THE “WHOLE LIFE” BOX
WHOLE LIFE (WL) is the most “opaque” and complex
life insurance product ever created. By
design WL cannot be broken down into its different parts. This fact has long frustrated accountants and
technical types who crave clarity, transparency and factual disclosures.
The infancy of WL’s design dates back into the early 1900’s. Its design has evolved in many ways over the decades. The products sold forty and fifty years ago are different in many ways versus the WL products sold today. But still the basic chassis onto which various refinements have been added remains unchanged.
WL products and resulting illustration systems embody dozens of interrelated assumptions spanning decades. These are all bundled into multiple formulas the combination of which determines illustrated WL values.
These assumptions are never disclosed to buyers of WL products. Not in product brochures. Not in the footnotes of the illustrations buyers are presented with. Not in subsequent annual statements. Never.
Complicating matters further is the fact those who sell these products are also not “in the loop” relative to these assumptions. Nor are they ever informed as to how subsequent future realities compare to the assumptions built into the illustrations they presented to buyers in the past. Not that this deters a small but dedicated group of sales associates addicted to the sale of this life insurance product.
The reality is, by design, WL is a “trust me” product. Those not so inclined should never purchase WL. If they do they will be forever frustrated in their efforts to understand what they have purchased.
So WL is not suitable for sale to those who wish to understand the products they buy. While not a perfect analogy, the ideal buyer would be similar to a car buyer who only wants to know the car they buy will get them where they want to go, with zero concern for how the car’s engine works.
The combination of its design and undisclosed assumptions also make it virtually impossible to “compare” WL to other life products (or even to other WL products) in apple to apple terms. The information required to do so is simply not available. And the range of possible variations in the design of the WL product only further complicates this situation.
None the less WL is by default often the benchmark for comparison to other life products now on the market. The reason is no more complicated than the fact it is a product many people already own. The older the person the more likely this is to be true.
So the classic question likely to be put to anyone presenting more recently developed alternative types of life insurance to prospective buyers is: “tell me, how does this product compare to the life policy I already own”.
Therefore some method for explaining how WL works is needed, even by those who have no interest in selling WL. Absent that they cannot address the question asked and their credibility with the prospective buyer will fade away.
As such it is necessary for any sales associate in the life insurance business to have a way to show prospective clients why this simple request is impossible to answer. Otherwise, the sales associate will appear to be either evasive, or poorly informed. Neither of which is ideal when trying to build a relationship with a new prospective client.
What follows is the allegory that serves to enlighten the prospective buyer while avoiding the need to spend hours trying to explain why WL is impossible to explain. After all, the prospective client isn’t asking for an in depth education in life insurance design.
Any attempt to educate the prospect to a level they will have a detailed understanding as to why no one can explain to them how the WL product they own works is doomed to failure. And, in order to compare what they own to what is about to be presented, it would require they understand what they own. Which they never will.
The following “whole life box story” has been reviewed by the actuaries of two of the nation’s largest life insurance companies and it has been pronounced “generally accurate” and suitable for use in training life insurance sales associates and for use with clients.
It avoids complexities and focuses on a more conceptual approach to understanding how WL works. It has proven to be useful to hundreds of life insurance sales associates and thousands of WL product owners of a span of many decades.
What follows is an allegory I evolved to explain WL to anyone wishing to understand what they owned or were being shown. It’s been reviewed by the actuaries of two of the nation’s largest insurance companies and pronounced “generally accurate” and suitable for use for training associates and for use with clients.
I hope it proves useful.
“THE WHOLE LIFE BOX STORY”
The best way to explain whole life is by making an allegory to a fictional private club whose finance committee has just proposed an idea for consideration by its members.
This club has 1,000 members; all male, non-smokers, age 35, doing well economically and with families that depend on them. The very reason they belong to this club is because they have so much in common.
The finance committee has proposed, and its members have already voted to approve a new program. The plan is for each member to pay $1,000 per year into a fund (a box) with the agreement that when a club member dies their surviving family will receive $100,000 from the fund (box).
The goal of this program is clearly focused on helping the surviving family members continue to be able to function economically in the near term without the deceased club member’s ongoing income.
QUESTION #1: HOW MUCH MONEY
WILL BE PAID OUT OF THE BOX
The first question which is to be posed to the new prospect is: “how much will be paid out of the box”. Clearly, this determines the amount that needs to be accumulated in the box.
When most people are asked this question they think in terms of the upcoming next year. So, if they guess at all, they will usually say between $100,000 and $300,000. Meaning they feel only a few members are likely to pass away in the upcoming year which is a logical assumption since the members are all so young.
