Insurance, in its basic form, is very simple. If you are buying insurance, you are making a deal with an insurance company in which you pay them money either up front or over time in exchange for them paying your beneficiaries a larger lump sum at a future date dictated by the death of the insured person(s). There can be many bells and whistles attached to a policy but at heart it is a simple transaction. For the sake of conversation, we’d like to call this simple, core part of the transaction the insurance “chassis”.
In a car, the chassis is the structure which holds the wheels, body and engine together. Without a strong chassis, you are likely to end up with a pile of disparate junk rather than a functioning machine. In an insurance policy, the chassis is the minimum premium you pay and the amount your beneficiaries get out at the end. Overall, the elite financial management professionals of the world could better explain the gist of this area.
If a person gets an insurance policy with a strong chassis that is then customized to their personal needs with additional provisions, the investment potential can be exceptional. Unfortunately, as insurance policies with strong chassis become extinct, opportunities to attain exceptional risk-adjusted returns will disappear. If insurance companies are providing guaranteed returns, to life expectancy, in the mid-to-high single digit range, and making less than that lending out at current interest rates, how can they sustain this negative spread?
Insurance companies are extremely large institutions which have been around for decades. They can take a very long time to react to problems which are below their radar screens, and these strong-chassis permanent life insurance policies flew stealth for years. These life insurance policies were not always unprofitable for insurance companies. In 1982, the return on a 30 year Treasury bond was 14%! Back when interest rates were that high, insurance companies could afford to offer policies with exceptional returns.
As worldwide interest rate practices changed, however, many of the old insurance policies continued to be offered in the marketplace, mostly due to inertia and the lower volumes at which such policies were sold. These lower selling volumes may have had something to do with lower compensation to agents selling these products. Although many financial management professionals have their clients’ best interests at heart and act accordingly, the combination of the two adages that (a) “insurance is sold, not bought” and (b) “the best policy for the client is the worst for the broker” lead to a market in which, generally speaking, strong-chassis permanent life insurance policies are undersold and can remain in the marketplace despite being unprofitable.
Tax Benefits of Insurance Investments
A discussion of insurance as an investment would not be complete without getting into the Uncle Sam element of insurance. The investment return on a superior permanent life insurance policy is due in part to the strong-chassis element described above and in part to the favorable tax laws in the United States for life insurance policy holders. The gains on the investment – which is the payout by the insurance company minus the premiums paid by the policyholder – are provided to the beneficiaries without any tax having to be paid. Having said that, there is a 2% tax on all insurance premiums paid and deposits to life insurance policies.
In addition to the tax benefit on gains, there are additional tax benefits if one’s corporation is the owner and beneficiary of the life insurance policy. These tax laws are somewhat technical but, in short, they can be used to significantly reduce tax expenses for shareholders from a corporation.