Every year, usually sometime in November, life insurance companies that sell participating whole life insurance report their plans to pay dividends to policyholders. When the insurance companies talk about it, they often refer to as their whole life insurance dividend rates.
Generally, the companies make their announcements by noting the sum of dividends–expressed in dollars–they intend to payout to those holding a whole life policy.
Many also note the effective dividend interest rate the payout represents.
For a long time now, many have offered up the dividend interest rate out as some sort of metric that showed an insurers victory or defeats through the year.
There are definitely too many people out there who believe that a higher dividend interest at one company manifests some superiority over another company with a lower whole life insurance dividend rate. Others make a more insidious claim comparing the dividend interest rate to various yields on investments and suggest that because of a higher dividend interest rate, whole life insurance is always the better choice.
All of this is wrong. It's important to understand how wrong it is. Plus, I wanted to tease out a more important and better question.
Should we just get rid of talking about whole life insurance dividend rates altogether?
The Purpose of Whole Life Insurance Dividend Rates
The dividend interest rate reports the input of a single variable used by the life insurer to calculate the dividend paid to each policyholder. All dividend payments use three basic components:
- Investment income
- Underwriting Profit (Mortality)
- Operational Expense
To expound a bit on each…
This is the income that the insurer generates from investing the money it collects from the policyholder.
In other words:
Policyholders pay a premium → Insurer takes premium and places the funds into various income-producing investments → Insurer books this investment income as a component to its cash flow.
At the end of the year, the portion of investment income attributable to profitability will go to policyholders.
While not universally true, most insurers generate the largest portion of their cash flow and profitability from investment income.
Whenever a life insurance policy exists, the insurer assumes the risk of paying out the death benefit associated with the policy. As a result of this assumed risk, the insurer must charge appropriate expenses to the policyholder and hold funds necessary to pay the death benefit should the policyholder die.
When policyholders don't die and insurers don't have to pay a death benefit the insurer generally benefits by keeping at least a portion of the funds set aside to cover the death benefit. This results in an underwriting profit to the insurer.
While underwriting profits were generally a smaller component of life insurer profitability, low-interest rates following the 2008 financial crisis have led this piece of the dividend equation to play a larger role in delivering value to policyholders in recent years.
Everything costs money and running a life insurance company is no different. Employees have salaries, the lights have to stay on, copier toner runs out and must be replaced, etc.
The insurer must factor in its expenses to operate when figuring out how profitable it is and how much money it will ultimately pay to its policyholders.
While operational expenses is a much smaller variable in relative terms to the other two, it's also almost always a negative value. In other words, this consideration takes away from the dividend that insurers pay to policyholders.
This makes perfect sense since it represents the cost of doing business the insurer incurs.
There's No Universal Standard
Perhaps the single biggest problem with whole life insurance dividend rates is that there is no universal standard when it comes to reporting. When a company reports that its whole life insurance dividend rates are 7%, the logical next question is 7% of what?
And the truth is 7% of what specifically can vary from one insurer to another.
For the most part, the 7% is multiplied against the policyholder's reserve. This is essentially the money that the life insurance company holds to ensure that it can pay the death benefit when the policyholder dies. The reserve, however, varies from insurer to insurer and product to product.
So the reserve on a $1 million death benefit whole life policy held by a 40-year-old at Northwestern Mutual is likely not the same amount at a $1 million dollar death benefit whole life policy held by a 40-year-old at New York Life.
While all companies use similar mortality data and the probability of dying if you hold a Northwestern policy doesn't change versus holding a policy at New York Life, the companies do have some discretion to influence these numbers just enough to make differences.
Because these differences exist, it's impossible and flat-out incorrect to compare one company's declared dividend interest rate against another.
While tempting, declaring that a policy from MassMutual is better than one from Guardian, solely based on the fact that Mass has a 6.4% dividend interest rate compared to Guardian's 5.85% dividend interest rate, is inaccurate and misleading.
What Whole Life Insurance Dividend Rates Can Tell Us
We can use the dividend interest rate to compare changes in the dividend at a specific company over time. This means we can take the sequential dividend interest rate data at, for example, New York Life and look at how the dividend has changed over a period of time.
In fact, we have been doing this for several years and released the most updated version of this analysis recently.
While this analysis does show us how dividends at each company have changed over time and even allows us to compare the change at one company versus another, there are limitations to the data.
For starters, the start and end points are somewhat random.
We have to pick some standard for the timeline and we've landed on 10 years because it's long enough to be significant.
It's not so long that a particular windfall or talented personnel (that's no longer with the company) carries too much weight.
Additionally, any company that starts at an exceedingly high or low point might look worse or better respectively than it really is because of regression to the mean (i.e. normalizing after extraordinary circumstances skewed them one way or the other).
A Universal Metric for Whole Life Dividend Analysis
I'm sure we are not alone in our desire for a universal metric that clearly and simply compares dividend information across all insurers. A metric that would most likely eliminate whole life insurance dividend interest rates altogether.
This sounds wonderful in theory, but most likely lacks practical application.
One Product with Multiple Applications
At its core, the dividend reflects value delivered–or should we say returned–to the policyholder.
So the focus on understanding whole life insurance dividend rates is a pursuit to determine who brings the most value to policyholders. But the question is more complex when you dig below the surface.