That said, the correct answer is $100,000,000 since over time all thousand club members will die. The point is while the $1,000,000 paid into the box each year sounds like a lot, its peanuts in terms of the total promise being made.
Clarifying this usually finds the prospective client being told this story caught off guard. Which is good because that tends to get them thinking. It therefore ratchets up their level of interest in the tale being told.
QUESTION #2: HOW MUCH DOES
THE INSURANCE COST
The next question ends with even a greater impact than the first.
The fact is while it is by design a death benefit product WL is almost always presented as a savings plan. The reason being it also has a cash value component.
As such, most prospects when presented with a life insurance illustration ask: “how much does the life insurance in this product cost me”. This is true with any life insurance product that has a cash value element.
The thought being they could earn more in a product with no expense being deducted relating to the cost of providing a death benefit.
A very logical assumption indeed. The problem is with WL there is no answer. Which puts the sales associate in a very difficult position indeed since the owner of the product, or the person being presented with a WL product for the first time, has no way of knowing this is the case.
The fact is the expense that will be incurred relating to the life insurance element in WL is a total unknown at the time of sale. And, it will remain so each and every year the client owns the product until the day they die.
Naturally, this is not an answer that lends itself to building trust in that it sounds ridiculous and utterly impossible to believe. So it must be addressed in a totally different way than would be possible if the amount could be known.
Sadly, based on a lack of training and actual product knowledge, the overwhelming majority of sales associates feel compelled to make up a best effort, albeit often convoluted and totally inaccurate explanation to address this classic concern. The explanations they come up with are a tribute to the creativity of these sadly under-informed sales associates.
Getting back to the story at hand, it turns out the best way to answer this perennial question is to continue with the “club” analogy.
The good news is this can be achieved by sharing a little vignette anyone can understand. One that does a great job of explaining exactly how the payment of death benefits impacts the cash values which build up in a WL product.
To set the stage for continuing with the “whole life box” story the sales associate needs to ask the person they are meeting with two more questions.
The first being; “assuming no one died during the first year how much money would be left in the box.”
NOTE: Keep in mind, we had a thousand members pay $1,000 each into the box that first year.
Most people when asked ponder this for a moment and arrive at the conclusion the full $1,000,000 paid into the box would still remain in the box. Clearly, if no one died and nothing was paid out the entire amount paid into the box should remain in the box.
Which allows the sales associate to ask the second “loaded” question accomplished by simply asking: “so you mean to tell me there was $100,000,000 in life insurance in effect for an entire year on a thousand people and it didn’t cost anyone a thing?”
A question that really gets the person the sales associate is meeting with thinking. On one hand it seems ridiculous to assume that can be true. Clearly, having $100,000 in death benefit in force and promised to 1,000 club members adds up to that amount.
Still, the person being asked this question had just explained why the full $1,000,000 would still be in the box. And so a light goes on, so to speak. A light that allows the sales associate to have helped the prospective client understand how WL works in this regard.
So while it defied logic on one level that all of that life insurance protection could be provided at no cost, on another level the prospective client just explained it was the logical consequence of the facts presented. The sales associate is “off the hook” and does not have to appear either evasive or uninformed. Instead, the client has a new found respect for the first person that ever helped them understand a key point about a product they own (or are being presented with).
NOTE: That is exactly the way WL works. If no one died nothing is paid out so there is literally no cost for having provided the promised death benefit.
The usual initial result is a very confused look on the prospect or clients face. After all, on the surface this seems clearly ridiculous. Followed by an obvious look of enlightenment and understanding.
The real beauty of this approach is it allows the average person to understand why there is no cost for the insurance in effect unless someone dies.
The result is a person with no knowledge of insurance products and who most likely also had an inherent distrust of the sales associate sitting in front of them now views the associate as having educated them. Which gains the sales associate considerable respect.
The best aspect of this is the fact it allowed the one asking the initial question about how the product they owned worked to arrive at that conclusion for themselves.
Clearly, the sales associate would have no idea how many people have died, or will die, in any given year relative to any given WL product sold by any given company, including their own. So clearly the sales associate cannot provide an expense amount charged against the cash value to fund the death benefit.
So this answers the question; “what does the insurance cost”. The answer being, no one knows. And that’s OK since the prospective client understands why.
The only one in a position to have an educated guess on the amount would be the actuaries who design WL products and the executives that monitor death benefits paid. Information that is never shared with either the sales associates of any given company who sell WL products or those who buy them.
While this approach allows the average person to understand one critical aspect of a WL products design it is still just the starting point to explaining the inner workings of this incredibly complex product.
