One thing I don’t understand at all – in accounts of early and mid-20th century America you see life insurance policies treated...
One thing I don’t understand at all – in accounts of early and mid-20th century America you see life insurance policies treated how homeownership-by-mortgage is now: as an investment you gradually build equity in and can later partially or fully “cash out” as a nest egg.
And I kinda get it - an active policy is like a bond of unknown (but actuarially predictable) maturity and negative coupon rate (the premiums), I can see why that would be a negotiable instrument and tax/regulatory policy might’ve favored that vehicle over other types of savings
But when doomed-seeming AIDS patients were pre-selling their insurance payouts in the 80s it was something distinct, “viaticals”, so how did the prior system work?
You may already be familiar with how whole life insurance works, but to briefly review, overpayment of premiums (relative to the premiums that would be required for a comparable term life insurance policy) build up an endowment to pay for the eventual death benefit.
The question is: why don’t people buy the (economically equivalent) term life insurance policy plus bundle of securities? One answer is that savings options for middle class people in the era before online brokerages and index funds were substantially worse than they are today, so while the fees of whole life insurance make it unattractive today it was comparatively more reasonable back then.
But there is another piece. And, as you surmised, that missing piece is a tax arbitrage. In the US, life insurance payouts are generally not taxable income for the insured. Estate tax is paid the inheritance of life insurance proceeds, so for an actual payout, the money is still taxed to some extent (also you’re dead). But insurance companies would let people borrow money against their endowment. The loan is also not taxable (because it’s a loan, not income) and the interest rate is low (because it’s 100% secured). Voila, a tax-free savings vehicle for your retirement in the era before Roth IRAs.
Now, viaticals for AIDS patients is something else. A “viatical” is not an insurance policy, but the technical name for that kind of “pre-selling” of the payout for an existing policy.
The “loan against the endowment” (or the larger-but-taxable cashout option) requires you to have built up an endowment. That works for retired people who have paid into their policy for decades, but not for young people. However, young people who actually die still get the death benefit (paid for by the “non-excess” proceeds, which effectively pay for a term life insurance policy). So a young person who’s terminally ill and needs money before they die can go to a third party and get paid a lump sum in exchange for the right to collect the insurance payout when they die. The third party is willing to pay almost as much as the value of the payout, because the insured is, as noted, terminally ill, so the third party doesn’t expect to wait long for the money.
oh!