Whole Life Insurance

Nelson Nash’s Infinite Banking Concept (IBC) is a process that allows individuals and households to “become their own bankers.” Although Nash’s book is about banking, it just so happens that in today’s financial environment the ideal platform for implementing IBC is a dividend-paying whole life policy (ideally issued by a mutual company).

For full details, see the Nelson Nash Institute website as well as the videos archived at its YouTube channel. The present post will provide just the basics of what a whole life policy is and how it works.

To start, there are two general classes of life insurance: permanent and term. Under a term policy, the customer is effectively “renting” life insurance coverage for a specific term of time, such as 20 years. The customer pays the premiums during that term, and the life insurance company agrees to send a check (equal to the death benefit) to the beneficiary named in the policy, if the insured party dies during the term. If the term expires, however, and the insured party is still alive, the insurance company is off the hook, and the accumulated premiums are gone, just as the monthly rents paid to a landlord are gone once the tenant moves out of an apartment.

In contrast, with permanent life insurance (the plain vanilla version of which is called whole life insurance), the insurance company is contractually locked in with the client for his or her whole life (hence the name). So long as the policy owner makes the premium payments, the insurance company must pay the death benefit if the insured party should die. However, if the insured party reaches a specified age (nowadays it might be 121 years old), then the policy “completes” or “matures.” The insurance company still issues a check for the stated “death benefit” (even though there has been no death). Therefore, just focusing on the customers who keep their policies in force (by making the contractual premium payments), the life insurance company knows it will actually pay out only on very few of its term life policies, but it will eventually have to pay out—one way or another—on all permanent life policies.

Because of their different structures, the typical premium on a permanent life insurance policy will be significantly higher than the premium on a term life insurance policy for the same person and with the same death benefit. Intuitively, the permanent life policy is more expensive to keep in force because it is so much more valuable; it has an embedded “continuation option” that the term policy lacks.

Behind the scenes, in order to ensure that it can meet its contractual obligations, the life insurance company is taking a large portion of each premium payment on a permanent policy and using it to acquire financial assets. Effectively, the insurance company has a growing pile of assets in its portfolio that “backs up” a particular permanent life insurance policy. The customer who holds an in-force permanent life insurance policy is a ticking time bomb from the insurance company’s point of view. This is why the insurer contractually agrees to pay the “cash surrender value” to the policy owner who agrees to forfeit the policy.

To reiterate, many financial planners scoff at permanent life insurance as a horrible savings vehicle; instead, they would recommend that their clients “buy term and invest the difference,” meaning that they provide for their strict life insurance needs with a cheaper term policy (rather than the more expensive permanent policy) and use the extra money to acquire a larger share of mutual funds. However, this typical advice overlooks the ironic fact that in an accounting sense, someone who takes out permanent life insurance is engaging in “buy term and invest the difference” with the portfolio managers of the life insurance company running a very conservative mutual fund. If and when the life insurance company exceeds the (very modest) expectations underlying its contractually guaranteed growth targets in the policy, the company will also issue dividends to its policyholders. These can be taken as cash disbursements or reinvested in the policy to buy more “paid-up” insurance (thereby immediately boosting the death benefit and cash value). The glib “demonstrations” that financial gurus put forth to prove the superiority of “buy term and invest the difference” typically compare apples to oranges—for example, by looking at the historical returns on an equity-based mutual fund that has none of the contractual guarantees that a permanent life insurance policy possesses.

Taking out some or all of the dividend payments is one way that the policy owner can fund later expenses through a life insurance policy. But another mechanism is that the insurance company is prepared to advance policy loans with the underlying cash surrender value serving as the collateral. Because the life insurance company itself is guaranteeing the collateral, it doesn’t care when—if ever—the borrower pays it back. Whenever the insured party dies, the insurance company simply deducts any outstanding policy loan balance before sending out the (net) death benefit check to the named beneficiary. Policy loans are a way that people use permanent life insurance to finance major purchases.

[Note: The bulk of this article is excerpted from Robert P. Murphy’s longer article at FEE.]