QUESTION #3: WHAT SHOULD BE DONE
WITH THE MONEY IN THE BOX
Getting back to the “whole life box” story, immediately after the vote to create this fund each member had written a check and placed it in a box on the Treasurer’s desk.
The question then arose, what should be done with the funds in the box. After all, there was a $1,000,000 in checks just sitting there. And no one expected ten members to die in the year to come. Clearly, there was more money in the box than was needed for the immediate future.
It was agreed by all that when the checks were cashed some of the money should be invested. Clearly, it made no sense to leave $1,000,000 just sitting in the box until it was needed to fund one or more death benefit payments.
So, the clubs finance committee was asked to interview a few money managers and present their choice at the next meeting, along with the chosen manager’s recommendations.
At the next meeting the finance committee chairman took the podium and proceeded to introduce the committee’s choice of money manager. A gentleman with an extensive track record and glowing recommendations from current and prior clients.
To refresh everyone’s memory the Chairman briefly reviewed the plan the members had voted to put in place for the benefit of members that may have missed the prior meeting. This was actually the first time the money manager learned about the purpose behind the funds that were available to be managed.
So as the money manager approached the podium a realization hit. The generic plan he had devised for managing $1,000,000 was not consistent with the purpose behind the funds he was to manage.
So, instead of going to the podium he turned to the committee head asking for a moment to confer. After that conversation he proceeded to the podium and explained to the audience of members the problem he had discerned.
The problem was he had no idea how many club members were likely to pass away in the next year or two, not to mention the decades that would follow. Meaning he had no idea how long the funds entrusted to him would be able to remain invested before they would be needed to pay the promised death benefits.
In short, the club needed to hire an actuary who could provide the money manager with that data. Only then would the money manager know how much of the money “in the box” must be kept liquid initially, and in the future, to meet death benefit payment needs. Which in turn would tell him how much could then safely be invested for the longer term.
So, the current meeting was then adjourned with the finance committee chairman giving the money manager permission to retain the services of an enrolled actuary. This is a profession with relatively few members who require extensive training and access to a large data base of mortality related informational facts. So while this expense was substantial it was necessary one that must be incurred.
ACTUARIES AND “BELL” CURVES
Prior to the next meeting the money manager was given a graph prepared by the actuary.
The graph indicated how many otherwise healthy, age 35 year old non-smoking males would be statistically likely to pass away in each future year, until such time as all thousand club members would have passed away.
Oddly enough, the graph itself was in the shape of a bell (it’s literally called a bell curve). The reason for this makes sense when the setup of the graph is understood.
On the left side of the graph, running from the bottom to the top, was a line with notations of increasingly large numbers (starting at zero at the bottom and increasing to 100 at the top). So the numbers progressively increased on that side bar line. They represent the number of deaths that might occur in any given year. The bottom line, running from the left margin to right, represented the years between age 35 on the left increasing to age 100 on the right.
The reason the graph resembles a bell is because initially only one or two members per year were statistically likely to pass away. So the line representing the number of deaths was at the bottom of the graph moving slowly to the right. However, as the years went by the number of deaths per year steadily increased. So the line crept upwards at first and then moving sharply upwards between ages 45 and 65, after which it levels off for a few years to age 70 near the top of the graph before beginning to sharply move downwards and to the right from age 71 to 90. Finally, the line was back near the bottom of the graph to the right and moved slowly downward to the right margin.
What the graph was reflecting was the relatively few deaths that would occur between age 35 and 45, the gradual increase each year until age 65, the leveling off at a fairly high number per year from 65 to 70 and the declining number of deaths per year after age 70. The decline occurring because fewer and fewer club members remained alive and kicking after age 70 and beyond so the number of deaths per year declined.
If the reader were to sketch out this trend the result would be in the shape of a bell.
NOTE: There is an age old joke deemed humorous by actuaries. It says out of any given group of a 1,000 people they can tell you the number of people that will pass away each year; they just can’t give you the names. Such is what passes for humor among actuaries.
INVESTMENT PLAN LOGIC
So, with the bell curve results in hand and now knowing the likely amount to be “paid out of the box” in each year to come, the money manager was ready to step to the podium and present a “plan” to the club members. A plan consistent with the need for a certain amount of liquidity to cover death benefit payments and with the rest of the money able to be positioned for the longer term.
Actually, the money manager intended to present two totally different plans. One featuring extremely conservative guaranteed investments that were lower yielding and the other presenting a far more aggressive and diversified portfolio with far higher yields.
The money manager explained to the members the very purpose behind the fund allowed for a longer term investment strategy. Explaining this was good news in that the use of a longer term investment focus would result in dramatically increased earnings.
