Life insurance has become this excruciatingly difficult topic for most people. It’s not fun to think about, it’s not fun to talk about. And, it’s not fun to buy. It’s a financial product that you purchase that provides a lump sum of money to your family (or to anyone you wish) if you die while the policy is in force (meaning, all the premiums due are paid). Think of it as a savings that you don’t have in your bank account, but are paying for on a monthly basis that is guaranteed to be there if your family needs it. It’s sort of an “emergency” savings. The emergency being your death. Not a pleasant thought.
For some life insurance contracts, the insurance company builds an equity (cash) reserve against that death benefit, reducing the risk to the insurance company and giving you the value of that death benefit in cash over the life of the contract. These are considered “permanent life insurance” contracts. Until you decide to take the money, it just sits there on account with the insurance company. Other life insurance contracts, called term insurance policies, provide just the death benefit, and no access to any of the money you’re putting towards the policy.
OK, so far so good. With any luck, you understand what I just wrote. If you’ve “been around the block before”, you’ve probably also heard some of what I just wrote.
Now for the stuff you probably haven’t heard before. Because the next question that arises is:
OK, so what kind of life insurance should I buy?
This question is always funny to me because it’s like asking “what should I buy for transportation-a bicycle or a car?”. If we assume that term insurance is more like a bike and permanent insurance is more like a car, I’m sure you’ll see how the answer to this question really depends on what you need or want the life insurance for. Most everyone living today needs a car if they plan on doing any kind of long distance driving. But, some people, who never plan on ever doing any long distance driving, never buy a car. And, they don’t need one.
The “bicycle approach” to buying life insurance is simple and cheap, but limited in what it can do. It will get you from point “A” to point “B”.
The “car approach” to buying life insurance requires an initially higher cash outlay and is a little more complex in what you need to look for. But, if it’s a well designed policy, you’ll always get back more than what you put into it.
If you’re out and about on the Internet, you might have noticed that there are just a few articles about life insurance…and a few more on what kind of insurance you should be buying. Don’t worry, I’ve noticed it too.
However, I’ve also noticed a few misleading statements that keep cropping in these articles, so I thought I’d spend some time clearing up some of the confusion. Most of the misinformation in the industry centers around permanent life insurance, so I think I’ll end up focusing mostly on that aspect of things in this article. OK, so here we go…
Misleading statement #1:
Cash value life insurance is one of the worst financial products available, and it is definitely the worst type of insurance you can buy to insure your life. The BEST kind of insurance is term insurance because it’s cheap and I’m not paying all those extra fees to the evil and greedy insurance company. Besides, don’t insurance companies have a record of being reckless, cheating their policyholders, and systematically going out of business.
Fact: Oh boy. Let’s be very careful when we use terms like “the best”. There is no way to answer this question rationally when it’s posed like that. The best always implies “for whom, and for what purpose?”.
For example, term insurance can be the best type of insurance if you think you only need a policy for 20 years to cover your mortgage and all you are considering is the cost of pure insurance. You’re only paying for the pure insurance coverage, which translates into those dirt cheap premiums you see advertised on T.V. and plastered all over the web.
A term policy is also great when you just can’t afford very much in the way of premiums, but still want to insure your financial responsibilities right now. While annual renewable term is the cheapest, at least initially, it will become more expensive (all term policies do). A level term policy inflates the cost of insurance, similar to a permanent policy, but by doing this up front, it holds down the cost of insurance in the later years of the term policy which effectively levels out the premiums for a specified period (the term of the policy).
Statistically speaking, term insurance doesn’t pay out very well. The industry estimates that only about 2% to 3% of all term insurance policies ever pay a claim. Insurance agents sell a lot of term insurance by “selling the fear”. You could die tomorrow, and then what? That’s the summary of a life insurance sale’s pitch. It’s the idea that you have uncovered financial liabilities and unprotected moral responsibilities (i.e. children) that you need to insure right now in the event that you die unexpectedly.
