This is the second installment on my financial toxic series. In this article I shall explore a common insurance product known as whole life insurance plan. It is also known as whole of life in some countries. Basically, it is meant to last as long as the life of the underlying person insured under it. I am sure many people have such plans in their portfolios and it has generated a lot of commission income for those who sold it. However, the product itself is toxic and I am going to prove it.
Before I move on to the proofs, let me repeat my disclaimer. This article is an expression of my personal opinion. I am neither a licensed financial adviser nor a financial expert. I am only an engineer. Here is the difference: Financial advisers and financial experts are trained to obey everything written in their text books without question while engineers are trained to think and analyze logically. In addition, engineers do not receive commissions for selling financial toxic.
Now that I have presented my disclaimer, I shall proceed with my points. Let me start by presenting the sales pitch for this product.
This is a savings plan. You save some money regularly in this plan. If you die, the insurance company will give a huge sum of money to your family. However, if you live to old age and do not need insurance protection anymore, you can take out the money you have saved. You will get back all the money you have put it plus interest which will definitely be more than what the banks can give. So, you have everything to gain and nothing to lose in this plan.
The hidden truth.
As you can see, the above is the common sales pitch for this product. Is it true? The answer is, it is only partial truth. There are other facts that are intentionally hidden in order not to lose the sale. Let me present the hidden truths in this product.
I shall address the insurance portion in the later part of this article. Here I will show you the flaws in the “savings plan” pitch. It is true that you keep the whole life plan for a long time like 20 years before surrendering it, you can get back more than you have put it only if you do not factor in the inflation rate for the whole of 20 years. If you factor in the rate of inflation, your real gain in this “savings plan” will be very small if not negative. So, it is a bad savings plan.
The sales pitch also compares this product with bank deposit. I find this comparison to be totally idiotic. Maybe, those sales folks really think the public as idiots to come up with such comparison. Let me show you why this comparison is flawed. Our money in the banks is liquid. We can withdraw them anytime we want. Even if you have put your money in a fixed deposit, you can still take the out at some cost like forfeiting the interest or even some penalty fees. You can never do that in a whole life plan.
If you have just bought this plan, there is no money in your account even after you have paid a few installments. Why? Most of the money you paid goes to the commission income of your agent, your agent’s manager and the agent’s manager’s manager. (In Singapore, the government allows up 3 levels for commissions.) The rest goes to the insurance company to cover the cost of administration and risk. So, you have nothing. Does this sound like day light robbery to you? This tells us that it is possible to rob legally. All you need is to sell this plan.
After some time, when the agent stop taking your money, you will have some cash value in your account. However you can never take them out without giving up this plan. The insurance company in its mercy will lend you the money you want based on the cash value in your whole life plan with interest. In other words, the insurance company will lend you your own money and charge you interest for it.
Next, let us look at the opportunity cost of this plan. If you have put in the same amount of money in an index fund that tracks index like S&P500 for 20 years, you will surely have much higher profits with close to zero probability of loss.
Are you convinced by now that the insurance companies have a very low opinion of your intelligence?
Therefore, the slogan that says the whole live plan is a savings plan is nothing more than an insult to our intelligence.
Next I am going to present what the whole life plan truly is.
Components of the whole life insurance plan.
The whole life insurance plan is made up with the following components:
1. High cost insurance.
2. Low yield investment.
3. High commission.
This first and second component makes it toxic but the third makes it the bestseller for insurance companies. Welcome to the world of financial services. You can sell any toxic waste as long as you are willing to be generous with the commissions. There will be a lot of people are willing to suspend their moral integrity to help you to sell your toxic. Of course the buyers of this toxic will the ones who will suffer the consequences but who cares. The commissions are in the accounts of the agents when it happens.
I am sure many people, especially those who make money from selling this plan will challenge me on the first two points. I shall explain in detail on them.
High cost insurance.
