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Tuesday, July 15, 2014

Life Insurance: Seceding from the System?

This forgotten savings vehicle could be a substitute for the status quo

Most Americans implicitly assume that the financial system has always worked the way it does now. Although they may have a vague knowledge that the U.S. dollar used to be tied to gold, they can’t really imagine a world in which prices don’t steadily rise, year after year. It’s also difficult to imagine an economy working without a central bank, since the Fed has been around for a century now. These just seem like facts of life. 

Most Americans also take it for granted that Social Security, Medicare, and other federal “social insurance” programs must exist to supplement the wildcat free market. Yet historically, the institution of life insurance provided not just protection from an early death, but also was a popular savings vehicle for average Americans. Even in today’s sophisticated financial markets, churning with derivatives and mutual funds, boring old life insurance may provide a way to secede from the broken system designed by the planners.

There’s a scene from It’s a Wonderful Life when George Bailey (played by Jimmy Stewart) is down on his luck and runs to the greedy Mr. Potter for help. What does Bailey bring to Mr. Potter as an asset? Why, his life insurance policy. This scene seems odd to many modern viewers; I remember being puzzled myself when I first saw the movie. This was because I only thought of term life insurance, rather than permanent (or cash-value) life insurance. The modern financial gurus, such as Dave Ramsey and Suze Orman, counsel their listeners to avoid permanent life insurance as a terrible investment, if not an outright scam.

Yet it was not always so. Here is the great economist Ludwig von Mises, writing matter-of-factly in his 1949 treatise Human Action: “For those not personally engaged in business and not familiar with the conditions of the stock market, the main vehicle of saving is the accumulation of savings deposits, the purchase of bonds and life insurance” (p. 547).

Later in the book, Mises goes on to explain that these market institutions would be adequate for all of life’s contingencies, were it not for government meddling in the economy:

[Under capitalism, even] for those with moderate incomes the opportunity is offered, by saving and insurance policies, to provide for accidents, sickness, old age, the education of their children, and the support of widows and orphans. It is highly probable that the funds of the charitable institutions would be sufficient in the capitalist countries if interventionism were not to sabotage the essential institutions of the market economy. Credit expansion and inflationary increase of the quantity of money frustrate the “common man’s” attempts to save and to accumulate reserves for less propitious days. (p. 834)

Now, I have read Human Action at least five times, but it was not until I had become familiar with permanent life insurance that I truly understood what Mises was saying. A permanent life insurance policy doesn’t merely provide a large check to widows (or now widowers) and orphans if the breadwinner dies. On the contrary, a permanent life insurance policy also acts as a savings vehicle that has a steadily rising “cash surrender value” over time. It is this feature of permanent life insurance that allows it to provide “living benefits” (in contrast to the death benefit check), so that the policyowner can draw on the policy to finance a child’s college education, pay for a wedding, and provide income during retirement.

The easiest way to understand how permanent life insurance works is by contrasting it with the more familiar term life insurance. 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 policyowner 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 policyowner 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.

Although Mises refers matter-of-factly to life insurance as a savings vehicle, in the United States it was gradually displaced by mutual funds, which had become more accessible to the average household and looked very attractive by the late 1970s. The high interest rates and inflation of this era—the result of government manipulation in the financial markets—suddenly made conservative life insurance look boring and sluggish. Americans were steered by the “experts” into Wall Street, and federal tax laws—which levy large penalties on all assets except the ones exempted by the IRS—only reinforced the transformation of the conventional wisdom.

Yet even though we can understand the historical events that pushed Americans away from the use of life insurance as a savings vehicle, the pendulum is beginning to swing the other way. The downside of “tax-qualified” retirement plans is that their tantalizing breaks on tax treatment come with significant strings attached, such as stiff penalties for early withdrawal. Furthermore, the appeal of the stock market as a hedge against price inflation is greatly muted when it is subject to periodic crashes.

Taking all things into account, a growing number of Americans are surprised to discover that a boring old permanent life insurance policy offers a simple way to largely secede from the financial system in which the masses participate, yet without going into truly exotic outlets (such as cryptocurrencies) that are difficult for some to understand. As things currently stand, permanent life insurance offers an outlet for savings that is remarkably robust across several criteria (such as liquidity, safety, privacy, and usefulness in estate planning). By relying on a permanent life insurance policy as a main vehicle for long-term saving, a household is naturally assured of substantial financial assistance in the event of a breadwinner’s death, reducing reliance on government “social insurance” programs. Yet this vehicle reaps other benefits, too: The household is much less vulnerable to stock market volatility, and (over time) can wean itself from the use of commercial lenders to finance car purchases or other major expenses. To repeat, this growing trend of using life insurance as a savings vehicle is nothing revolutionary or faddish; a century ago Americans would have considered the practice quite commonplace.

The purpose of this post is to educate readers on the forgotten history of life insurance as a savings vehicle. To even see how that could work, I had to walk through the mechanics of how permanent life insurance works. As I personally became more knowledgeable in this area, I realized that the broader free-market community didn’t appreciate the virtues of insurance, especially in contrast to the banking sector that has been more heavily corrupted by government intervention. In closing, let me quote the analysis of one of the world’s current experts on monetary and banking theory, Austrian economist Jesús Huerta de Soto:

The institution of life insurance has gradually and spontaneously taken shape in the market over the last two hundred years. It is based on a series of technical, actuarial, financial and juridical principles of business behavior which have enabled it to perform its mission perfectly and survive economic crises and recessions which other institutions, especially banking, have been unable to overcome. Therefore the high “financial death rate” of banks, which systematically suspend payments and fail without the support of the central bank, has historically contrasted with the health and technical solvency of life insurance companies. (In the last two hundred years, a negligible number of life insurance companies have disappeared due to financial difficulties.)

For more information, see the author’s essay, “My History with the Infinite Banking Concept” and the short videos here.

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.