That’s exactly how life insurance agents sell a lot of life insurance policies to customers. Get them thinking that they could wrap their car around a telephone pole on the way to work. Nice huh?
The reality is, insurance companies aren’t stupid. If premature death was that prevalent, there wouldn’t be a life insurance industry. Insurance uses something called the Law of Large Numbers. Basically this is how it works: the larger the group of people you are insuring, the more certain you can be about the number of losses you will sustain.
For example, if we were to start an insurance company and we only had one customer, we would be taking on an incredible risk because of the nature of life insurance. If that one person dies, we could be out of business very quickly (imagine that one customer giving you $20 for a $250,000 death benefit and then dying the very next day). If, however, we have a million customers, then we can better control the risks we are taking by insuring other people’s lives. No one can predict when an individual will die, but if we study a large enough group of people, we can make surprisingly accurate predictions about the number of individuals within that group that will die in any given year.
To further illustrate this principle, consider this: A 40 year old male who is a non-smoker may live to be 100 years old. But he may also be hit by a drunk driver tomorrow – it is impossible to know exactly how his life will play out. However, if we sample 100,000 40 year old non-smokers, we can study how many of them will die due to car accidents, how many will die of “natural causes”, and so on. We may develop a statistic that tells us that every year roughly 300 40 year old non smokers will die. We won’t know before hand exactly who those 300 people will be (obviously), but we can make a very accurate prediction that 300 people will die. We can, in turn, use this information to create and price life insurance policies accordingly.
It is no accident that term insurance is the cheapest form of life insurance. Remember there is no such thing as a free lunch. The reason it can be priced so low is going to be one of two reasons: the insurance company expects you to lapse your policy before they have to pay a claim, or, you simply outlive the term of the policy and they raise the premiums high enough to the point where you can no longer afford to pay for the coverage.
Now, that ‘s not to say that term is a ripoff. It isn’t. You are paying for coverage and you’re getting it. The insurance company is taking a very low risk, and collecting a lot of money from people buying term insurance without the fear of ever having to pay out very many death claims.
In response to the argument that “insurance companies have a record of being reckless, cheating their policyholders, and systematically going out of business”, this is simply a case of mistaken identity. In his book Money, Bank Credit, & Economic Cycles, Jesús Huerta de Soto writes that:
The institution of life insurance has gradually and spontaneously taken shape in the market over the last two hundred years. It is based on a series of technical, actuarial, financial and juridical principles of business behavior which have enabled it to perform its mission perfectly and survive economic crises and recessions which other institutions, especially banking, have been unable to overcome. Therefore the high “financial death rate” of banks, which systematically suspend payments and fail without the support of the central bank, has historically contrasted with the health and technical solvency of life insurance companies. (In the last two hundred years, a negligible number of life insurance companies have disappeared due to financial difficulties.)
During one of the most turbulent financial times in our nation’s history – the Great Depression – it was the insurance contract which provided the most stable financial shelter, not the demand deposit accounts (checking and savings accounts) offered by banks. While many banks failed and never reopened their doors, while the stock market crumbled, and many people lost their entire life’s savings, insurance companies were one of the only institutions to survive intact and almost virtually unscathed. This scenario continues to repeat itself during every period of recession or depression in this country.
Even when giants like AIG are supposed to be reeling (but their life and annuity business has not lost any money), the industry as a whole is hunkering down and can (and probably will) weather yet another financial storm.
Insurance companies don’t cheat their policy holders. On the contrary. Because of their more conservative approach to investing and money management, insurance companies can shelter their policyholders from market risk (excluding variable life insurance), are able to avoid calamity, and as a result come out on top when compared to other financial institutions. With a cash value insurance policy, they can actually protect the bulk of their policyholder’s savings from unnecessary exposure to market and bank volatility. With a term insurance policy, the company’s reserve account is kept in tact to pay any claims that need to be paid.
