Development of Insurance
Before exploring this new life insurance market -- let’s quickly review how insurance came into existence in the first place. Since Biblical times, there have been arrangements for the transfer of risk. Merchants, in ancient times, who sought financing for their overseas trading expeditions obtained loans from investors. If a ship and its merchandise were lost, the owners were not responsible for paying back the loans. Since many ships returned safely, the interest paid by numerous successful merchants covered the risk to the lenders for the few that did not. Fast forward to 1688: Edward Lloyd was running a coffeehouse where London merchants and bankers met informally to do business. At that coffeehouse, financiers who offered insurance contracts to seafarers wrote their names under the specific amount of risk that they would accept in exchange for a certain payment, or premium. These insurers came to be known as underwriters. Less than 100 years later, Lloyd's of London had became a formal syndicate of underwriters -- one that has since grown into the foremost market for marine risks.
As the saying goes, “success breeds success”. The success of transferring risk in the maritime industry was extended to property/casualty risks, sickness, accident and life insurance. Today, it is hard to imagine life without insurance. Starting with those informal roots in Lloyd’s coffee shop, the insurance industry has grown into an indispensable part of the modern economy.
As the industry grew and became more formalized, governments imposed regulations designed to foster solvent insurers and fair treatment of the insurance buying public. In 1774, the British Parliament passed the Gambling Act, which outlawed policyholders from insuring the lives of those whom they had no documented connection. This law turned life insurance from a simple wager (whether somebody -- for example, a member of the royal family -- would live or die) into a far more respectable tool with legitimate financial purposes.
Life insurance -- which started out as simple term policies -- eventually evolved into “permanent” insurance. Permanent life insurance allowed for a lifetime of coverage at a level annual lifetime premiums. Permanent life insurance builds a growing “cash value” into the policy to offset the amount of “pure insurance“ offered by the insurer. For years, the insurer would keep any accumulated cash value if the policy lapsed -- which many did. In 1905, the Armstrong Commission met in New York state to investigate abuses in the insurance industry. As a result, states enacted laws guaranteeing that the policyholder, not the insurer, was entitled to cash values if the policy was surrendered. These are the so-called non-forfeiture options.
Today all states require permanent policies to project a table of “guaranteed cash values”. Those cash values are based on “endowment at age 100” -- which means that the cash value is scheduled to grow until it equals the policy’s face value when the insured reaches age 100. In a traditional whole-life policy, the policyholder can refer to his or her policy to find what the accumulated cash value will be at any age. This cash value grows tax-deferred, providing an investment aspect to the policy. If the insured dies, the insurer pays the full face value of the policy to the beneficiaries tax-free. Those death benefits represent return of the policyholder’s cash value with the insurer contributing the balance. If the policyholder were to surrender the policy prior to the insured’s death, the policyholder would simply receive the accumulated cash value. Any cash value in excess of the policyholder’s cost basis (total premiums paid) is taxable as ordinary income. Until recently, those were the two values available under the policy -- death benefits or cash surrender value. The lack of alternatives led to the buy-and-hold mindset that has predominated life insurance policyholders.