Most peoples’ opinions are not from experience or knowledge but based on other people’s misconceptions.

These misconceptions are based on a lack of knowledge about whole life insurance.

So, what is the truth about Whole Life Insurance?  To understand the truth, we have to identify what it is.

First and foremost, Whole Life Insurance is a contract. 

The contract has two parties 1) the Insurer, and 2) The policy owner. Additionally, two other parties are involved but not part of the contract – the insured (usually the policy owner) and the beneficiary.

In this contract, the insurer agrees to indemnify the beneficiary on the death of the insured. That is, the insurer guarantees to pay a death benefit to the beneficiary designated by the policy owner on the death of the insured. That death benefit is guaranteed, established at signing.  This means it has a guaranteed future value.  Example:  $1,000,000 at death, or age 121, of the insured.

This is a unilateral contract.  The only party forced to do anything is the insurer.  The insurer will pay the agreed upon minimum death benefit so long as the policy owner upholds their side of the contract – that is paying the agreed upon minimum premium.

This contract represents a liability for the insurance company.  The closer the insured gets to natural mortality and age 121, the more likely the insurer will have to pay the death benefit. 

Because it is a liability, there is a surrender value – the amount the insurer is willing to pay the policy owner to walk away from the contract.  Remember, the insurer is the only party forced to do anything.

The closer in time to the death of the insured, the more the insurer is willing to pay to avoid paying the full contractual death benefit.  This surrender value is also called the present value or the cash value.

In the 1980s, the IRS decided Whole Life was too good of a place to store capital, so single premium life insurance was determined to be a Modified Endowment Contract (MEC), along with any policy that built cash value too quickly relative to death benefit.  This is determined by what is called the “7-pay test,” performed after the 7^th year and on any substantive change of the policy thereafter.

Since we don’t want our contract to be a MEC, let’s consider a contract with annual premium payments.  When you pay a premium, you are making installment payments on that contract.

Consider:

You and I make a contract that if you give me $100 a month for 12 months, after 24 months I’ll give you $2000.

After 6 months, how much money would you accept from a buyer?  Not less than $600 you paid me so far.

How much would a buyer pay? Not more than $2000.  In fact, the buyer needs to account for needing to pay an additional $600.  So at most he’ll pay $1400, but he’d be paying $1400 + $100×6 = $2000, for no gain after 6 months.

If the buyer pays you $1000, you make $400 after 6 months and he makes $400 after 18 months.

If the buyer pays you $800, you make $200 after 6 months and he makes $600 after 18 months.  $800 is the fair present value.

Present Value = (Future Value, discounted for time) minus unpaid premiums.

From this, let me address some common…misconceptions about Whole Life Insurance.  I want to say “lies,” but that conveys a maliciousness I hope is not true.  But there is certainly ignorance.  And in the case of financial entertainers who make the below claims, there is also negligence.  If getting a life insurance license is as easy as rolling out of bed, as one has said, then they have no excuse.

First, it should be evident that Whole Life insurance is not composed of two parts:  “Never ending term insurance” and “a side savings account”.

It is one “thing.”  The “cash value” is not a side account.  The cash value is the present value of a future death benefit.

The two cannot be separated.

The ignorance and negligence are further evidenced by a brief history of the advent of Universal Life (and its derivatives).  In 1979, self-appointed consumer advocate Ralph Nader decided that whole life was complicated and needed to be “unbundled.”  Apparently, he couldn’t understand the concept I described above in about 450 words.

This fact alone demonstrates that the entertainers are ignorant.  First “never ending term” is a contradiction in terms….it violates the law of non-contradiction.

Second, if it was the “never ending term coupled with a savings side fund” then there would be nothing to “unbundle” – it is already unbundled. Universal Life (UL, EIUL, IUL, VUL) and its’ many failed iterations would never have been necessary.

This leads into the claim that when you die, the “evil insurance” company keeps the cash value and pays you the death benefit.

The nonsense of this claim should also be self-evident, it is clear that the cash value IS the death benefit discounted for time and unpaid premium.  It is the present value of the future death benefit.  The insurance company does not keep the cash value.  The beneficiary receives the full death benefit: cash value (which is greater than the premiums paid) and then also receives the difference between the death benefit and the cash value. 

Lets say you purchased your house for $200,000. Over time you have paid it off and in that same amount of time its value has increased to $350,000. When you sell your house, does the evil realtor give you the sale price and keep the equity?

No, that is nonsense.  You do not receive the sale price of $350,000 and your $200,000 equity for a total of $550,000. You receive the sale price which is your original equity of $200,000 + the $150,000 additional value that it earned.

Another common refrain is “why would I pay money to the insurance company to borrow my own money”.