While it is possible, corporate theft in the life insurance business is rare. More often than not, what is often thought of as being “ripped off” is really just “concealment” on the part of the insured. A warranty in the insurance business is a statement made by someone who is applying for life insurance. The warranty refers to a statement made by the applicant. The insurance company is supposed to be able to trust that the applicant is telling the truth-this is the warranty. If the applicant lies about a material fact (a fact that has a bearing on whether insurance would be issued or how an insurance contract would be issued by an insurer), then the insurance company can revoke the contract or alter its terms.
To the unknowing public, this can easily be made to look like an insurance company scamming a poor helpless individual, when in fact, it was the individual that was lying to obtain insurance coverage that he or she may not have gotten otherwise.
Misleading statement #2:
Cash value life insurance is overpriced for what you get. Also, you can never tell how much money you are spending on death benefit and how much money is actually going into the cash value of the policy. With term insurance, the costs are clear.
Fact: “Overpriced” is a very generic term. Overpriced compared to what? Normally, when a salesman is telling you that life insurance is overpriced, they are trying to sell you mutual funds or stocks. Of course, someone is probably trying to sell you life insurance when they tell you that mutual funds and stocks are expensive, so it works both ways.
When you hear words like “overpriced for what you get” or just “overpriced”, always ask “compared to what?”. People who buy life insurance are primarily looking for one of two things (sometimes both)
1) a death benefit and/or
2) a secure savings
With this in mind, compare life insurance contracts. Don’t compare life insurance to other investments. The reason is simple. When you look at financial products, you want to be comparing the product with its peers, not other products that are outside of its investment function or experience. For example, when you buy a share of Microsoft, you don’t compare it with a real estate investment trust to see if the Microsoft share is a good buy. You compare the Microsoft stock to other software and tech companies. Likewise, when you buy a life insurance policy, compare it to other policies. There are many different kinds of contracts on the market. Some are built and priced well, some aren’t. It is possible to buy a poorly designed whole life, universal life, or variable life policy. But it’s also very possible to buy a policy that will return 10 times its annual premium in interest or dividend payments every year.
As to the costs of the contract: with term insurance, the costs are very clear. With whole life insurance, it is not possible to know directly what the cost of insurance is, though it can be calculated over time indirectly from the guaranteed and non-guaranteed cash values of the policy. A universal life insurance policy is, in actuality, a term policy with a separate cash account – often called ‘the pot of money’. The UL contract separates out the mortality function of the policy and the investment component. You can know what everything costs, how much is going to pay the death benefit, and how much is going into the cash value of the policy.
Cash value insurance can seem expensive in comparison to term insurance because of the front load (commissions and administrative fees) nature of the contract and the fact that you are forced to save money in a cash account. In the early years of the policy, perhaps the first 2 or 3, there’s not much cash available inside the cash account and you start to wonder if you’ve made the right move by buying a permanent policy. Of course, over time, this tends to even out. Especially if your policy was designed well
Misleading statement #3:
If you are smart with the money you have today and you get rid of your mortgages, car loans and credit card debt and put money into retirement plans you don’t need insurance 30 years from now to protect your family when you die.
Fact: Being a “smart” investor doesn’t guarantee that you will be shielded from market corrections. Many investors who were otherwise pretty good at investing (i.e. high net worth investors) lost a lot of money in the 1930s, in the ’80s, in the 90s, in 2000 and 2008.
It’s true that you might not need a death benefit when you’re old and gray and the kids are gone and your home is paid off. At that point, you might be wondering why you purchased a permanent policy. Of course, the death benefit isn’t likely to be costing you much, if anything, since the net amount at risk to the company decreases as you grow older. Many people would have dropped the death benefit at age 65 and relied on their savings to produce a consistent, reliable, income. Others are OK with having the death benefit that comes with a permanent policy. Paying the cost of insurance at that age is still cheaper than paying taxes on investment earnings and well designed permanent policies tend to be income producing in the latter years anyway (if that’s what you purchased the policy for). So, in terms of the savings component, this is largely a personal choice.
However, one financial responsibility that is certain is your death. You are responsible for your own burial expenses. And, for that alone, a small permanent policy-at the very least-is a wise choice.
