Life Insurance as an Asset Class

Updated October, 2006

When it comes to financial mysteries, few seem as impenetrable as life insurance. The basic product is quite simple: you (and a lot of other people) contribute a fixed amount of money each year (called a premium) for a certain period of time (called the term of the insurance policy) into a common pool. Some of these funds are used to pay the life insurance company's operating expenses (including the commissions they pay to the people who sell their product). The remaining funds are invested so that they grow over time. If you die during the term of the life insurance policy, your beneficiary receives a predetermined amount (the death benefit) to make up for the income that is lost through your death. This simple product is known as "term insurance", and it is a pure risk management product.

The confusion about life insurance is caused when life insurance companies bundle investment products with their basic risk management offering. Because these bundled policies have no fixed expiration date, they are known as "permanent" insurance. Conceptually, they all work the same way. First, you pay the life insurance company an annual premium. As in the case of term insurance, some of these funds are used to pay the insurance company's operating and distribution expenses. Most funds are invested in a mix of asset classes (e.g., equity, bonds, real estate, etc.). From this investment pool, some payments are made for death benefits. The funds not used for this purpose are distributed back to the policyowners at the end of the year in the form of what life insurance companies call a "dividend" payment. Over time, these dividend payments increase the "cash value" of the policy. This is the amount the policyholder would receive if he or she terminated the policy before his or her beneficiary received the death benefit (in insurance speak, this is known as "surrendering" the policy). This is the amount the policyholder would receive if he or she terminated ("surrendered") the policy before his or her beneficiary received the death benefit (of course, there are other options for using dividend payments, like buying additional insurance coverage or reducing annual premiums. However, in this article, we will assume they are used to increase the policy's cash value).

Permanent insurance goes by many names. In general, four broad categories of products can be distinguished. In the case of traditional "whole life" policies, your premium amount is fixed, and you have no control over how the insurance company invests the funds you give them. In "universal life" policies, you have some ability to vary the size of your premium payment, but no control over how your funds are invested. In the case of "variable life", your premium is fixed, but you control how it is invested between different separate accounts offered by the life company (e.g., a bond account, a U.S. equity account, etc.). Conceptually, these separate investment accounts are like mutual funds. Finally, a "universal variable" policy allows you to both vary the size of your premium payment and control how those funds are invested.

All this complexity raises an obvious question: why would someone choose a bundled product over the apparently simpler alternative of purchasing term insurance and investing in mutual and exchange traded funds? The first reason is that, thanks to very effective lobbying by the insurance industry many years ago, the build-up of life insurance policy cash values is exempt from annual income tax. However, if the policy is surrendered before death, ordinary income tax is owed on the difference between the cash value received and the sum of premium payments made over the policy's life (unless the cash value is rolled into another life policy or annuity, in which case no tax is owed). In this case, if a person had already made their maximum contribution to other tax advantaged savings vehicles (like a 401k and IRA), then a permanent life policy might make sense.

The second reason is that a person might prefer level premiums over time. While some term policies offer level premiums for certain periods, their cost increases quite sharply with age. Only permanent insurance offers a constant premium payment over the life of the policy.

The third reason a person might choose a bundled policy is because he or she believes (usually based on a sales agent's presentation) that in addition to risk protection, it offers an attractive investment alternative. The problem we face is that the life insurance industry makes it virtually impossible to ascertain the accuracy of such assertions. While life insurance companies disclose their gross dividend rates, they do not, as a rule, clearly disclose either the operating or mortality expenses that are charged to arrive at the net dividend that is added to a policy's existing cash value. As a result, the question of whether or not a whole life policy is a good investment can only be answered approximately.

In light of this, we have chosen to address this question by looking at the example of a single type of policy from a single company. To keep it simple, we have chosen a whole life policy. To put the insurance industry in the best light, we have chosen to look at the gross dividend yields on a whole life policy from Northwestern Mutual Life (NWML), which for years has been widely regarded as the best company in the industry.

As an aside, we should note that, beyond good underwriting, investment management, and cost control skills, Northwestern Mutual's top performance rating also derives from its mutual ownership structure. In mutual companies, policyholders own the company, and receive the entire benefit of investment returns that are in excess of operating and mortality charges. In an investor-owned insurance company, these benefits must be divided between shareholders and policyowners. We should also note that in the mutual fund world, only Vanguard is owned by its fundowners, which is another reason it is able to keep the expenses charged on its index funds at such low levels.

But we digress. Back to our NWML example. Between 1971 and 2000 (a period chosen to allow comparisons with other asset classes), the gross dividend on our NWML whole life policy averaged 8.21%. Various writers have noted that operating expense and mortality charges typically reduce gross dividend rates by two to three percent. At most, this would reduce NWML's average dividend yield to 5.21% per year. However, as regular readers know, return is only one third of the investment story. The variability of those returns (as measured by their standard deviation), as well as their correlations with returns on other asset classes are also important.

When these are taken into account, the NWML whole life policy looks quite attractive. First, the standard deviation. At only 2.05%, it yields a return per unit of risk ratio of between 4.00% (8.21/2.05) and 2.54% (5.21/20.05). Over the period we analyzed, only one year U.S. treasury bills could come close to this performance, at 2.33% (average return of 7.71% divided by a standard deviation of 3.31%).

The correlations with other asset class returns are also impressively low, as shown in the following table:

Despite these results, we caution against drawing any broad conclusions from this analysis. While it clearly indicates that a whole life policy from Northwestern Mutual seems to provide attractive diversification benefits in an overall asset portfolio, it does not in any way suggest that this is the case with other whole life policies (or other types of policy) from other life insurance companies, whose investment, operating, and mortality experience will undoubtedly be different from NWML's.