling 100% of the funds out in less than 5 years acts as an Endowment. Most financial services reps know Endowments are illegal as per the IRS and TAMRA,DEFRA etc. The first several years covers that expense to ensure the insurance contract is just insurance contract not an Endowment.

Prior to the 1980s, Endowments were used heavily, the various tax acts in the 1980s removed this product out of the marketplace. This notion holds true for all permanent life products, as the surrender charges are high upfront.

Think about it: How would the insurance company leverage its assets if these long term contracts were that highly liquid in the first 0-5 years of its existence? Each policy holder would simply place money in a contract, and then remove the cash. The Insurance Company would be unable to loan out money for commercial developments, purchase bonds, etc etc. They would be unable to expand their portfolio to pay future claims. It makes no sense. This is why the surrender charges exists, the insurance company must look at all the funds and all the insureds. Its not some zero sum game.

Keep the policy contract for longer than 10 years, report back. The results are staggering. I have of no client who complains after 10 years regarding their permanent life insurance contract. Focusing on the first several years is horrible analysis of a permanent life insurance contract.

However, if you need the cash right away(e.g less than 5 years), it makes no sense to purchase any permanent life insurance contract, annuity, 401(k) plan and the like. It is a long term proposition. If this is a concern, utilize a different financial vehicle, like your savings at a credit union or a brokerage account.

In short, that post is a fallacious critique of a permanent life insurance policy, as it is tantamount to saying that a Porsche 911 is a poor vehicle because it can not carry hay in the back seat. Buy a pick up truck.

One of the biggest myths is that the cash value is "your money". It's not. It was never intended to be. It's there to support the death benefit and all the guarantees of the contract while also providing a profit to the company. Can you use it? Yes, but you should never borrow cash value that you can't pay back in a short time. The interest rates on loaned out cash value are hardly a bargain. And, if you don't pay the interest, it is added to the principal of the loan. Agents that don't fully understand and explain how a whole life policy works are doing the policyowner a great disservice and it results in questions like those that Hollywood poses. The author of the article owes Hollywood a proper response.

Robert Williams Jr
"The interest rates on loaned out cash value are hardly a bargain. And, if you don't pay the interest, it is added to the principal of the loan."

This too is slightly false. Most loans are done on a net or "wash" basis. With whole life policies, they are direct and indirect loans also. The loan interest rate is done with simple interest, as it does not reduce your compounding of the cash value. At death, the loan is taken off the death benefit.

"One of the biggest myths is that the cash value is "your money". It's not. It was never intended to be"

Ipso facto, this is correct. It is the beneficiaries' money. However, as the owner of the policy, one controls the cash value. Similar to someone who is a member/owner of a LLC. The Cash value is the over-payment of premiums in the earlier years, yet in the later years the corridor of insurance(The Net between the Cash Value and the Death Benefit) shrinks, making the actual amount for the insurance company to "pay out" at death smaller.

Since the cash value grows tax free and compounds, the IRS assists in this process of paying the insurance cost. In this case, one is actually "buying term and investing the difference", but the Insurance company and the IRS are sharing in the risk.

Discussing whole life when writing an article on life insurance for the general public is one thing that has caused people to be so confused that life ownership is now at an all time low!.

The fact is that for 95% of people TERM life insurance is the least expensive and best answer. Term life is used to: insure dependents to replace income, provide financial security for dependents, pay-off a mortgage, fund college, or for final expenses.

The typical profile of a term life insurance owner is someone who is a family breadwinner and has minimal savings. It is critical protection and easy to understand and buy.

One thing you can do is visit an online life insurance site to learn more about life insurance, and the better ones offer free quotes, allowing you to get rate comparisons for most insurance products.

Robert Williams Jr
"The fact is that for 95% of people TERM life insurance is the least expensive and best answer. "

This is a false statement on so many levels. First of all, term life is cheaper, under this one condition: If the insured dies within the policy "term" period. Since Insurance is based on statistics, econometric models and probability, these factors along with risk are some of the factors in pricing insurance. If the policy is "cheaper", then the probability or risk is lower for the insured's death. For example, if a 30 year old purchases a 20 year term policy, of course it will be "cheaper" than a Whole life policy. The probability is lower for the 30 year old to die in the 20 year term, vs a policy contract that runs to age 120.

Secondly, this quote totally ignores the notion of suitability. How does one possibly know what is best for 95% of the people 100% of the time? Is this agent/adviser omniscient? Do they have God like tendencies to know each person's resources, goals, wants, desires, etc? The BEST life insurance contract is the one that functions as promised in the contract and what assists the client to achieve their individual goals and objectives.

A video explaining why Whole Life Insurance is an economic Work Horse: