Why Does Life Insurance Matter? What Does It Do For You?
Life insurance is a way for you to buy money at a discount. A $100 premium might buy an individual $500,000 of insurance, for example. In the case of whole life insurance, an individual can buy a guaranteed future savings. If the individual dies before using it all, a death benefit in excess of the savings is given to the individual’s beneficiary. There’s nothing else like it.
As a practical matter, life insurance helps you save money for your future and hedges against the risk of financial ruin. Imagine, for a moment, that you need to save up $1 million. You have some future expenses, or series of expenses, that you know will cost a cool million (at least), so… it’s pretty important that you have this money. And, let’s also assume that saving up this money is important regardless of whether you live or die.
Hopefully, you live long enough to realize all your goals and see your dreams become a reality. Hopefully, you’re able to buy the house you want to buy, drive the cars you want to drive, start the business you’ve always wanted to start, raise the family you’ve always wanted to raise, and so on. But… maybe it doesn’t happen. That is the great mystery of life.
Perhaps you have goals and dreams that extend beyond your natural lifespan — a lifelong pursuit, passion or cause you believe in that is unlikely to be accomplished before you die. Or, perhaps you’ve made an explicit promise to safeguard your spouse’s or children’s financial future and it’s important enough to you, and your promises are so significant, that it likely extends beyond your natural (expected) lifespan. That kind of planning is similar to what Benjamin Franklin did. He knew he wasn’t going to live forever, and so he took out a special type of insurance policy, and named 2 of his most beloved cities as beneficiaries. The insurance fund became a charitable endowment that was to last 200 years.
OK, so… we’re talking about very important stuff.
The primary risk, then, is that you fail to save up this amount of money that you need or want. Perhaps an even more significant risk is that you fail to save up this amount of money before you die.
How do you solve this problem?
Simple. You buy life insurance.
Life insurance is a financial contract (often referred to as a “life insurance policy”) which transfers the financial risks associated with your death away from you and onto a life insurance company. Specifically, it eliminates the risk of you not saving up enough money for various financial goals you have, chosen obligations that are important to you, or important causes you believe in.
It takes the uncertainty surrounding your future income and savings and transforms it into a known and certain outcome.
And… if your advisor designs a good insurance plan, it is one of the most efficient — if not the most efficient — way to guarantee yourself (or your beneficiaries) a future savings.
The basic mechanics of it are simple enough. You use a small amount of your current income to pay a “premium.” In this example, I used $1 million in death benefit, but the actual dollar amount will depend on your specific financial situation, goals, and your earning potential over your lifetime. Anyway, in exchange for this premium, a life insurance company gives you (at minimum) a death benefit. The death benefit is paid when you die. This is the savings your beneficiaries receive.
While you’re alive, you may either build a savings “inside” the policy, build a savings “outside” the policy, or keep some of your savings “inside” the policy and some of it “outside” the policy. The idea of the savings is that it will eventually be used to pay for future insurance charges or it may even be used to replace the insurance altogether, converting it to savings.
This is what eliminates the risk of you not saving enough money. Under normal circumstances, the death benefit guarantees that you save up enough money… regardless of whether you live or die. So, no matter what, your goals can be realized.
If you keep all of your savings separate or “outside” the policy, you will buy term life insurance and keep a personal savings (which is normally not guaranteed). If you go this route, you must use some complex risk-management techniques to try to meet your financial goals while you’re alive.
If you keep your savings “inside” your life insurance policy, you will buy either whole life or universal life insurance. With whole life, your cash value is guaranteed to grow by a certain amount each year, making it easy to predict how much money you will have in the future while you’re alive.
If you do a combination of both (savings “inside” and “outside” the policy), then you will likely buy both term and whole life (or universal life) insurance.
What You Should Know About Term Life Insurance
The policy owner pays a specific and defined amount of money for a specific amount of death benefit. For example, you might pay $20 per month for $500,000 of death benefit. When payments stop, the insurance generally ends.
Term life insurance premiums tend to be very low when you’re young, but they are guaranteed to increase as you get older.
Due to very low expected mortality rates during the prime term insurance buying years (i.e. your risk of croaking is very low when you’re young and ready to buy a term policy), term policies also tend to have a very low payout ratio which is estimated to be about 1% or less.
In other words, only 1 percent of term policies ever really pay a claim. For the most part, people simply outlive the term of the contract, so the beneficiary never collects the death benefit.
That might sound like a bad deal, but it’s not always. More on that in a moment.
A defining characteristic of term life is the fact that term policies only remain in force for a set number of years. The term of the policy is structured in one of two ways:
- One-Year Renewable. This term contract gives you one year’s worth of death benefit protection for a set premium which does not change for the entire year. That premium is just enough to cover one year’s worth of insurance charges. At the end of the year, you must renew this policy. Upon renewal, your premium is guaranteed to increase since your risk of death increases with age. Yup, your risk of buying the farm increases every year on your birthday.
