Learn more about Life Insurance than your Insurance Agent knows Part 6

In today’s post, we’ll discuss how the high interest rates of the 1980′s created lots of change in the types of insurance that were sold thereafter. This is Part 6 in the series, and you may want to read the other articles by clicking on the following: Part 1, Part 2, Part 3, Part 4, Part 5. So the first thing you might be thinking is "What do interest rates have to do with insurance policies???" – well let’s revisit the graph from Part 5.

If you remember, the overpayment in the early years is directed into an investment portfolio which is predominantly fixed-income in nature. The rate of return on fixed income investments are very closely tied to prevailing interest rates. During the 1980′s interest rates were incredibly high – around 20% at the peak!!

What the insurance companies do when they are figuring out the insurance premiums for whole life is factor in the expected death of the "life-insured" along with their current age first. This allows them to calculate how much the pure cost of insurance is. Essentially, if you are expected to die at 85, and are 25 now, and would like $500,000 in coverage – they will calculate how much money they will need from you over the next 60 years so that they will have $500,000 to give you at age 85. If you live longer – you "lost" in that you overpaid for the $500,000. If you die early, you have "won". They also factor in how fast they can make the money you give them grow.

So with whole life, where you are overpaying in the early years, the investment portfolio’s rate of return needs to be estimated for a very long period of time because once the premium has been determined, the insurance company has to stick to it. And of course because the insurance companies are not "non-profit" companies, they will tack on an additional amount to cover their expenses and also to produce a profit for their services. Because of this, they tend to underestimate the rate of return of the investment portfolios when calculating premiums – which means premiums go up in price.

Well, during the 1980′s, and specifically after the interest rates had started to come back down, the insurance companies were being a little too cautious with their estimates. Whereas the premiums were based on perhaps a 6% long term rate of return, they were collecting 10% or more on these investment portfolios. So let’s say in any given year that 100 people with policies died and they all had policies for $500,000. The insurance company was on the hook for $50 million – but they knew that, and using the estimated rate of return for the portfolios (example 6%) they would’ve had $60 million (example) – enough to pay the claims with something left over for expenses and profit. But since the portfolios grew at 10%, maybe they had $120 million – so they had $70 million left over for the same expenses and therefore MUCH HIGHER PROFITS.

Check the price histories of insurance companies during this time – they were amongst the best stocks to own because they were money making machines! So what happened after that? Well, people became wise to this and they decided to do something about it! Which we will cover in Parts 7 and 8! Stay tuned…

CLICK HERE TO GO TO PART 7