Another beneficial reason for owning life insurance in your old age is to offset the taxes that must be paid on retirement accounts or your estate. Your beneficiary will receive the value of your retirement plan when you die and the amount will be subject to income taxes. If you used an IRA and the beneficiary is your spouse then, under current tax law, the spouse can just roll over your IRA into theirs – delaying the tax due until the spouse draws the money out (note: this approach may also increase the RMD on the IRA at age 70 ½). If your beneficiary is not your spouse, and you used an IRA, then your beneficiaries may be able to “stretch” the IRA over their lifetime. They will still pay income taxes on the money, but they are basically just delaying the inevitable – the money will eventually drain out of the account and be taxed.
Since life insurance death benefits are tax free, they can help your beneficiaries pay the taxes owed on these accounts. Obviously, you are under no obligation to buy permanent insurance to cover this cost after you are dead. However, if there are things that you really and truly want to have happen (with your estate) after you’re dead, it’s probably a good idea to make sure that things get done the way you’d like them to get done.
These are just a few examples of when you might want life insurance as you get older. Saying, as a blanket rule, that you’ll never need it is simply not true. You might not, but then again you might.
Misleading statement #4:
Instead of buying a cash value life insurance policy, you would be better off getting a term policy and investing the difference. If a $100,000 whole life policy cost $100/month, you could likely get a bigger term policy (i.e. $150,000) for just $10/month and put the extra $90 in a cookie jar or under your mattress. After 3 years you would have $3,000 and when you died your family would get your savings.
Fact: This is actually something Dave Ramsey uses as an example. If you invest $90 per month, even at a 10% NET rate of return, you have $3,791 after 3 years. Both Dave Ramsey and Suze Orman love to point this out and then say that there’s nothing (or close to nothing) in your cash value life insurance policy.
It’s true, the first 3 years of most permanent life insurance policies have little or no cash values available for you to use (unless it’s a high cash value policy or a limited pay policy, in which case cash is always in there in the first year).
I don’t really like the way interest is compared using these kinds of comparisons because it compares the savings without the cost of the term added in. Remember, with permanent insurance, the savings and insurance are lumped together. When you figure out the effective yield on Ramsey’s “superior” plan, it’s a measly 1.73% (you contributed $3,600 over those 3 years with the cost of the term added in and your total cash at the end of 3 years is $3,791).
Ramsey loves to think that anyone can average 10%, 12%, or even 15% in their mutual fund for 20 or more years. Perhaps he knows something that DALBAR INC. doesn’t. Most investors only earn 2%-3% in mutual funds. Most whole life policies earn 3%-4%. A well designed policy will earn 4%-6%.
And, besides that, averaging investment returns can be a bit deceptive in and of itself, so I caution anyone, even those interested in some of the fancier life insurance policies with investment sub-accounts, that averaging doesn’t always tell the whole story. Actual compound growth can differ significantly from your averages.
As long as we’re talking about investments, that’s another thing I see a lot of financial advisers doing. They try to draw a connection between insurance and investing in the process of telling you what a lousy investment cash value life insurance is. Comparing life insurance to an investment is a bit nonsensical – at least from the policy owner’s perspective. You’re not buying an investment, you’re buying a contract designed to leverage your savings and transfer financial risk to a large financial institution.
To say it in simpler terms, you don’t have $500,000 to give to your children or your spouse if you were to die tomorrow, but a life insurance company does. As time goes on, the cash value in your policy builds up. In the later years of your life (and of the policy), your cash value becomes the savings you didn’t have when you started the policy. It really is that simple.
On the other hand, investing is a long-term approach to increasing the value of your savings, but it is not guaranteed to be there for anyone in the future. It is an attempt to grow your savings by applying an objective method of buying financial assets with the expectation, but not the promise, that they will increase in value. This stands in clear contradiction to cash value life insurance. Fixed cash value life insurance is guaranteed to be there in the future, usually with some type of appreciation. An investment is not.
Buy permanent life insurance if you want to leverage your savings. Buy mutual funds if you want to speculate. Buy stocks if you want to invest or speculate.
