Content: Page 22-23 Becoming Your Own Banker Fifth Edition

As a result of what you learned in lesson 11, the company now has an ever-increasing pool of money. Your premium payments are pooled with that of all other policy owners, but all the accounting is separate. Every policy has the potential of being different. From time to time an insured person dies. It doesn’t happen very often, but when it does, the company pays the beneficiary from the pool of money and the cost of doing so is allocated among all the participants on an equitable basis.

The “hired help” (administrators, etc) must be paid for their work, too, and that cost is also allocated among all the participants.

At the end of each year the directors that actually run the company call the accountants in and, in essence, ask, “How did we do on John Doe’s policy this year in comparison with the assumptions made by the actuaries and the rate-makers in designing it?”

We must remember that an actuary is a kind of engineer and that all engineers “overbuild” everything they design. I think about this fact every time I am at the controls of an airplane. I have never seen an instrument panel that does not contain an airspeed indicator with a red mark somewhere on the face of it, telling you, “Don’t go past this point or the airplane will come apart on you!” That is not really true! It won’t come apart until the airspeed is some 20 to 30% greater than the red mark. The engineers have put a “fudge factor” into the equation.

But, if you operate the airplane just beyond the red line on a regular basis, you are inducing stresses on the wings that are cumulative in their effects and one of these days it will come apart on you. Unfortunately, it will be too late to correct the error of your past behavior!

The actuaries and rate-makers in a life insurance company have done, essentially, the same thing. They have collected more premium than is necessary to do the job. This is because the results of a life insurance plan is all predicated on (1) collection of premiums, (2) earnings on the investments, (3) mortality experience, and (4) business expenses. There are no stockholders in the kind of company that I’m describing so the “extra premium” is the capital that assures the success of the plan.

Furthermore, the policy is engineered to get more efficient every year, no matter what may come. This is a strange phenomenon to most folks, so let’s go back to the airplane world to make an analogy that will help us understand it. Imagine that we are going to make a very long flight in a Boeing 747, and so we load it with all the fuel it will hold. This means that it can fly about 10,000 miles. By the time we have flown 8,000 miles the airplane will now be able to do things that we would never attempt at takeoff – all because we have burned up an enormous quantity of fuel and the airplane weighs that much less. But the engines are capable of producing the same power as when we took off. Therefore, every mile that we fly, the airplane will get more efficient – and you can’t do a thing about it! It gets better – no matter what!

In comparison, a life insurance policy with a mutual (dividend-paying) company enjoys a similar phenomenon – it is engineered to get better every year, no matter what happens (that is, if the Owner does what is called for in premium paying, loan repayments plus interest that is at least equal to or better that the general investment portfolio of the company). In designing a life insurance policy, the rate-makers have taken into consideration the advice of the actuaries that their assumptions (i.e. interest earnings, death claims and administrative costs) are not set in concrete. Over a long period of time the actuaries will be very accurate, but from time to time the results can be better or worse than predicted and can affect the dividend scale declared for the next year. In fact, you can safely say that the real results will never exactly match the illustration provided at the beginning of the life of a policy. But, once a dividend is declared, it is now guaranteed from that point on. It can never lose value in the future.

A significant period of lower than expected earnings of interest, or a period of more than expected death claims and/or administrative costs can result in a “downer” for the company. When this happens in a regular corporation it is the function of the stockholders to “take up the slack.” But, in the case of a mutual life insurance company there are no stockholders! So, the rate-makers are cautioned by the actuaries, “if we calculate that it would take $1.00 per year for a given plan – don’t collect $1.00 – collect $1.10.” This extra .10 is the capital that makes the whole system viable.

We will continue this examination of what is happening in a life insurance contract in lesson 13.