I hope from the above it is clear that you are not “borrowing your own money”. Your money was exchanged as a payment for the contract. The insurance company allows you to take loans up to the equity you have built up in the contract – the cash value.

Yes, that insurer charges you interest on the money they lend you. We are talking about a mutual insurance company. A company you own. If you owned a Kroger would you buy your groceries at a Winn-Dixie? If you owned a Kroger, would you allow your wife steal the groceries? Your interest payments contribute to the profitability of company you own and that pays you dividends. I find it hard to believe a business owner entertainer doesn’t understand this.

Speaking of the Dividend. Yes, it is (rightly) classified by the IRS as a return of premium. It is not less than that. But if it was only that, your total dividends could never exceed total premium paid. But they do. It is also your share in the profitability of a company you own. The dividends buy PUA and PUA buy future death benefit. Future death benefit means a higher present value. This also represents a larger share of ownership in your mutually owned company. Which means more dividends in the future.

Thankfully this one is uncommon, and I haven’t heard it out of a financial entertainer’s mouth (that doesn’t mean they haven’t said it)- but I have heard it claimed that Whole Life is a liability.

From the above, do you think Whole Life is an asset or a liability?  Investopedia defines a financial asset as “a non-physical asset that gets its value from a contractual right or claim.”

Whole Life imposes a cash flow out – in the form of premium. It is more akin to a deposit, but that is not accurate because “deposit” implies ownership of the money paid, which isn’t true (although this isn’t true of your bank either). You own the contract. When you make car payment do you own the car and the payment you made?

Yes, it does impose a cash flow out, akin to a bill, but you have a contractual right to stop paying.  And, within certain limits, if you give up and quit – the contract remains in force.

Unfortunately, the same person who claimed that Whole Life is a liability asserted that Term Insurance has a future value and therefore a present value can be calculated.

What is the Future Value of a 30-year term policy on day 10,949, one day shy of 30 years?  It is zero.

Term insurance has only a contingent value.  It only has value IF two conditions are met – 1) that the insured dies and 2) during the term.  It has no future value.  Yes, it is a contract.  But no one will buy that term policy from you.  And no bank will allow you to use it as collateral.

For fun, I challenge anyone who thinks term insurance has future value or that term insurance is an asset to go ask a bank for a loan with their term policy as collateral.

Another oft repeated lie is that Whole Life insurance is a terrible place to store your money.  If you were paying attention, I already addressed this a little bit.

In 1986, congress passed the Tax Reform Act.  Among many changes to tax law, reducing the number of tax brackets, reducing marginal tax rates, and eliminating tax-shelters – this act also increased the capital gains tax to 28%.  In accordance with the law of unintended consequences – this had many ripple effects.  Black Monday (the 19 October 1987 stock market crash) and a large crash in the real estate market, were among the most devastating. 

In response, wealthy individuals began searching for another place to store their money and legally protect it from the IRS.  Well, guess where they put it.  The very place financial entertainers say is a horrible place to store your money:  Whole-Life insurance.

This then led to the passage of the Technical and Miscellaneous Revenue Act of 1988, with provisions specifically designed against single-premium life insurance.  It added the category of “Modified Endowment Contract” or MEC, where an insurance policy is considered an investment by the IRS and subject to taxation under “First In, Last Out” treatment. 

This isn’t the place for a full discussion but in short – MEC Status is determined by the “7-pay test”.  The “test” compares premium paid to death benefit.  If at any point the premium payments exceed the payments required for a 7-pay policy of the same death benefit, the policy is a MEC.

Single-premium policies are automatically MECs. If a 7-pay base-only policy with death benefit of $100,000 dollars, requires $2,000 a year, and at any premiums (including dividends) exceed $14,000, then the policy is a MEC. If a policy is put into RPU status before year 7 it is also a MEC.  MEC status is also re-calculated every time there is a substantive change to the policy.  Buying PUA is a substantive change to the policy. 

Any way – if Whole Life insurance is such a terrible place to put your money, why would the wealthy have moved so much of their wealth into it after 1986 Tax Reform Act?  If it was such a terrible place to put your money, why would congress pass laws to slow it down?

Most of what people know about whole life insurance comes from other peoples’ opinions not their own experience. 

This is true, not only of the general public who can be forgiven, but also of the financial entertainers and apparent professionals who have a duty to be better.  Truly it is the arrival syndrome at its worst.

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All content on this site is intended for informational purposes only and is not meant to replace professional consultation. The opinions expressed are exclusively those of Reformed Finance LLC, unless otherwise noted. While the information presented is believed to come from reliable sources, Reformed Finance LLC makes no guarantees regarding the accuracy or completeness of information from third parties. It is essential to discuss any information or ideas with your Adviser, Financial Planner, Tax Consultant, Attorney, Investment Adviser, or other relevant professionals before taking any action.