#164 | Permanent Life Insurance and Future Capital

If liquid capital is cash sitting in your account ready to deploy at your discretion, then contingent capital is cash that arrives because of a specific triggering event. Borrowing liquid capital has a discrete cost in the form of an interest rate, but what’s the price of borrowing contingent capital? If the event may or may not happen, then the cost of contingent capital is an insurance premium. But if the event is definitely going to happen and it’s only a matter of time before it does, then contingent capital isn’t really contingent capital – it’s future capital. It’s life insurance. Think about it. What other insurance policy lasts for 120 years with a guaranteed cost to pay a specified amount for an inevitable future event? Life insurance stands alone. There is no substitute. And that’s why we have so much trouble both thinking and talking about it.

But I think this idea of life insurance as future capital builds a nice mental model for explaining the product to laypeople. Let’s start with a basic question – what’s the price of securing future capital? In the case of life insurance, where the future capital is contingent on a mortality event, the cost of future capital is the likelihood in any given year of a claim. In life insurance terms, the cost of future capital is a mortality curve for each client that looks something like this:

When the likelihood of a claim is low, so is the annual cost for future capital. When the likelihood of a claim is high, the cost of securing future capital is high. Makes sense – but it’s immensely problematic. These costs are economically unfeasible. By age 88, the total costs have exceeded the future capital amount. The problem is that the cost of future capital isn’t just the probability of death in any given year, but also the fact that there have to be enough people paying the cost of the potential for a claim in order to cover the full claim. As the population dies off, the burden of the costs are spread amongst fewer people, which is why the costs spike to such an uneconomic level. The strange reality of financing future capital is that paying the pure cost for it is always a bad trade. It just doesn’t work. There needs to be another way. Enter Whole Life.

The core concept behind Whole Life is simple – transform the cost of financing future capital from an ever-steepening curve to a flat annual cost for the life of the policy. How does Whole Life accomplish that? By charging an amount of money that is guaranteed to reduce the amount of future capital by replacing it with invested, liquid capital. Eventually, future capital has been entirely transformed into liquid capital. The magic is in the transformation of capital that has an explicit charge (future capital) into capital that earns an interest rate (liquid capital). The guaranteed premium in a Whole Life product is designed to transform future capital to liquid capital on a guaranteed basis, using guaranteed maximum costs (in the form of a CSO table) and a guaranteed minimum interest rate.  Here’s what the transformation looks like over time:

The principle of transformation only works within the wrapper of a permanent life insurance policy. If the client were to just pay the mortality costs out of his own pocket and invest the premium difference at a compounding 4% rate, after taxes and investment expenses, the side-fund would run out at about age 92. Even at 6%, the side fund would only last until age 98. If permanent life insurance is the goal, then buying term (in this case, annual mortality costs) and investing the difference requires a massive return assumption precisely because future capital can only be transformed into liquid capital within the confines of a life insurance policy. The only way to economically and efficiently get permanent life insurance is with a permanent life insurance policy.

So what type of permanent life insurance should the client choose? I’ll leave you with a simple rule of thumb – the cost of a Whole Life policy is the benchmark price for permanent life insurance protection. Any policy that delivers the same death benefit at a lower price (guaranteed or not) means that someone, somewhere is taking more risk. For Universal Life, Indexed UL and Variable UL, the client is taking risk in the non-guaranteed charges and crediting rates (or subaccount performance, in the case of VUL). For Guaranteed UL and VUL, the insurance company is taking on the mortality and interest rate risk. The reason why Whole Life has stood the test of time is that it is the only structure that fully prices risk for both the policyholder and the life insurer via the guaranteed transformation of future capital to liquid capital. Will these other policies, and the insurers that write them, also stand the test of time? Only time will tell.