He explained that while the reason the fund had been established certainly had nothing to do with accumulating earnings, there was a benefit to the members if higher yields were earned. The benefit being every dollar of earnings effectively would lower the cost incurred by the club members to fund the payment of the plans promised benefits.
The money manager explained he felt it was also appropriate to show the club members a far less complicated albeit lower yielding plan. This plan ignored a focus on maximizing earnings and instead focused on safety and guarantees. This allowed the money manager to contrast the pros and cons of each plan to the members.
So, instead of just one plan, the money manager presented two alternative for the members to vote on:
PLAN #1: This plan had a mix of asset classes; including money market accounts, treasury bills, bonds of various durations, mid and long term mortgages, and even a few leased office buildings. The average maturity of those assets was in the 20 to 40 year range.
On average, over time, only 10% of the assets in the fund (box) needed to be kept liquid (money markets and treasury bills) to pay expected death benefits. The remaining 90% would be positioned with a focus on maximizing earnings in those other asset classes.
The money manager explained this plan would have the longer term 90% of the money “in the box” placed in a mix of investment grade assets ranging from a low of BBB to the highest AAA ratings.
The money manager explained the longer the portfolio’s average maturity and the less liquid the assets; the higher the anticipated earnings level would be for any given asset class.
The proposed portfolio mix included a mix of bonds and mortgages, most with 20 and 30 year terms. Finally, about 15% of the assets would be invested in commercial office buildings to be leased out to Fortune 500 companies.
The plan would retain just enough near term liquidity to pay the anticipated promised death benefits based on the actuary’s bell curve. Unfortunately, the money manager explained the yield on the shorter term, highly liquid assets would be very low. But having only 10% in that category would minimize the impact of the lower earnings levels.
This money manager presented historical data indicating the proposed mix of asset classes and maturities would historically have yielded a 10% return (net of fees) over a typical thirty year time frame. This return rate was not guaranteed, but it was historically typical for the mix.
PLAN #2: The second plan was to keep all the funds invested in shorter duration, AAA rated and totally liquid instruments. Basically, money market accounts and T-bills.
The trade-off for this very conservative investment strategy was a dramatically lower average return anticipated to be in the range of 2% to 3% over the life of the money invested “in the box”. The positive was there was very little cost to be incurred when it came to investing in these types of assets and absolutely no need to pay a money manager.
The money manager explained the first plan was designed to maximize returns. It could do so relative to the plans intended purpose because it matched the duration of the investments to the cash flow model derived from the actuary’s bell curve. While illiquid to a large degree for several decades, it would become gradually more liquid over time when the bulk of death benefits were forecast to be paid out. The highest level of average earnings would occur in the first 30 years when the balances in the fund (box) would be the greatest.
The second plan was designed to be fully liquid at all times and ultra conservative in design with no focus on earnings. It ignored the fact the promise being made allowed for investing much of the plan assets in a longer term mode. It focused on absolute safety of the principal in the plan.
NOTE: In the life insurance industry there are WL companies that harp on the “sacred promise” inherent in life insurance and the need to honor that sacred promise by being ultra conservative in how assets supporting WL policies are invested.
These two examples exemplify the differences in how any given WL company invests its general account assets versus another WL company. And, more to the point, how this impacts those who buy their WL policies; which is our next point shared in the WL box story.
HOW LONG TO PAY
The money manager proceeded to explain a key point the club members before asking them to vote on which of the two plans they wished to adopt.
The key point made was this:
- Under “Plan 1” (the10% overall rate of return) club members would only have to pay $1,000 per year for the first ten years in order to fund the promised $100,000,000 in total future death benefits. The reason being this level of earnings compounding over many decades would provide sufficient funds to eliminate the need for club members to pay the $1,000 from year 11 on.
The money manager stressed this is not a guarantee. Instead it is a likely result based on historical norms for the mix of asset classes, maturities and ratings proposed in Plan 1.
The money manager pointed out the investment mix fit perfectly with the nature of promise the club was making to its members. It was a literal mirror of the bell curve. Meaning the timing of when the programs benefits would be paid out dictated how the funds available in any given year would be invested.
- In contrast, if Plan 2 (the 2% to 3% overall earnings plan) was adopted the money manager indicated his cash flow model showed club members would need to pay the $1,000 per year for 35 years to fully fund the promised benefits. On the plus side, the money manager noted, this plan would have lower expenses and it would eliminate the need to pay money management fees. The reality being the costs associated with owning longer term, less liquid complex assets were high versus the cost to own money market accounts and treasury bills.
The money manager explained under this plan the club would just put the funds in a money market account and T-bills. Historically, those asset classes would average the 2% to 3% over the plans anticipated 60 to 70 year duration. There would be no need to retain a professional money manager in order to implement or maintain this plan.