In order to help you to understand this part, I shall explain the basic operation of an insurance company. This may sound surprising to you but the truth is, insurance companies operate on the same principle as casinos and gaming companies. It is based on the law of probability.
If you go into a casino and place your chips in one of the squares on the table, you may win or lose but the casino always wins at the end of the day. In every hour, the casino collects a lot of money from those who lost their bets and gives away a lot of money to those who won. However, at the end of each day, it can be very sure that the amount of money it collects will be more than the money it gives away. Why? The rules of the games are designed this way. The house always has the edge.
Insurance companies work the same way. Every month, they collect a lot of money in insurance premiums. At the same time, they also give away a lot of money as insurance pay-outs, commissions and other costs. However, they can be very sure that in every year, the amount they receive is more than the amount they give out. They set their rules like the premium rates to ensure this.
This is why insurance companies operate the same way as casinos. The difference is, casinos do not insult our intelligence by telling us that they have savings plan for us, they care for our financial future or they care for our families.
How does this relate to my allegation of high cost insurance? Suppose that you are young and healthy. You want to buy a one year term insurance. How much do you think the insurance company will charge you in relation to the payout you expect? The answer is it will try to charge you a low as it can. Why? There is close to 100% certainty that you will stay alive for the coming one year period. The company can collect your premium and expect not to pay you anything. You are an ideal client. The company will try to charge as low as possible in order not to lose your business to its rivals.
This is like lottery. You pay a small amount of money for a small chance of winning a lot of money. In the above insurance example, you pay a small of money for your family to have a chance of receiving a lot of money if you die within the one year period. However, there is a huge chance that you will not die.
How does this affect the whole life insurance plan? In this plan, as long as you hold on to it, you can be certain that you will be eligible to receive the payout. In other words, you can be sure of hitting the jackpot. You only don’t know when. Let us use some common sense here. Do you think in the insurance company will lose money selling your this plan? Do you think insurance companies will design products that will make their customers make profit at their expense? I believe the answer is quite clear. The premiums must have been set in such a way that they will be more than the payout you are expected to receive after taking into account their time value.
Buying a whole life insurance plan for protection is like buying all the lottery tickets for one draw. If you buy up all the lottery tickets in one draw, I can give you 2 guarantees. The first guarantee is you will qualify to win all the prizes offered. The second is, the total amount of money you spent in buying all these tickets will be more than the total amount of prizes you receive. So, you will have a net loss. In other words, a certainty of loss.
The only way you can “win” in a whole life insurance plan is when you die early. If you happen to live to ripe old age, your situation is like buying all the lottery tickets. So, do you still think this product is a good deal? Welcome to the high cost insurance.
Low yield investment.
Now, I shall explain why the investment returns for the whole life are always so low even when the stock market is booming. If you have such plans, you will notice that the cash you have inside it will always go up and never comes down no matter how bad the stock market is. This is an example on how the system works.
Suppose the market is booming and the insurance company makes 20% from its investment return in a year. It will not give you the full 20%. It will credit only 3% into your account leaving the balance of 17% in reserve. In a bad year where the investment suffers a loss of 5%, it will take out the reserves, make up the loss and still give you an annual return of 3%. So, you will have the impression of a consistent gain but do not be fooled. It comes from your own money. As I have mentioned earlier, if you have placed the same amount of money in an index tracking fund for the same period of time like 20 years, you can get in excess of more than 10% annualized returns safely. This is certainly more than the mere 3% annual returns from the whole life plan.
(The 3% I used is meant to the overall investment returns including the generous commissions paid to the agents. Without the commissions, the investment return in your insurance plan will be much higher.)
This explains why the investment portion in the whole life insurance plan is consistently low.
I hope I have explained sufficiently on why the above product is toxic. The money spent on this product can be allocated somewhere for better returns. Please note that I have never said insurance is bad. All I said is some insurance products are simply toxic and should be avoided. Otherwise you will only be making others rich at your own expense.