The dark side of whole life insurance

For your general amusement, and mine, here are “skeletons in the closet” and all the nasty bits of whole life insurance:

  1. The whole underwriting process is just plain weird.You have to go through a blood and urine test, answer a bunch of health questions, and wait 2 to 3 months while the insurance company’s underwriter thinks about how much of a risk you are to other policyholders of the insurance company.A normal investment just requires you to tell the brokerage firm a bit about your finances and income and how you’ll be funding your investment account and BOOM, you’re in.
  2. The returns are slow to materialize and very conservative.Long-term historical returns for “off the shelf” whole life range from 3% up to 4%. Some of ultra-rare custom life insurance policies (similar to something I might design for you) have earned a compound return of 7% or more over the last 20+ years, net of all commissions and fees.But… it takes at least 3 years for a policy to really get going. Some policies take 4 or 5 years before they’re earning a positive annual return.

    And… positive total cumulative returns don’t materialize for between 7 and 9 years in most cases. In some policies, it can take up to 15 YEARS for cumulative returns to become positive.

    Meaning, if you cancel/cash out your policy inside of, say, 9 years, you’ll have a net loss (the amount of cash value you get back will be less than the total of all the premiums you put in).

    Honestly, that’s tough to stomach for most people. And if you find it a tough pill to swallow, I don’t blame you.

    But wait! There’s more!

    It’s true that many people never actually make 10% from the stock market due to fees (and for a variety of other more complex reasons I won’t go into here)… but the fact is, the stock market offers the *potential* for MUCH MUCH higher returns than whole life is capable of (which is a very good and sensible thing).

  3. The insurance company can delay your policy loan for up to 6 months. The primary way you access cash value in a whole life policy is through policy loans. But, there is a provision in every single policy contract (even my policy) which allows the insurer to delay a policy loan request for up to 6 months.Insurers do this to prevent a run on the insurance company if the insurer’s reserves are too low and there’s a risk the insurer will become insolvent if it processes the loan. It hasn’t happened since the Great Depression when the government forced insurers to close their doors for an insurance holiday but… hypothetically it could happen again. Of course, even during the Great Depression, you had a better chance of getting your money from a life insurer than you did a bank but… it’s not foolproof.
  4. The commissions to the agent are huge. Not gonna lie to ya. There is a boatload of fungolas in selling you a whole life policy. Typical first-year commission is between 50% and 100% of the first year premium. And THEN, the agent gets a small trailing commission, usually for up to 10 years, but sometimes he or she will get it forever.Do the math. If you pay $10,000 per year in premiums, your insurance agent can make up to $10,000 off you (it’s a one-time payment, but still…)Now… I don’t make 100% commission off my clients, but it’s still a fair sum of money. And, I get higher-than-average trailing commissions for the next 9 years of the policy (I’m no “saint”, as they say).
  5. The lapse rates are high. Oh man did the critics nail this one. First-year lapse rates for whole life insurance are double-digit. I haven’t seen the latest actuarial reports on this, but it has to be over 13%. Lapse means the policyholder terminates coverage, surrenders the policy, or the policy terminates due to nonpayment of premiums.A lot of the critics and financial bloggers will say cumulative 20-year lapse rates for whole life are about 60% (meaning 60% of everyone who bought a whole life policy 20 years ago lapsed their policy by year 20) , but I think that’s probably low.
    It’s probably closer to 80%.

    And that, my friend, is awesome.

    Here’s why… by the way, this is from a recent(ish) actuarial report, which tracked lapse rates for all life insurance policies. This section was about whole life policies in particular:

     

    “Larger sized policies, face amounts greater than $100,000, have more volatile lapse rates during policy years 10 through 25. These policies are more likely to be surrendered or converted during retirement or mature at older ages”

    What does this mean? It means people are converting their whole life cash values into annuities and drawing income from them, which is what’s causing the lapse.

    I just wish the 25 yr lapse rates were HIGHER and more people understood how to use their cash values to have fun and provide for them in their old age.

    Incidentally, large policies with face amounts over $100,000 in death benefits have much MUCH lower than average lapse rates before year 10.

    And teeny tiny policies ($5,000 in death benefits) have the highest lapse rates (by a mile).

    Young people lapse their policies more often than middle-aged and older folks.

    Nothing shocking there. How many people do you know in their 20s who are financially responsible individuals? They are a rare bird.

    In fact, when I do happen upon them, and they become clients, I practically BEG them for some kind of testimonial just to prove to the world that they exist.

  6. If you DO lapse your policy and there’s a gain (your total cash value exceeds the total of all premiums you’ve paid), you’ll pay income tax on that gain.Since most people who buy large amounts of whole life use it for retirement income… and since the primary way to access these cash values is through policy loans… there IS a risk of lapsing your insurance policy when you’re like 80 years old and getting a big fat tax bill from the IRS. I protect my clients from this by forcing the policy to automagically “shrink wrap” around itself and prevent it from terminating but… most agents don’t know how to do this.
  7. The premiums for whole life are something like 10 times what you pay for term insurance and the implied term costs embedded in whole life are difficult to calculate accurately. To make matters worse, many life insurance actuaries are a somewhat secretive bunch. If you ask them straight up “So, what’s this thing cost?”… you’re likely to get a bunch of academic answers ranging from what mortality costs are to what the cost of securing the guarantees are from the insurance company’s perspective… to various methods of comparing your policy to a hypothetical bond investment. Kinda seems like they’re hiding something, doesn’t it? They are… years and years of education. Sometimes they’ve signed non-disclosures and other times they just plain don’t feel like explaining how stuff works to every Tom, Dick, and Harry. My personal experience with actuaries is a lot of them are really REALLY smart. Like genius-level smart and… they all have an uncanny ability to assess financial risk with a scary-level of accuracy but… they don’t really like their job. Many of them sound chronically depressed when they talk about their future… kind of like dentists.

And there you have it… the so-called “underbelly” of the life insurance biz.

Onward.

If you want to learn more dirty little secrets about life insurance and the life insurance industry, hop on my email list.

David Lewis

This post brought to you by //The Rogue Agent//. David has been a life insurance agent, and worked with some of the oldest and most respected mutual life insurance companies in the U.S., since 2004. Learn more about him and his business, here.