The money manager closed his comments by again noting the information provided by the actuary clearly showed there was no need to keep most of the funds liquid and available for the first few decades. The nature of the promise made fit ideally with a longer term investment strategy.
The money manager then turned the meeting back over to the finance committee chairperson who announced it was now time to take a vote. He stated a vote for the 10% plan was literally a vote to pay the $1,000 for just ten years. While a vote for the other lower yielding plan was a vote to pay the $1,000 for a full 35 years.
NOTE: Some WL companies tout their AA or AAA ratings, solely a function of how the premiums they collect have been invested, as their primary strength. Those ratings reflect the mix of assets making up their general accounts.
What those companies never mention is the fact their WL clients will end up paying far more to own a WL policy with them versus A rated, or BBB rated companies. That is the offsetting consequence of investing with a focus on AA and AAA ratings. The fact is A and BBB ratings are also considered to be “investment grade” ratings.
The question is; does such an ultra-conservative investment approach make sense when the very nature of the WL product finds the bulk of the benefits will be paid out many decades in the future as any bell curve created by an actuary would reflect.
And, the answer is no.
A focus on high ratings by a WL company is little more than a marketing gimmick. Worse, it’s a gimmick their clients pay for in terms of paying either higher premiums, or paying premiums for many more years.
AN UNEXPECTED TWIST (OR TWO)
As the chairman made the announcement it was time to take a vote, two club members in the audience began shouting and waving their arms as they ran up to the podium. Both of these club members indicated they wanted to withdraw from the program.
They each had a different reason:
- One stated he just separated from his spouse so he didn’t need to be in the plan until he remarried. As fate would have it, he could literally see his check sitting on top of the pile in the box that was sitting on a table in front of the podium.
- The second member announced he had just become aware of a scheme that sounded great to him. He could put his $1,000 into this other plan and have ten times that amount back to him by the end of the month. After that, assuming those return levels would not be available forever, he would then be happy to get back into this plan because he loved his wife and family.
This totally unexpected turn of events took the finance committee chairperson and the money manager totally by surprise.
The money manager once again huddled with the finance committee head; explaining why this turn of events presented a problem. After all, if the funds in the box could be requested back at any time, or if members didn’t have to pay the $1,000 each year, then none of the money in the plan could be invested for the longer term.
By default, if this level of liquidity were allowed to club members, then the assets in the plan would have to remain equally liquid. As such, there could be no “Plan 1” alternative.
The money manager explained there would be no way of knowing how much to keep liquid in any given year, including the first year, since any member at any time could request some or all of their funds be returned.
Even worse, the same problem would exist if it were possible for a member to just stop paying into the fund at any time in the future; at least under Plan 1 for the first ten years the plan was in effect, but remain able to benefit from the death benefit payment.
If either or both of the above were allowed there would literally be no way to model the cash flow into the investment pool. In fact, there would be no way to assure the funds required to honor the promise being made would be available when needed.
A VOTE TO RESTRICT ACCESS
TO PLAN FUNDS
After an extended discussion with the money manager and finance committee members the committee head returned to the podium. The problem created by the requests by the two members had been discussed at length.
The committee head informed the audience that a vote for the 10% plan would involve two added conditions or rules being imposed.
RULE #1; LOANS: Club members could not retrieve their contributed funds, or earnings thereon, from the “box” for at least ten years. Instead, the funds would be gradually made available after ten years depending on the level of earnings achieved and considering market conditions that might cause losses to result if assets had to be liquidated to fund loan distributions. Distributions would only be available in the form of loans for those wishing to remain “in the plan” so their families could continue to benefit from the death benefit promise. The funds in the “box” deemed “available” to borrow would serve as collateral guaranteeing the loans future repayment. Finally, interest would be charged on the loans consistent with the rate then being earned on the funds remaining invested in the plan. Meaning there would be no loss of earnings simply because funds were removed from the “box” to meet other needs of the respective borrowing club members. Any outstanding loan balance at the time a club member passed away would be deducted from the promised $100,000 death benefit. Essentially, that amount would be deemed to have already been distributed. The loan balance would be zeroed out at the death of a covered club member so no further interest payments would be due. Meaning only the net amount remaining after the club loan was considered eliminated would be disbursed to the surviving family.
