Life insurance gets a very bad rap in the personal finance industry. However, it has been around for a very long time, and even fifty years ago, around 90% of all husband and wife families had some form of life insurance. In particular, the type of insurance I am speaking about is called dividend-paying whole life insurance, or mutual whole life insurance. The idea is basically this: you pay premiums to a life insurance company in return for a giant IOU that they will pay to your family upon your death. In order to pay that eventual IOU, they put your money to work in all sorts of ways, including loans, bonds and real estate. (Life Insurance companies tend toward very safe assets with predictable income streams)
Mutual life insurance companies of the sort we are describing do not have any stockholders, so there is no such thing as profit in these companies. Instead, the owners are the policy holders. So, every year they take in a certain amount of money from premiums, income from their investments and have to pay out to anyone who has died. With the remaining money, they save some for a “rainy day” fund, and pay the employees, but the rest is distributed to the policy holders in the form of dividends. You can cash these out or roll them back into the policy, increasing your death benefit (the eventual IOU above).
The obvious benefit to this is that as long as you keep paying your premiums, your family will eventually receive that IOU, whether you die tomorrow or at age 100 (technically if you live to be 121, the policy matures and you will be paid out personally). That means that you are essentially purchasing a guaranteed inheritance for future generations.
But the real advantage to life insurance policies is not at all obvious. In fact, there are several books on the subject that require a few re-readings to get a handle on. I will try to do my best to explain in summary.
The trick to a whole life insurance policy, other than the obvious cash flow of potential dividends (which you can roll back into the policy), is that the policy itself is worth something. Think about it. If you loaned a friend $100 and got an IOU for $120 payable in five years, that IOU would be worth something. True, you can’t collect that money from him right this second, but you could sell it to someone else, right? Maybe in a year you sell it to a third friend for $107.
The same kind of thing exists with life insurance policies. It is called the “cash value” of a life insurance policy. At any point, there is a complex calculation that they can do to determine how much their eventual IOU is worth now. Basically, the intuitive way to look at it is: the cash value of a life insurance policy is how much they will pay you now to cancel your policy (and void the IOU). They figure this out by taking your age, the likely amount of time they would have left to invest your premiums before they will have to pay you out (when you die), how much more money in premiums you will pay by that point and what their return on the premiums will be, then they subtract that from the IOU’s amount and the difference is how much they will pay you.
What this comes down to is that even though you never know when someone is going to die, you know that each year that person is one year closer to death and will pay one year less in premiums. The exact calculations of how you take into account all the probabilities is called actuarial science and it is not simple.
But what it means to you as the policy owner, is that you have an asset that is worth a certain amount of money that is guaranteed to grow over time. This is because no matter how any market does, you are guaranteed to be one year older next year and therefore slightly more likely to die.
But what can you do with this asset? Well, you can borrow against it at very favorable terms. They usually will loan you money at an interest rate that is roughly similar to the rate of growth of the policy itself, which means that, over time, you are borrowing the money almost at no cost to you at all. In addition, you do not HAVE to pay it off according to any particular schedule (not to say you shouldn’t pay it off, but you are not obligated to pay it off). You are probably wondering why the insurance company would give you such favorable terms. For the moment, set that aside. Suffice it to say that you can borrow money at what turns out to be an interest rate close to 0%.
This has a lot of advantages, obviously. For one thing, it is very similar to using cash (since you borrow at a rate close to 0%). However, it also throws into sharp relief the idea of opportunity cost. You see, by leaving that money alone, you’ll be making a return (right now the return is roughly 5%, though it’s a bit more complicated than that). So whatever investment you intend to make with that money, you should expect it to be better than 5%, otherwise you are wasting your time.
Another advantage is that although you can borrow from your growing asset at close to 0%, you do not pay taxes on the growth. The reason for this is that a loan is not considered income. This means that, in reality, you should expect your return on any possible investment to be better than 5% after tax.
So what this essentially becomes is a forced savings account. And given my point earlier, a forced savings account fits perfectly the idea of paying yourself first. You can invest in a life insurance policy, then borrow against it to fund whatever other investments you are considering. In the meantime, the policy provides a floor of return that you can always fall back on when you don’t have any obviously good opportunities to invest.
There are actually a lot of other advantages that are not immediately obvious. First of all, it is a very stable investment. Its value can never go down because you are always older next year than you are this year. Therefore, when you want to draw from it, you never have to worry that market fluctuations have made this a bad time to tap into it, as you would with stocks. Secondly, there is a way to use the growth in your policy as a permanent stream of income. If the policy is increasing in value at a rate of $50,000 per year, and you can borrow at almost 0%, you can get around a $50,000 a year income from that policy growth, by borrowing that money each year. And since it is actually a loan and not income, it is tax-free!
Before investing in a policy like this, however, I strongly recommend you read the book “Becoming Your Own Banker” by Nelson Nash or “The Case For IBC” by Carlos Lara and Bob Murphy. The reason is that there are a lot of nuances to using a policy like this wisely, and there is a particular way to structure the policy to make it the most efficient it can be for this sort of usage. You will almost certainly want to speak with someone who is familiar with this concept and can structure the policy in the way described here.
Another warning: there are many other types of life insurance that do not have the characteristics above. Some of them may be good investments in their own right, but they are completely different animals than what I am describing. For that reason, if this sort of investment interests you, please read the above book(s) and speak with someone who knows what they are doing to draw up the policy.