The motivations for purchasing whole life insurance vary and vary quite a lot. Some focus on death benefit while others focus on cash value. And while those two categories–death benefit and cash value–would appear pretty straightforward they can further break down into a plethora of niche focuses.
Further complicating the analysis is the fact that products change and the value delivered to policies of varying time periods can and does differ.
The Life Insurance Industry's Contention
At present, reporting dividend interest scale is voluntary. No regulatory body forces a life insurer to formally announce its whole life insurance dividend rates and several companies DO NOT make this information readily available for public consumption.
The attitude within the industry and regulatory forces has long been one that avoids any degree of mandatory performance disclosure that one might use to evaluate how one insurer performed against another on a specific product level.
Regulators aren't keen on additional requirements and we don't see a coordinated effort to volunteer any more information than is absolutely necessary.
Comparing Data Related to Whole Life Insurance Dividend Rates
While a single metric would be nice, we submit to the fact that it's probably impractical.
So we take a multivariable approach to evaluating life insurers when making inferences on dividend performance.
We review five key metrics for each insurer:
- Investment income to contract obligations
- Dividend payment to operating cash flow
- Dividend payout to dividend interest changes
- Investment income growth
- Changes in Asset Valuation Reserve
I'll break down what all these mean.
This is an accounting of how much investment income the life insurance company generates in excess of its obligations it makes to policyholders through the insurance contract guarantees.
If an insurer generates $2 billion in investment income while having $1.5 billion in obligated payments to policyholders due to contractual guarantees outstanding, it generates $500 million in excess of its obligations.
It's a good thing to generate more investment income than you have in required contract payments to policyholders. Most insurers are on the right side of this equation, they're pretty good at generating profits through investment income.
The larger the gap between investment income and contractual obligations the better.
Whole life insurance dividends are paid from operational cash flow (not as a component of net income as would be the case for public for-profit companies). In other words, life insurance dividends are paid before EBIDTA not after.
So the larger the percentage of operating cash flow that dividends take up, the less room for error an insurer has each year.
There are certainly regulatory requirements for how much an insurer must pay to policyholders of participating policies. At times, this metric might differ for companies that are heavily engaged in issuing participating policies versus those who don't issue quite as many.
Tracking the total sum of dividends paid against changes in whole life insurance dividend rates isn't an exact science at all, but it does give us some insight on the company's management (in some cases struggle) with an ever increasing pool of policyholders.
An example will best explain how this works.
Say company A pays a total dividend in 2017 of $500 million dollars and declares whole life insurance dividend rates of 6.5%. Then in 2018 pays a total of $800 million dollars in dividends and declares whole life insurance dividend rates of 6.4%.
The company paid more dividends in the aggregate, but the dividend rate indicates that each individual policyholders received slightly less in dividends than they would have under last years dividend calculation.
Investment income is a primary driver of profitability and therefore the dividend payment.
Paying attention to how investment income grows over time gives us an indication of the insurer's strength to keep up with growth in new business and their ability to deliver ever-increasing value to policyholders.
Remember, that value is added when the company pays more in dividends to each policyholder, not just stating a higher whole life insurance dividend rates. The two can be related but not inextricably linked.
We generally look at investment income growth as a compound annual growth rate over a period of time. Here's a helpful post to help explain this subject.
The most indirect indicator we look at, the Asset Valuation Reserve (AVR) is a regulatory calculation. It is the required amount of capital an insurer must hold as a component of surplus to cushion against “asset impairment”–i.e. the risk of loss.
We use AVR to evaluate the change in investment risk exposure taken by the insurance company. For example, if the AVR rises dramatically over a five year period, we know the insurer has taken on a riskier investment mix as expressed through the higher calculated AVR.
While this variable by itself isn't necessarily useful for the purpose of speculating on dividends, using it in connection with the above variables does give us plenty of information to evaluate.
For example, if the AVR has risen significantly and investment income growth has declined, we have to question if the insurer is on the right track. Those two conditions indicate an increased risk and a decreased reward for taking that risk.
Not a winning combination under pretty much any circumstance.
Why Bother Worrying About This?
Some might suggest that since insurance companies all have access to similar assets they most likely will produce similar results to one another. They manage large pools of assets and all employ extremely smart people with a deep and wide understanding of institutional investing.
But we do know through empirical evidence that insurers don't always produce similar results to one another and the difference between the good results and bad results matters.
If someone buys whole life insurance for the purpose of accumulating wealth, there is a reasonable expectation that they hand money over the life insurance company with expectations. Chief among those expectations–the ability to deliver value on paid premium.
And not just adequate value, policyholders expect to receive value in excess of other alternatives with a similar risk profile.
You can't just take the insurance company's word for it. There have to be indicators on a level playing field for review. Those metrics that go beyond the brochure filled with pictures of smiling families.
So while we may never get a simple solitary metric we can track to evaluate life insurers' success or failure with whole life from the insured's perspective, there's a real benefit to unearthing other material data points that help guide a buying decision among all the options.
You may never get a simple, solitary metric to track to evaluate a life insurance company's success or failure with a particular whole life. Especially one that is easily decipherable by the average policyholder.
But there's a real benefit to unearthing other material data points that help guide a buying decision among all the options. Just please don't too much faith in whole life insurance dividend rates or may be disappointed.