Rule #2; WITHDRAWALS: If the available funds were instead withdrawn, or the club member failed to make their annual contribution during the first ten years (or longer if subsequently required) the club member would no longer be part of the plan and all contributions to date and earnings thereon not previously made available to the club member would be forfeited. Only when earnings in “the box” resulted in dividends sufficient to pay all the members annual $1,000 contribution would club members be allowed to skip subsequent contributions to the plan which would occur for all club members simultaneously. If withdrawals occurred prior to this time contributed funds or earnings thereon that had not as yet been made available would be forfeited. Meaning only the funds announced on annual statements as available for borrowing or withdrawal would be eligible to be withdrawn without being subject to forfeiture penalties. Any funds forfeited would inure to the benefit of those club members who remained in the plan.
Basically, this meant the club members needed to agree the funds they paid into the fund (the box) would be restricted for a period of time with no access. The finance committee chairman promised a schedule showing the gradually increasing percentage of each member’s plan assets available for borrowing or withdrawal over time would be made available to club members. It would be updated each year as earnings were realized on the invested funds “in the box”.
So, a vote for Plan “1” now included an agreement that the funds in the plan would be restricted as noted above. And, a vote for Plan “2” would mean the club members would be paying for 35 years (or more) and total liquidity would exist at all times for all club members who wished to drop out of the plan. This would also mean club members understood the plan itself might fail since it was entirely possible at any future point in time there would not be sufficient funds on hand to pay the promised death benefits.
NOTE: Ask yourself how you would vote.
If you picked the 10% ten year pay option you just voted to have the funds in a whole life policy restricted; as in voting for there to be surrender charges.
Surrender charges reduce the amount available in a WL policy to an amount lower than the total premiums paid to date and typically make zero funds available for the first few years.
People typically don’t like surrender charges, largely because no one ever explains the benefits they confer on the WL policy owner. However, once the purpose of surrender charges is understood my experience is most people decide they make sense and are necessary.
When it comes to the member vote in this story it should be no surprise to learn the final tally was 998 in favor of the 10% plan, with just two dissenting votes opting for plan #2’s total liquidity.
The bottom line is this. The higher the earnings rate on the invested assets (all other things being equal) the fewer the years members will have to pay into the plan to deliver the promised benefits. And, unless payments are mandatory there is no way to guarantee the benefits promised will actually ever be paid.
It’s that simple. So that’s how WL, a guaranteed product, must be structured.
Logically, most people would want their funds to be invested in such a way they could both access them if needed and earn the maximum return possible. But that simply isn’t possible with the promise made with WL insurance. The two “goals” are mutually exclusive.
Surrender charges are a must.
The singular negative when it comes to cash value access restrictions is the fact a small percentage of people will run into unexpected financial obstacles. They will sadly lose some or all of what they paid into their WL policy. Which is necessary if the majority of those who buy WL products are to benefit from the promises and guarantees it offers.
There is no way to sugar coat this negative. It is what it is. Still, the other side of the coin is, the vast majority of WL policy owners benefit by the imposition of cash value access restrictions.
NOTE: A full withdrawal effectively cancels a WL policy and a partial withdrawal has a pro-rata reduction impact on the death benefit.
It is the mandatory nature of WL premiums and the fact cash value access is severely restricted for a great many years that allows the money managers at the nations many life companies to invest the majority of WL premiums for the longer term and thereby maximize earnings and minimize required premium payments.
So that’s the “whole life box story” which is the only way I’ve found to help the average person understand how this product works.
THE REST OF THE STORY; PART 1: EXPENSES
Pivoting to the real world insurance companies have a myriad of expenses that must be paid for by their general accounts. It’s at this point where the oversimplified “whole life box” story begins to morph into a far more complex reality that represents the “rest of the story” as relates to WL products. A variety of expenses are inherent in the design and administering of life insurance products.
- Insurance companies must hire actuaries to provide them with the bell curve information they need to create internal cash flow models and the illustration systems used to sell WL products. These actuaries are often senior officers with a wider range of financial skill sets, product design responsibilities and executive duties.
- Insurance companies also hire the best money managers money can buy. Large insurance companies manage billions of dollars that must be invested from the general accounts (the box in our story). These are highly paid individuals.
- Insurance companies have substantial overhead related costs. Many employ thousands, or even tens of thousands of employees. Expenses include staff, rent, benefits and all the things that go along with running any business.
- A further complication and reality is large life insurance companies are often involved in a myriad of other businesses, some directly related to the business of life insurance and others with no relationship whatsoever to that business. These subsidiary businesses (or divisions) generate either profits or losses which impact the capital base and needs of overall company. Sometimes a major impact.
Clearly, in the “WL box” example the club will need to keep track of which members have paid the $1,000 into the “WL box” each year, and those who have not. This will involve sending out annual billings, maintain receivable ledgers, following up on delinquent club members and ultimately managing the forfeitures pertaining to those club members who fail to pay. These are clearly expenses that relate to the promised benefit. They have nothing to do with club operations. It is entirely possible the club would have to hire a new employee to handle these duties.
