“Someday financial markets will decline...rising stock/bond markets will no longer be government policy. QE will end and money won’t be free. Corporate failure will be permitted. The economy will turn. Someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be commensurate with risk.” Seth Klarman
Friday, October 30, 2015
Buy Term, Whole Life Insurance, or Both? Part 3: Whole Life Insurance and Economic Modeling—Enter "Buy Term and Invest the Difference"
This is the third in a series of articles summarizing a preeminent, recent study examining the intersection of insurance and personal savings.
In “Buy Term and Invest the Difference Revisited,” finance professors David F. Babbel from The Wharton School of the University of Pennsylvania and Oliver D. Hahl from Tepper School of Business, Carnegie Mellon University examine in detail term vs. whole life insurance in a paper published in May of this year in theJournal of Financial Service Professionals.
Whole Life Insurance
Babbel and Hahl define whole life insurance this way:
“The insurance contract known as whole life differs in several respects from term life. In its classic textbook form, whole life has level premiums that are paid through life and a death benefit paid regardless of the age of the insured at death—hence the name ‘whole life’. Unlike term insurance, the whole life contract never expires, so it never has to be renewed nor be converted. The insured maintains protection against the financial consequences of death as long as he or she lives, and regardless of changes in health.
Level premium whole life has an investment element that accumulates over time and goes to offset the higher costs of life insurance as the insured ages. This investment element provides a number of options to the insured that enhance the policy’s flexibility.”
Economic Modeling of Whole Life Contracts
Beginning in the 1960s it became popular to break down various investments into individual parts. For example, it became possible to purchase the “principal only” or “interest only” portions of mortgages or U.S. Treasuries, or even various tranches of payment streams, from years 3 to 6, for example. In this spirit, economists attempted to model whole life insurance into its component parts:
“…early studies considered whole life insurance to be ‘a linear combination of one period (year) term life insurance and a savings plan of some sort(emphasis added)” The last part of this statement is emphasized for a good reason. The ‘sort’ of savings plan assumed was not, and even today is not, available to consumers apart from what is embedded in a whole life policy, as will be discussed later.” [Emphasis added.]
Enter Buy Term and Invest the Difference
Financial marketers eventually got a hold of this idea and decided to “unbundle” whole life insurance into its “assumed” components of term life and an investment program. This marketing campaign was titled “Buy Term and Invest the Difference” (“BTID”).
These solicitations conveniently happened to offer not only term insurance, but an assortment of mutual funds and other investments that could be purchased together with the term insurance.
One such marketing program, initiated in 1977 by a former high school football coach named A. L. Williams grew extraordinarily, exciting the surrender of many whole life policies to deliver monies to Williams and his favored companies, including his own.
Life insurers were concerned that replacing whole life with term and a separate investment program might leave the financially inexpert consumer worse off. They felt caution should precede such decisions given the increased risks involved with inexperienced individuals making specific investment decisions in a field with which they were not commonly familiar.
To keep these articles manageably brief, I will end until the next installment:
PART 4: Significant Behavioral Limitations to the Buy Term and Invest the Difference Model: Adverse Selection and Mental Accounting in Budgeting
 David F. Babbel and Oliver D. Hahl, “Buy Term and Invest the Difference Revisited.” Journal of Financial Service Professionals 69, No. 3 (2015), 92-103. (LINK)
 Scott F. Richard, “Optimal Consumption, Portfolio and Life Insurance Rules for an Uncertain Lived Individual in a Continuous Time Model.” Journal of Financial Economics 2, No. 2 (1975): p. 188.