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.
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