Nomenclature

I’ve been writing this blog for a couple years now which isn’t my point today. My point is this: Why do I write this blog? And the reason is because I am searching for the truth. Leonard Read, one of Nelson Nash’s mentors, wrote, and I paraphrase, “that for someone to fully be knowledgeable about some particular topic they must be able to write it down.” As I initially began attempting to share IBC with others I found it hard to express what I’d found to work in my own life.

As time progressed I found it easier to express myself on paper (electric paper though it be) and others told me that they were able to benefit from reading what I’d written. That’s when I began to publish this blog. Not as someone who knew it all or even someone who was attempting to correct the many falsehoods and misapplied truths that are circulating out there in the financial world.

With this cognizance, I’m mindful of times where clarification or even correction has been needed for something which I’ve published here that was not fully precise or could be implied to be inaccurate. Whenever this happens I think of what I was taught in school when training to be a doctor. A doctor, I was taught, is in practice because he is practicing his applied knowledge on patient subjects. His knowledge may be correct or partially correct based on his training and skills. But it is his duty to use his best judgment and skills with each patient and to determine what would be best in each case. That is why a doctor’s clients are called patients and a doctor’s business is called a practice.

Enough with medical terminology though. Let’s discuss some insurance nomenclature.
Many people want to know what the guarantee in whole life insurance contracts really means. Of course a search of the internet can give you a fairly good idea of what the guarantee is all about, but I have asked several actuaries to explain to me what it means and I want to pass that knowledge on to you as best I can.

First of all there are two sides to a whole life insurance policy illustration. The first side of the illustration is the side which is contractually guaranteed. This means that the numbers printed here are going to happen. These numbers can be guaranteed because the actuaries have calculated them by using an assumed rate which produced these numbers. Furthermore, this assumed rate is listed somewhere in your policy contract with the insurance company.

In the past I have referred to this assumed rate which the actuaries use as a guaranteed rate. However, that is not a precise definition and can be implied to mean something that it is not, namely a guaranteed rate of return. This rate is simply an assumed number used to calculate the numeric values which the company can guarantee to you and which they list on the guaranteed side of the policy illustration. This is a bit like saying that your house is guaranteed to be blue after you have it painted because the painter used an assortment of assumed colors which are known to produce blue when he mixes them together in the paint he’s going to paint your house with. But in today’s legal world there is a difference and you need to know what that difference is. But which is more important to you, the assumed rate the actuaries use to get your guaranteed numbers or, the guaranteed numbers? That depends on if you’re the type of person who needs to know the assortment of assumed colors the painter uses to provide you with a guarantee that your house will be a blue house after he paints it.

Secondly, dividends in a whole life policy can concern a policy owner as they attempt to figure how they add up or how they were calculated to begin with. The easiest way I’ve come to understand what dividends are and how they are calculated is to think of a business. If the business is profitable then that means they were able to sell more than what it cost them to stay in business.

In whole life insurance you pay a price for your policy based on an assumed number which the actuaries use to figure out what it will cost the insurance company to stay in business. That means paying for the cost of mortality and expenditures which is their cost of doing business. If that assumed number is too big (which actuaries always attempt to make it) then the insurance company will take in more than it needs to pay in mortality and expenses for the year. Once the company knows exactly what amount it has cost them to stay in business for the year any extra money which they have taken in or earned in their portfolio for the year can be returned to the whole life policy holders. And that is called a dividend.

Now the way this dividend number is reported can be confusing too. For example; if the company reports a 6% dividend, many policy holders may think that they are going to receive a cash value increase of 6%. But this 6% is not a fixed amount of money that is going to be placed in a policy owner’s non-guaranteed cash values and raise those cash values by 6%. This 6% is simply the extra money which was collected in premiums or, which was produced in the portfolio of the insurance company, beyond the costs of mortality and expenditures for the year. Historically this dividend has and can exceed what the cost of your insurance policy premiums were given a long enough time.

Finally, a concern can arise about how to calculate future cash values in your policies for retirement purposes. And we have to remember that retirement is not a word that is grounded in reality. When you consider what you do with a coat or a pair of shoes which you retire you realize that retirement is not what you’re really looking for to make your life more enjoyable in later years. With that frame of mind, knowing exactly what your policy cash values will be in 10, 20 or even 50 years from now is no longer crucial for you to know. All other methods of preparing for retirement are based on rates of return and contain no guaranteed values or factual tax basis for the future. Yet these methods are widely used in future planning even though they are based on assumed numbers which historically have not been accurate. On the other hand whole life insurance cash values and death benefits are guaranteed, even though the rate used to calculate these guaranteed values are assumed. Go figure. On top of this the dividends which are paid over the life time in a whole life insurance policy become contractually yours each time they are declared and as mentioned earlier, historically your dividends can more than pay the cost of your insurance over time.

So thank you for letting me continue to practice. As I learn more I’ll share it with you if you’ll be kind enough to share with me how the application of that knowledge is working for you. There is nothing more exciting as a doctor than to see that what you suggest (prescribe) for a patient is working.

by Dr. Tomas McFie