When Whole Life Insurance Fails to Deliver

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Life insurance agents often sell whole life insurance policies by presenting the prospective buyer with an explanatory document that projects future values.  This document often goes by the name “illustration” because it seeks to illustrate the features and functionality of the product.  This document helps to explain not only the features of a specific product but also shed light on how various features compare among a group of potential whole life products/possibilities.

But the projections in these products rarely hold true for a variety of reasons.  This causes some to criticize whole life insurance, or more specifically life insurance companies, for making overly optimistic forecasts regarding policy values.

Do life insurance companies intentionally lead potential buyers down an overly optimistic path in a clever bait-and-switch?  Probably not.  But why then are these documents never correct?  Also, given that they aren't correct, is the opposition party correct in its claims that life insurers lie and fail to deliver on their illustrations?

Understanding The Source of the Variation

There are two primary sources behind the variation in whole life insurance projected values versus actual results.  One is a somewhat amusing misunderstanding of whole life insurance functionality.  The other is an unfortunate consequence of broader economic forces that push life insurers in a negative direction.

We'll start with the amusing misunderstanding.

Understanding Whole Life Insurance Guarantees

Whole life insurance policies provide guarantees.  If the policyholder pays all of the required premiums, he/she has a guarantee from the insurance company to provide:

• A specific death benefit
• A specific amount of cash value accumulation
• Complete control over the ability to keep coverage for the policyholder's “lifetime”

Let's focus on the “specific amount of cash value accumulation” component because that's the one at play for today's discussion.  Whole life policies do provide a guaranteed accumulation of cash value with each premium paid to the policy.  This guarantee also applies to any cash value the develops in the policy from non-guaranteed sources.  In other words, the whole life contract guarantees that cash value inside the policy will accumulate a specific amount that the life insurer cannot change.  That promise exists for the lifetime of the policy.

Additionally, whole life insurance cash value cannot go down/be taken away.  So if, for example, an insurer experiences a really bad year, it cannot go to whole life policyholders and take some of their money in order to make up the difference between what it wanted to accomplish and what it did accomplish.  Once the cash is in the policy, it's the policyholders for the remainder of the policy's existence.  And it's then entitled to accumulate at whatever the guaranteed rate on the policy is.

There's a subtle, but important consequence to the above.  Any cash value that accumulates in a whole life policy up to the present day is guaranteed cash value in the policy.  That seems to some like an underwhelming realization, but overlook its implications at your own peril.  This further means that whenever a non-guaranteed accumulation of cash value takes place, the future guaranteed cash value in the policy grows larger.

The stumbling point over this fact for the less whole life insurance proficient comes when they review an in-force policy and note that the guaranteed cash value and non-guaranteed cash value are very similar–if not identical per the reporting.  This leads the less savvy to assume this is an almost catastrophic failure of the policy.  Why?

Because these individuals know that at inception, the guaranteed and non-guaranteed results of a whole life policy are very different.  So if now some years into the future, the guaranteed and non-guaranteed results report the same value, it must be that the policy performed horribly after all this time.  This is not the case.  The assumption that reality pulled the poor policyholder down to the less favorable projection of values.  But the reality truly is that the “worst-case” scenario pulled closer to the assumed scenario as non-guaranteed features materialized up to this point.

We showed in this blog post from last year that an in force whole life policy now projects a dramatically improved guaranteed cash value rate of return because of the non-guaranteed results achieved after six years of the policy's existence.

So this explanation is a sigh of relief.  The policy you bought wasn't as bad as someone might have led you to believe.  But what about the policies that do fall short of original non-guaranteed projections?  What gives there?

Whole Life Values are Driven by Interest Rates

Interest rates drive the values of a whole life insurance policy.  When a life insurance company designs a policy, it makes assumptions about the interest rate environment to price the product as well as project the accumulation of non-guaranteed values.  These non-guaranteed values include dividends, non-guaranteed cash value, and non-guaranteed death benefit.

Interest rates play such a key role because life insurers invest the majority of the dollars they manage in debt-like instruments (e.g. bonds).  If the insurer earns a higher return on these investments than it originally assumed, this bolsters the non-guaranteed features of the life insurance contract.  If the insurer does not earn a return higher than assumed, this forces the non-guaranteed elements down.

Living inside this reality, life insurers are somewhat at the mercy of the broader interest rate market.  I say somewhat because they do have some latitude to opt for different investments that hold less grounding in this market.  That being said, the overall interest rate level weighs heavily on how insurers product investment income.  And interest rates currently sit at a level far lower than most people predicted they'd be 10 years ago.

This leads to a squeeze on the insurer's ability to produce the income it anticipated from the assets it manages on the behalf of policyholders.  This reduction in planned income means the insurer may not meet the profit goals it had and needs to reduce non-guaranteed features of policies.

The insurer didn't intentionally reduce non-guaranteed features and it would prefer not to.  But economic forces being what they are, it might have to.

Why then don't insurers make assumptions about the possibility of such declines and project lower values–under promise and over deliver in other words?

We have to keep in mind that they live in a competitive environment.  If an insurer chooses to project low while others project high, it likely loses significant business to the insurers who are more in line with consensus projections.  So there is a careful balance each insurer must develop between reasonable forecasts that is neither too optimistic nor too pessimistic.

Interest rates are rather odd right now.  And globally, they appear even odder.  This poses a challenging puzzle for life insurers.  But despite the challenge, many insurers continue to deliver high value to policyholders.

Lastly, keep in mind that insurers make projections based on a static variable that calculates future values.  This static variable is the current dividend rate used to compute the payable dividend to policyholders.  It's virtually guaranteed that the rate any insurer has today will be different at some point in the future over the course of the next several decades.  This will impact actual results.  This potentially changes projections both positively and negatively.  Why not build a better protocol for projections?  That's a fair question.  The answer involves the gargantuan task of bringing all life insurers on board with some new method for projecting values that is likely far more complicated than the current method.  That is not likely an ask met with agreeableness.