The same scenario applies in the real world insurance companies which may have tens of thousands, or even millions of policy holders to keep track of.
And, as is the case in the real world of WL, once loans are allowed (as cash values increase over time) the club will have to have someone to process loan requests, advance the funds, keep track of loan balances and bill the borrowers for the interest amounts they owe. This will require ledgers and bookkeeping functions to be completed that may be in place for decades. The availability of borrowing collateralized by cash values creates many complexities for a life insurance company. Large life companies have entire departments devoted to this area.
The club would also need to have someone who verified when death benefits should be paid. At a minimum a death certificate verifying a club member had passed away would be required. Files would need to be maintained so payments made in the past could always be verified as valid. And other departments would have to be advised so billings were discontinued and loan balances outstanding would be subtracted from the death benefit due effectively “paying off” the loan and ending interest billings. Again an expense that relates only to the promise made by the club, not to day to day operation of the club. It’s easy to imagine the number of people that might be employed by a large life insurance company to manage this area when tens of thousands or even millions of insureds are involved. And, in the real world, there are also issues of potential fraudulent claims that must be addressed based on the substantial sums of money that might be involved with any given life insurance policy.
Then comes the need to provide club members with an annual statement showing the values in the club members account (policy). This is clearly something real world companies must provide to each policy owner at least annually. These reports show the values accumulating in the policy, loans and interest activity, dividends credited into policies, as well as the death benefit amount payable which may increase based on the mechanics of dividend crediting.
Clearly, even in the over simplified “WL box” story there would be a need to hire staff to do this work. Staff solely preoccupied with the promised benefits to be paid from the money “in the box” who have no other duties pertaining to the operation of the club. Which means it’s only fair that these expenses be paid “from the box” instead of from the clubs normal operating funds.
And so it is that WL companies pay for these expenses from their general accounts. Meaning they either eat up a portion of the premiums being paid by WL clients or the earnings those premiums generate; or both.
And on and on it goes.
When it comes to the real world of operating a life insurance company there are literally hundreds, thousands or tens of thousands of staff level employees and executives working in these companies.
What this means is these overhead cost are “buried” in the values illustrated when a WL policy is sold and annual statements are created in the years that follow. However, there is no accounting for the impact of these expenses (or others) shared with those who buy WL policies or those licensed associates that sell them. These expenses are literally buried in the sense they are netted against the receipt of premiums and earnings in the general account.
It is fair to say that “generally” these and other expenses effectively reduce the earnings rate produced by invested assets to the extent those earnings can be converted to dividends payable into in force WL policies.
Relative to illustrations provided to prospective buyers there are multiple assumptions built into a WL policies design they are never made aware of. Some of them pertain to estimated future expenses that will reduce the dividend values that drive policy accumulations. These are never broken out or disclosed and the actual future overhead costs may prove to be higher or lower than those that were assumptions. Again, this is something those who buy and sell WL products will never know.
With the real world there is also an expense relating to the distribution (sale) of the life insurance products a company designs. After all, the promise of a death benefit payment to protect ones family is of interest to a large segment of the population.
Which gets back to the reason the “club” developed a program of this nature for its members in the first place. That purpose and thought process is very close to the reality behind how life insurance products and the companies that sell them came into being many, many years ago.
Relative to the WL box story, one could surmise other clubs upon hearing about the program might reach out asking if they too could participate. Which could possibly prompt the club to hire sales associates to solicit other clubs to participate in the program under the logic they might then be able to spread the cost of maintaining the program over a bigger base.
Thus creating yet another expense that must be built into the values illustrated and absorbed by the funds in the “WL box” (general account). That being the commissions or salaries paid to those who sell the idea.
And so the life insurance industry was born.
NOTE: The fact is, in the real world, regulators later came into the picture because the idea became so popular hundreds of companies began selling it. Regulators imposed requirements, including the need for life insurance companies to retain capital reserves. Reserves intended to assure the promised benefits would be paid. Funds not available for crediting into policy holder accounts. Funds that would offset problem investments, errors in the estimates of future earnings rates and or expenses, or mistakes in assuming the number of people who might pass away per year.
These are added issues that real world life insurance companies must contend with. Reserves come from either premiums paid, or the earnings on them in the general account; or both. They do not find their way into the policy values available to WL policy owners. They are considered as owned by the life insurance company itself.
The impact created by regulations on WL policies is complex and substantial. They have literally destroyed the viability of the product, at least in the context of its past ability to deliver favorable results. As such, aside from the brief comments noted above, there is a separate write-up devoted to this topic.