Misleading statement #5:
Cash value life insurance is a complete rip-off. When you buy a cash value policy, you pay high premiums, and you start to build cash value, but when you die, the life insurance company effectively “steals” the cash value you’ve worked so hard to save up and your family never sees a dime of that money.
Fact: Cash value life insurance is not a “rip off” at all. The life insurance company isn’t stealing anything from you, or anyone else. There is no trickery or malicious intent involved at all. You are getting exactly what you paid for – a leveraged savings tool.
You may have put $15,000 into a life insurance policy, and may only have $10,000 in cash value in the first 5-10 years. When you die, it is true that the cash value may be soaked into the policy. Your family will never get any of the money that was in the cash value.
They’ll have to suffer with $100,000 of death benefit you purchased, which is 10 times the amount of the cash value. How, exactly, this is supposed to be a rip off, I’m not sure.
If the life insurance company has received $15,000 in premium payments from you, and they turn around and pay out $100,000, it doesn’t take a math wiz to see that you are benefiting here. There is just no way that you could have somehow given your family $100,000 income tax free with $15,000 sitting in a savings account earning 1% (even 5% on high yield savings accounts).
Some “gurus” argue that if you died and had bought term and invested the difference, you would have the value of your savings plus the term insurance death benefit. And, you could, but these “gurus” are forgetting that most term policies never pay a death benefit so this theory just won’t come to fruition for most folks. So what you are really getting is a taxable savings that may or may not go through probate (depending on whether you had all of your savings invested in a retirement account, or sitting in a savings account).
Misleading statement #6:
There is no way a life insurance company can guarantee anything in their cash value policies. This is all just a big “trust me” scam. I could do better if I took the money and stuffed it under my mattress or better yet, put my retirement savings where it belongs – in a 401(k).
Fact: I’m not sure when people started believing that stuffing money under mattresses was safe, but in any case this again is simply untrue. The guarantees provided by fixed life insurance come from bonds and bond-like instruments that the insurance company holds.
A bond is a long-term IOU. It is a contract that represents a loan from a corporation or the U.S. Government. With a bond, you know up front exactly how much interest the bond will pay, what the returns will be, and these returns are guaranteed. The only real risk taken in a bond is whether or not the institution will pay. If the institution that is issuing the bond can meet its financial obligations, then it will pay the interest specified in the bond every year and no less.
Many of the bonds in a life insurance company’s general investment account are investment grade bonds. Investment-grade bonds are bonds, like corporate bonds, that have a very low risk of default. These are bonds that are usually issued by very high profile, old companies with a solid track record or repayment history.
Some of the bonds in the insurance company’s investment portfolio are U.S. Government bonds. These bonds pretty much never default.
By investing in both types of bonds, an insurance company can make a meaningful guarantee to the policy holder that actually has substance.
One important thing to note is that, unlike bonds, a life insurance contract provides guarantees that, generally, a bond cannot. Additionally, in fixed-type permanent life insurance, the interest rates rise as the bond environment changes. So, when interest rates climb, you’re not stuck with a low fixed rate.
Misleading statement #7:
Cash value life insurance is a rip-off because if I ever want to access the cash value of the policy, I have to borrow it and pay the insurance company interest. Why should I have to pay the insurance company to use my money?
Fact: You are not borrowing your own money. It’s idiotic that the anti-cash value crowd insists on saying that you are, especially when those people are Dave Ramsey and Suze Orman-they know better. You are borrowing money from the insurance company. The insurance company then uses the value of your policy as collateral for the loan. It’s just like putting money into a savings account and then getting a signature loan. What does the bank do with a signature loan? They secure it with the money you deposited in your savings account. It’s the exact same thing that happens with a life insurance policy loan (except that the insurance company pays a much higher rate of interest on that savings account to offset the interest on the loan you are taking).
