The
Fundamentals of Life Insurance
This essay was written by Ron Muhlenkamp and originally published
in January 1996, © 2005. All rights reserved.
As professional investors our perspective
and conclusionsdiffer from the conventional wisdom in several areas.
One important area of difference is life insurance, which plays
an important part in many financial plans. The following is a discussion
of life insurance from an investment perspective.
Any whole-life policy has two parts. The first part is pure insurance,
just like a term policy. The second part is a savings account (the
insurance company calls it cash value). The savings account is designed
to equal the death benefit of thepolicy at the end of the insured’s
life expectancy. As the savings account grows, the amount of pure
insurance declines. (See Chart 1.)
The insurance company estimates the interest rate it will earn during
the life of the policy to determine the amount of the premium required
to fund the savings account. They then add on the insurance premium,
which is required to offset the risk that the insured dies early.
The sum of the two is the annual premium. Thus, the policy “illustration”
is based onthe premium and the assumed interest rate. If future
interest rates match the estimated rate, the cash value of the policy
will match the illustration.
But if future interest rates do not match the estimated rate, the
insurance company will “adjust” premiums or the value of the policy
to reflect the actual rates. When estimating future interest rates,
most insurance companies use a rate similar to what they are currently
earning. This rate reflects securities, which they have bought and
still hold. Since companies don’t replace their entire holdings
each year, their response to changing interest rates tends to be
gradual and to reflect market changes with a lag. As rates moved
up in the 1970s, this lag was reinforced by company’s reluctance
to sell bonds at a loss. As rates have moved down since 1981, the
lag has been determined largely by “call” protection.
The bonds and the mortgages which insurance companies own are callable.
Callable means that the companies issuing these securities can “call”
or refinance them when interest rates drop. As interest rates fell
over the past 15 years, many of us benefited by refinancin gour
mortgages.
But this benefit was at the expense of the holders of these mortgages,
including insurance companies. Much of the mortgage refinancing
has been completed. But the bond refinancing is still going on.
This is because most bonds have 5 or 10 years of “call protection,”
therefore the call response lags the market by 5-10 years.
How do these changes in interest rates get reflected in individual
policies? In the 1970s interest rates rose, exceeding rates that
had been estimated in the 1960s.(See Chart 2.) As a result of this,
the death benefits on two policies, which I bought in 1964 and 1970,
were upped by 40% in the early 1980s. This sounds impressive until
you recall that the Consumer Price Index (CPI) doubled during that
period.
But since 1984, interest rates have fallen well below the levels
which insurance companies estimated in the early1980s. If you bought
a whole life policy 10-15 years ago, you have probably received
a statement in the past 2-3years saying that the insurance company
needs more money, or they will decrease your death benefit. But
this statement only reflects the decline in interest rates, which
occurred from the early 1980s to the late ‘80s. The decline in rates
that has occurred since the late 1980s means that 3-5 years hence
(due to the call lag), you will get another statement saying that
the insurance company needs more money again. The people who have
bought policies since 1985 will also receive statements asking for
more money. And we believe there is a 50% probability of a third
“adjustment” five to ten years down the road. We estimate that the
decline in the value of the policy will approximate 20% each time,
for a cumulative 40%-60% decline.
The problem is that old and obsolete interest rates are still being
used in policy illustrations. We recently reviewed apolicy proposal
in which the cash value illustration was based on interest rates
credited to the policy holder of 8%. Yet a footnote stated that
the actual rate credited will be 2% less than the company earns
on its investment portfolio. The illustrated numbers were obsolete
the day they were printed. In any other business, such illustrations
would be considered fraud.
Policies are sold on the basis of “illustrated” growth in the cash
value. In recent years, disclosure has improved and these tables
usually include a footnote which states that in fact the interest
earned will be 2-3% less than what the company earns on its investment
portfolio. So the company is telling you up front that your assets
with them will earn 2-3% less than the company earns with your money.
Since the bond sand mortgages they invest in normally earn about
1% more than Treasury bonds, you can expect to earn about 1-2% per
year less than if you had simply bought long-term Treasury bonds.
The conclusion of all this is that any money set aside to accumulate
in an insurance policy or a fixed annuity will earn returns of 2-3%
a year less than corporate bonds. This means it will earn 1-2% a
year less than Treasury bonds. It also means it is likely to earn
about 1% more than passbook savings and 4-5% a year less than common
stocks. It cannot do better. When insurance commissions are figured
in, the results become significantly worse.
If you are 35 years old, have little or no assets and have people
dependent on you, buy life insurance to cover the risk of early
demise. We strongly recommend term insurance. But if youare 55 years
old and have assets sufficient to care for your dependents, you
don’t need life insurance. Under these circumstances, buying “cash
value” life insurance merely prevents earning a decent return on
your money. We call that a poor investment.
A second area where we disagree with the conventional wisdom is
in the use of irrevocable trusts (the following comments do not
apply to revocable trusts). The use of irrevocable trusts is driven
by three factors:
1. IRS Regulations that gift to charities or heirs be irrevocable
to qualify for charitable deductions or for exclusion from the donor’s
estate;
2. The donors’ belief that they can only spend “income” during their
lifetime. Therefore, they believe they must keep their assets in
their name;
3. A third factor that sometimes comes into play is a desire to
control assets from the grave, either to protect irresponsible heirs
from themselves, or to benefit from the donor’s superior investment
acumen.
Our objection to irrevocable trusts is that they are irrevocable.
The trust may not be able to adapt to changes in the world or in
people. We’ve seen trusts that irrevoca-bly stipulated:
Trustees who became senile or died;
Bank administrations whose trust departments become incompetent
or were so careful to “protect principal” that inflation destroyed
the assets. (See our essay Estate Planning for Generations.);
Charities whose later administrators adopted policies counter to
the donor’s intent. Henry Ford II resigned as trustee of the Ford
Foundation (which his grandfather’s will created) in disgust;
Investments that become obsolete. (I had a college classmate whose
wealthy grandfather, observing the need for good public transportation,
stipulated that his assets should always be invested in streetcar
companies. His grandson was as broke as I was.)
Meanwhile the IRS discounts the value of any charitable gift to
its “present value” in calculating any tax deduction. We’ve seen
present values as low as 5% of the intended gift. The donor and
the charity would have been better served with a present gift of
5% of the expected future gift. This would allow the remaining 95%
to be invested (or gifted or spent) in concert with a changing world.
OUR CONCLUSION: The only way to protect your assets for use by your
heirs is to educate your heirs.