How Does Life Insurance Work?
“For by the grace given me I say to every one of you: Do not think of yourself more highly than you ought, but rather think of yourself with sober judgment, in accordance with the measure of faith God has given you.” (Romans 12:3)
The kind of life insurance that you want, whole life from a strong Mutual Insurance Company, is ownership in that company. As an owner, you receive a share of the profits of the company in much the same way that stock owners might receive dividends from their ownership in a stock company.
Again, this is important because the insurance company will always make decisions which are in the best interest of its owners. Many stock insurance companies today are in the news because they’ve been getting fancy with the books or investments of the company in order to impress stock holders at their quarterly meetings. A Mutual company is not incentivized in this same way and so by nature has a much longer term perspective. This is what you want in a company that you are going to be depending on 50 years from now!
So how does the company work? To put it simply (and they are fairly simple companies), they take in premiums from all the policy holders. They invest this pool of assets conservatively for the long haul. Over the course of the year they must pay the cost of their normal business operations and they must pay for all claims that they experience. The profit over and above this goes into the pool of assets which the company manages. At the end of the year, the company pays out a dividend which is typically just under the amount that it has earned on its assets to its owners, the whole life policyholders.
Because the company manages billions of dollars (and you have chosen a good one), it is able to manage the money in a more productive way than you can on your own while still offering a safe and guaranteed product. We’ll talk more about how your cash values grow later. But because of this benefit, your whole life cash values should grow at a higher rate of return than any other safe money vehicle, and as we discussed yesterday, this can all be tax free growth.
When a policy is put in force it is designed on a platform. Some companies only have one platform (typical if domiciled in New York), others have multiple platforms where you can choose the kind that works best for your needs. So there are variations, but they all work something like this. Depending upon your age, health at time of policy issue, and face amount of policy, there is a formula that determines how much premium you will pay and how much your guaranteed cash value and dividends will grow in the future. However, the future dividends can’t be predicted because they will depend on future portfolio growth of the company which is largely dependent upon what interest rates do in the future. But whatever rate they are declared at, they will be applied using this predetermined formula. The longer a policy is in place, they more cash value it will receive in both guaranteed and dividend form.
In return for your premiums, you also get a guaranteed Death Benefit. You also receive a guaranteed cash value and will receive dividends that are paid. The company will show you scenarios where they never pay out a dividend because the dividends are not guaranteed, but if you are with a good company, they will have been paying dividends every year since before you were born, so it’s highly unlikely that they will ever not pay a dividend. This guaranteed cash value and dividend makes up your total cash value in any given future year.
Whole life cash values and dividends always start out slowly and then build stronger and stronger over time. The way we look at it is that you are putting a couple years premium in to pay for the long term death benefit. (Over-funding your policy works differently and will be discussed later) Each year’s premium after this goes straight to cash value as if it were in a bank.
We’ll speak more about the way this works tomorrow with particular emphasis on the way funding these policies affects their performance.
This is Part 2 in a series on Whole Life Insurance. You might want to read the introduction to this series which will link to each post in the explanation of whole life and Ben’s story showing how whole life is used in a variety of ways in his life.
Photo credit: Doctor Hendii