Robert P. Murphy
Get-out-of-debt guru Dave Ramsey recently released on YouTube an excerpt of his show where he called IBC a “scam.” Specifically, someone called in to tell Dave that his financial advisor had touted the benefits of a Whole Life policy with a mutual company, including the dividends. Ramsey was aghast, and explained that since the owners of a mutual company are the customers, any “dividend” they send to you is necessarily coming out of your own pocket. In fact, Dave explained, the IRS itself acknowledges this, by calling such a dividend a “return of a deliberate overcharge of premium”; this is why the IRS doesn’t tax it as income. Dave ended the call by telling his listener that he needed to get a real financial advisor, not someone trying to sell overpriced Whole Life insurance.
On my podcast, I explained what was wrong with Ramsey’s analysis. Although there is a germ of truth in what he said, there’s nothing dubious about mutual life insurers “overcharging” out of conservatism and then distributing the surplus back to the owners, i.e. the policyholders, in the form of a dividend. Besides the convenient tax treatment, this is exactly how we want a conservative institution to behave, when it has the immense responsibility of ensuring that beneficiaries get paid death benefits and that in-force policies continue to hit their scheduled cash-surrender values. As usual, the glib critic—in this case, Dave Ramsey—merely gives us an opportunity to appreciate the wisdom of Nelson Nash. Nelson was right to insist that IBC must be implemented with a dividend-paying Whole Life policy, preferably issued by a mutual company.
Mutual Companies are Owned By the Policyholders
In their pure forms, there are two distinct ways of organizing a life insurance company. One is to raise capital from stockholders who are then the owners; this is a corporation like any other, which happens to be in the business of selling life insurance policies to the public. The other form is a mutual life insurer, in which the policyholders themselves are the owners of the company. (Also, to make life difficult, we must also mention that more recently a hybrid has emerged, namely the mutual holding company, which combines elements of the two approaches, ideally in order to enjoy the best of both worlds.)
A mutual company might sound odd to the uninitiated, but it actually harkens back to the days when clans and communities handled calamities through custom or religious duty. If disaster struck and the breadwinner of a family died suddenly, naturally the extended family and/or tribe (depending on the social organization) would be expected to care for the widow and children. By the 1800s, these notions of spreading risk through reciprocal agreement were codified in the creation of “mutual aid societies.” A mutual life insurance company is simply a more sophisticated, contractually-based outgrowth of these techniques for handling small but catastrophic risks.
Whole Life, Cash Surrender Value, and Dividends
As the name suggests, a “Whole Life” policy is in force for the entire life of the insured; there is no term of expiration. Consequently, when originally entered into, the contract for a Whole Life policy has guaranteed “cash surrender values” at various dates into the future. In other words, the life insurance company is guaranteeing the policyholder that if he should want to walk away from the policy at any point in the future, that he will be paid a cash spot payment as a severance package. The guaranteed minimum of these cash payments rises over time, reflecting the fact that the insurer will have been able to invest premium payments longer as the policy matures.
Now precisely because the policyholders themselves are the owners of a mutual insurance company, there is no external group of stockholders who must be shown a competitive rate of return on their investment. (As LMR readers surely know, for various reasons having to do with both government intervention and human avarice, this aspect of capitalism doesn’t always lead to the best long-run management of stock corporations.) This allows the actual managers of a mutual company to be extremely conservative in their decisions. They have the actuaries overestimate how many people are likely to die in the coming years, and they have their financial officers underestimate the upcoming performance on the company’s asset portfolio. With these extremely conservative estimates, they then charge contractually specified premiums on the life insurance policies that they issue.
After each accounting period, the dust settles and the company is typically left with a “divisible surplus,” which is then distributed to policyholders in an equitable fashion. (Remember, there are no outside stockholders with an equity claim on the company’s net income.) Now here’s an interesting quirk: Although mutual companies didn’t arrange their operations for this reason, their procedure happens to have an amazing tax benefit. Specifically, because the organizing rationale for the operation is to provide death benefit payments (and cash surrender values that hit their contractually guaranteed targets over time), the “dividend” payments aren’t treated as taxable income in the same way that a dividend from ownership in a regular corporation would. As Dave Ramsey said, the IRS treats the dividend payment from a mutual life insurance company as a partial return of the original premium, which in retrospect turned out to be higher than necessary for the mutual company to achieve its objectives for the owners.
(NOTE: In this article I am not giving formal tax advice. Please consult with a qualified professional before making any moves in your own personal or business finances. I strongly encourage you to consult the graduates of our Authorized IBC Practitioner Program, available here: www.InfiniteBanking.org/Finder.)
Problems for Dave Ramsey
The way Dave Ramsey explained it, you aren’t really benefiting from getting a dividend payment from a mutual life insurer, because after all you’re just getting (some) of your own money back. But wait a second. If you look at the first illustration in our book The Case for IBC—and by the way, I go through this example in our Foundations of IBC video series which is free online, if you can’t stand the suspense and want to see the numbers right away—you’ll see some problems for Ramsey’s story.
First of all, as the policy matures the dividend keeps rising every year. Eventually, the annual dividend becomes higher than the annual premium. Then, at a certain age the policy becomes “paid up” and the contractual premium goes to $0; yet the dividend continues to grow. Finally, and most troubling of all for Ramsey’s story, there comes a point in the policy where the policyholder has received more total dollars in cumulative dividend payments than he ever paid in cumulative premium payments. This, incidentally, is when the IRS would begin treating further dividend payments as taxable income, because clearly it can’t be construed as a “return of premium” when the entire lifetime premium payments have already been returned.
So what’s going on here? Ramsey’s mistake is that he ignored the time element. The mutual life insurer takes premium payments from the policyholders and invests them in financial assets, which themselves generate income over time. This is the source of “excess dollars” out of which the home office can afford to send policyholders more money than they originally put in.
Indeed, to see just how silly Ramsey’s mistake was, I could turn his critique on its head and say the same thing about his cherished mutual funds: “Hey everybody, Dave Ramsey is telling you to put your money in mutual funds. But think about it: The customer of the mutual fund is someone like you. The only place they get money is from customers like you. So if they give you ‘returns’ or ‘dividends’ on your investment, it can only be coming out of the pot of money that you and other customers originally put in. Talk about a scam!”
In my podcast episode, I designed a simple example (which abstracted away from the real-world complications of mortality risks) to show specifically how life insurance companies “overcharge” out of conservatism and then remit the surplus back in the form of dividends. For the curious, you can see exactly what’s going on under the hood, and you will understand why there’s nothing fishy going on. (See the endnotes for a link to the episode.)
Nelson Nash was an incredibly wise man. He saw an old and venerable institution—Whole Life insurance provided by a mutual company—and realized it would be the foundation upon which first hundreds, then thousands, and eventually millions would secede from the conventional banking system. Nelson was fond of quoting the Bible, so I think he would endorse my paraphrase of Deuteronomy 15:6 that IBC shows us how to become lenders to many outside entities but be a borrower from none. As Nelson said, becoming your own banker is a very stress-free way of living.
 The main episode is available at: www.BobMurphyShow.com/168. However, once there the reader should click on the link to the YouTube version of the episode, in order to see the Excel spreadsheet with the numerical example.