- Level Premium Term Policies. Level premium policies have the benefit of level premiums for an extended period of time. When you purchase the policy, you choose the number of years you want to keep the term insurance in force for. For example, the insurer may offer you the option of a 10-year, 20-year- or 30-year level term policy.It then collects an amount of money from you which exceeds the actual cost to provide death benefit protection. The excess premium collected is invested in the insurance company’s general investment account. In the later years of the policy, this excess premium, plus investment interest, is used to hold down the rising cost of insurance thus keeping the premium level for the duration of the contract term. So, when you buy that 30-year term policy for $500,000, instead of paying $20 a month, you might pay $50 a month, but that $50 doesn’t increase until the end of the term – until the end of those 30 years.
Some types of term life insurance, called “convertible term,” allow you to convert your temporary insurance to permanent insurance without having to qualify for coverage again. In that sense, it’s like insurance for your insurance.
Because convertible term insurance often comes with a lower premium than permanent insurance, it’s a great way to guarantee your future insurability if you can’t afford permanent insurance now.
Should You Buy Term Life Insurance?
The Good: Term insurance makes it easy to fully insure your life. Low premiums can potentially be sustained for many years before you need to pay more for the coverage.
Some term policies can be converted to permanent insurance at the same risk rating. If you get sick or become uninsurable later in life, this is an awesome feature because your term policy allows you to get permanent coverage without additional underwriting — the insurer must approve you, regardless of your current health.
The Bad: Term insurance is often sold on the premise that it’s “simple”. This is not necessarily true because the policy is never bought in a vacuum. It must be coordinated with an effective savings plan which takes into account risk capacity (how much you can objectively afford to lose), risk tolerance (how you feel about taking risks), your probability of earning a good return on your money, and a host of other factors.
It’s rarely something an individual can do on his or her own. And, in fact, there is ample research suggesting that most people who choose to “buy term and invest the difference” fail to actually save the difference. Even when they do (or try to), they often fail to accumulate sufficient savings because their investment returns are too low or too much of their savings is diverted to paying term premiums which prevents them from saving enough money.
Verdict: Buy it if you want life insurance coverage and are willing to save the difference between what you would have paid for whole life and what you’re expected to pay for term insurance. In other words, only buy it if you actually “save the difference.” Another reason to buy term insurance is if you want to preserve your insurability and intend to convert your term policy to whole life or universal life later.
What You Should Know About Permanent Life Insurance
Permanent life insurance is sometimes known as “cash value life insurance.” These policies are often defined by insurance companies as “a death benefit with a savings component.” This “savings component” is actually a cash reserve which is designed to grow in value over time and provide money to pay for the death benefit when you die. With some policies, the death benefit grows over time and with others, it doesn’t.
Like level premium policies, the insurance company collects premium payments which are more than enough to pay for the cost of insurance. The excess premium is invested to hold down the future, rising, cost of insurance.
Unlike level term policies, however, an insurer uses the excess premium to establish a cash value reserve associated with the policy.
With each premium payment, the costs associated with mortality and other expenses are either guaranteed to decrease every year (i.e. whole life insurance), or are merely expected to decrease every year with no explicit guarantee being made by the insurer (i.e. universal life).
A unique feature of cash value policies is that the cash value is allowed to grow income tax deferred. In some policies, the money can then be withdrawn or a loan can be taken against the cash value if it is ever needed during your lifetime. With other policies, only a loan option is available.
Why would someone ever borrow against their life insurance policy? For the same reasons people borrow against their home or any other valuable asset: they want the benefit of continued growth of the asset, but they also want or need some money right now.
Policy loans can be used in case of a financial emergency or for large or semi-routine purchases.
For example, it is not uncommon for whole life insurance policyholders to take on a series of policy loans to buy new cars, go on vacation, buy investments, or start businesses or… pay off debts and then repay their insurance company the interest they would normally have to pay a bank or credit union.
Either way, the life insurance company then returns some or all of this policy loan interest to the policyholder over time in the form of interest or dividend payments. Depending on the policy type, some of this interest can also be added directly to the policy’s cash value, helping improve the policy’s cash value growth and performance.
This can potentially make life insurance policy loans a very low-cost way to borrow money while still allowing you to grow your long-term savings. Since cashing out savings to pay for things in cash eliminates future earnings on that savings, the policy loan feature helps mitigate lost investment earnings while simultaneously growing savings.
The basic or guaranteed interest credited to a cash value policy is normally comparable to other competing savings instruments such as bonds, bank CDs, or high yield savings accounts. In addition to the basic interest payment, some policies, like dividend-paying whole life insurance, earn dividends. These dividends can substantially increase the cash value growth of a policy, making the growth on cash values comparable to some non-guaranteed assets and investments.
A major difference between investments and insurance is that life insurance cash values grow tax deferred inside the policy and can be accessed tax-free, unlike other savings options.