THE REST OF THE STORY; PART #2: OTHER DIFFERENCES
As previously referenced, the example used in the “WL box” story involved a club made up of all non-smoking males, the same age and in similar health. Each insured was promised the exact same amount of death benefit for the exact same premium amount. Which at a minimum would allow for the equal allocation of expenses and earnings between policies.
- All billings are the same.
- All benefits paid are the same.
- All policy account values, aside from loan activity, would always be the same.
This simplifies a great many things. In stark contrast in the real world all manner of insureds are covered relative to age, policy size, health issues, genders, etc. This wide range of differences serves to dramatically complicate matters on virtually every level imaginable for real world life insurance companies.
When it comes to the real world WL insurance companies insure people of both sexes, at a wide range of possible ages, including both smokers and non-smokers and including people with a wide range of different health histories and known health maladies. These people buy policies that range in size from $1,000 to many millions of dollars in death benefit.
Suffice it to say for the sake of this write-up those realities make everything a lot more complicated.
And, pertaining to WL policies issued by different companies, or the same company at different points in time, a great many differences in policy design may exist. These may relate to policy guarantees, premium levels charged, how general account assets are invested, the range of possible face amounts that can be purchased, the penalty assessed for smokers versus non-smokers, targeted age and gender preferences and a great many other factors too numerous to address here.
These differences and the impact they have on WL policy values are outlined in a dozen or so WL focused “How it Works” series of write ups. Again, the point being even within the same company there may be little similarity between policies sold from one year (or decade) to the next. So the general account will consist of WL values pertaining to substantially different design parameters. Meaning the assets within the general account must be segmented so they can be accounted for in relation to only the policies the premiums and subsequent earnings on them and expenses offset against them pertain.
These many additional write-ups are essential reading for anyone who really wishes to move beyond the theory of WL explained by the “WL box story” into the real world of actual policies that have been and still are being sold.
The fact is differences in policy designs between various companies and even within the same company are so extreme in nature these WL policies are not easy, or are literally impossible, to compare. It would be like trying to compare a bicycle to a car just because both are used as transportation vehicles.
To help the reader of this “WL box” write up understand how different policy designs compare there is an entire series of “How it Works” comparison write-ups devoted solely to WL. That alone should dispel the delusional thought many who sell WL have that WL is a simple product with little room for manipulation of values. Nothing could be further from the truth. The very “opaque” nature of the product lends itself to abuse. And abuse occurs. Lots of abuse.
The singular possible flaw, or fiction in the “WL box” story is the focus on $1,000 in premiums being paid by each club member as defining how the benefits are determined. The actual focus in WL policy design is the death benefit, which is in the WL box example always the over simplified same $100,000.
So when seeking to understand the inner workings of WL its essential to keep in mind all policy design factors revolve around a $1,000 of death benefit factor. This factor varies for every age, gender, and tobacco use status. Which is then further leveraged by assessing an added rating factor based on the insured’s health history.
The older and less healthy a person is, the higher the premium per $1,000 of death benefit. Smokers pay more than non-smokers. Males pay more than females. And so on and so on.
The logic is simple, fact based and scientific. Every aspect of a WL policy, including dividends, is a function of this $1,000 of death benefit focus.
NOTE: Obviously, a 50 year old doesn’t have as many years available to pay premiums before death is likely versus a 25 year old. The premiums paid by the 25 year old will be able to grow for 25 more years than the 50 year old, all else being equal. So the 25 year old can pay a far lower premium per promised $1,000 in future death benefits. Because their premiums will grow for far longer. And as their cash values in the policy grow the actual amount of death benefit (the difference between that cash value and the policy total specified death benefit) “at risk” declines. More and more of the future death benefit payable is made up of the policy owners own accumulated premiums and earnings. This is a concept most people simply don’t understand relative to how WL works. But it is the reality embedded in the design of the WL product.
So, if a given insured were to purchase $100,000 in WL death benefit, and another identical person (age, sex, tobacco use and health) were to buy $1,000,000 in death benefit, the per $1,000 of death benefit premium would simply be multiplied by 100 or by 1,000 to determine the total premium due.
For any given WL policy ever sold there is literally a schedule that states for every given age, gender, smoking status and health rating what the premium amount would be “per $1,000 of death benefit”. And, embedded in the master formula that will determine illustrated and future crediting, the same “per $1,000 of death benefit” focus is maintained.
Of course, this starts to get much more complicated and goes beyond the intent of this WL box conceptual write up and what it was intended to explain.
All of this and more is detailed in the series of WL “How it Works” write up referred to above.
So that wraps up the “Whole Life Box” story.