When you run out of collateral, you can’t borrow any money from the insurance company. But, because the policy is being used as collateral, there are no applications, credit checks, or anything else associated with these loans. You just ask for the money and they give it to you. Unlike traditional loans, you get low-or 0%-interest rate for the life of the loan, which doesn’t ever have to be paid off until you die (and then, they take the money from your death benefit to satisfy the loan). You couldn’t ask for better loan terms from any bank or any other financial institution for that matter.
Well gee, you put money into this policy and you can’t just take it right back out? I have to borrow money from the insurance company and use my policy as collateral? I’m not sure I like that….wait….do you want to know what the major benefit of having a savings like this is?
You get all of that money on a tax-free basis!
Holy cow, that’s amazing! Yep, you-and only you-get to control your savings without worrying about paying taxes on the money because you are “accessing” the money through loans, which is not income or gain according to the IRS. And, did I mention that the loans carry low (1%) or no (0%) interest on them? Meanwhile, the policy’s cash value continues to grow and continues earning interest to offset the interest you’re being charged for those loans. To be fair, you also need to make sure that you do not “overloan”. Overloaning is when you attempt to borrow more than what is in the policy and it lapses. If this happens, the loans are considered “forgiven” and you need to pay taxes on all of the interest you’ve earned for the life of the policy. Insurance companies are very good and preventing this from happening by either suspending borrowing when you’ve borrowed 95% of your cash value, or they at least warn you that you are about to lapse the policy and that it’s time to pay back some of the money you borrowed.
Another option on some life insurance policies is a withdrawal option. You don’t have to pay interest to access your money (even though, as discussed above, this is not really a major issue due to the design and terms of policy loans). Most policies have a withdrawal option where you may access either all or part of the cash value of a life insurance policy directly without taking loans. The terms of withdrawals vary from company to company, but are typically very liberal – especially in the later years of your life when you are most likely to need or want the money.
All in all, it sounds like I am a something of a cheerleader for cash value insurance. I’ll admit, I do like the contracts that are designed and built well. They’re becoming fewer in number, but they’re still out there. However, it’s not all glitz and glam and I’ll be the first to admit that.
The company you purchase your life insurance from should not necessarily be cheap on their pricing, but they should also not be wasting money, either. They need to be structurally sound with consistent managerial principles and a good industrial philosophy.
If an insurance company gets bought out, the new owners may not share the same vision that the original management had. For a cash value policy, this can be detrimental to policy performance. The new management may want to raise the internal cost of insurance or move those “trust me” movable parts found in many policies.
There’s nothing like buying from an insurance company whose management screws you over 10 years after you’ve been paying into your policy.
Look for companies that are either mutual companies or are structured in a way that offers a clear benefit to policy owners. Most permanent policies have moving parts to make sure that the insurance company can make enough money to keep paying claims (that’s a good thing).
But those moving parts can be abused by new management that doesn’t share the same vision as a management team focused on maximizing policy values to the policy owners. Don’t be afraid to ask representatives of the company what can happen to the movable parts in the permanent policy if the company gets bought out, and what the company has done to protect their policy owners from being taken advantage of by inexperienced or overzealous management.
The best protection against a policy going south on you is to just purchase a policy with no real moving parts. A basic, limited pay, whole life for example.
It’s hard to know who to trust in the financial industry sometimes. Some of the biggest names in the business have it all wrong. Some “gurus” try to paint every individual with the same brush, eliminating the context of an individual’s life. This makes for a terrible advisor, and downright dangerous financial advice. If you ever encounter a financial adviser who starts spouting any of the lies in this article, my suggestion would be to run for the hills and find yourself another adviser who knows a little bit more about insurance planning.
Before you make a final decision on whether to buy term or cash value life insurance, consider what you are really looking for. If you are looking for an investment, then be prepared to look for stocks, bonds, no load mutual funds, options, and other various financial derivatives (and learn how to research them). If you’re looking for a long-term savings tool, then cash value life insurance can fit that need very well. If all you’re looking for is very short-term insurance protection, you really can’t go wrong with a solid level term policy.
If you want to keep reading, I’ve got yet another article about life insurance. Feel free. I don’t mind.