Whole life insurance is the most basic form of permanent life insurance. Premiums are collected and invested in the insurer’s general investment account.
While not all of the investments in the general account are bonds, many of them are. Insurers attempt to diversify investment holdings so that you can be guaranteed a minimum interest rate on policy cash values. Insurers spend a lot of time and resources matching cash flows to liabilities, which is how they meet their long-term death benefit guarantees.
This also ensures that the insurer meets its contractual obligation to provide a guaranteed cash value that equals the death benefit amount at your age 100. Conceptually, this is what that looks like:
On top of the basic, guaranteed, interest rate, insurance companies also have the option to pay excess interest through one of several methods. The most common method, by far, is the participating rate.
The participating rate is based on the policy’s death benefit. Dividends may be used to increase the amount of death benefit, they may be paid out as cash, they may be invested with the insurer in either a fixed or variable-rate investment account, they can be used to buy supplemental term insurance, or they may be used to pay premiums due on the policy.
Dividends are not guaranteed to be paid out in any given year. However, once an insurer doespay them, and they are used to buy additional paid-up life insurance, they become part of the guaranteed cash value and you cannot lose them.
This is how it looks if I had to draw it out for you (which I did. I did draw it out. Just for you):
Should You Buy Whole Life Insurance?
The Good: It’s a relatively simple contract, mechanically speaking. You pay the premium and the insurance company gives you guaranteed cash value growth, a guaranteed death benefit, and guaranteed policy loan access. In most whole life policies, the premium is even guaranteed never to increase. So many guarantees. That’s why people love it.
Whole life insurance reduces, and in many cases it eliminates, the risk of you not saving enough money for your future financial goals because the cash value is guaranteed to grow by a certain amount each and every year. If the policy earns dividends, you can potentially realize your financial goals more quickly or save less money to realize your goals.
The main benefit of whole life insurance is predictability. You can match known future expenses to known future savings inside your whole life insurance policy. If you fail to save enough before you die, your whole life death benefit makes up the difference.
You can use the policy’s cash values while you’re alive, through partial surrender of paid-up life insurance or through policy loans. If you use policy loans for major purchases, and you repay those loan at a market rate of interest, there’s also the potential to increase your cash values and death benefit over and above what you otherwise would have had.
Whole life is essentially a “forced savings.” You have to make those premiums every month, which makes it easy to “stay on track” with your insurance and savings plan.
The Bad: The life insurance business is like any other business — there are poor, average, and excellent companies selling poor, average, and excellent policies. In the whole life space, it’s sometimes difficult to tell which is which.
With whole life, you also have to think long-term. Premiums go on theoretically forever, so you have to have the mindset of a perpetual saver. Not everyone likes that idea. Be willing to save money consistently each and every month and put that savings toward your premiums.
A poorly-designed whole life insurance policy, or a subpar product, will be an exercise in frustration and can make you feel like you made the wrong choice. With whole life insurance, your choice of agent or broker is very important. If this person shows little or no genuine interest in servicing your policy for the next 20+ years, then, it’s going to feel like you made the wrong choice.
Even with a good policy design, expect the first few years (e.g. 3-5 years) of the policy to have negative annual returns. Also, in general, your total net cash value is unlikely to equal your total premiums paid for up to 8 or 9 years, though in some cases, net cash value may exceed total premiums paid in 6 or 7 years.
Every whole life policy is built on the assumption that you will hold the contract for at least 10 years, and probably 20 or even 30 years. Thus, even though you may have substantial cash value available in the first year of the policy, the return on that cash value is guaranteed to be negative.
Your choice of insurance company also matters… a lot. For example, some mutual life insurance companies have demutualized over the years (becoming a public company, causing a reduction or elimination of dividend payments to policyholders) and some have exited the life insurance business altogether, leaving policyholders wondering how their long-term whole life policy will pan out. This circles back to the importance of choosing a good broker or life insurance agent, who has a deep and broad understanding of the life insurance industry and its fundamentals and can help steer you away from “high risk” companies.
Policy loans are an attractive feature of whole life, and they can help you grow a sizable savings. But… they can also get you into trouble if you’re not financially responsible. If you fail to repay your policy loans, or if you are using policy loans for retirement income and do not have a professionally-designed income plan from your insurance agent or broker, excessive policy loans can cause the policy to lapse. If this happens, you lose your life insurance and may be taxed on all the gains you experienced in the policy.
Verdict: Buy it if you are committed to saving money for the long-term, have a low risk tolerance, cannot afford to lose any of the money you’ve saved, and if you have an agent or broker willing to explain the ins and outs to you.
Insist on a fully custom design, which will incorporate your own personal financial goals. Ask for anti-lapse provisions to prevent your whole life policy from lapsing due to policy loans. Most policy designs should have a high early cash surrender value without compromising latter-year cash value growth.
Some high cash value whole life policies sacrifice long-term policy performance for high early year cash values or early access to cash values so ask your insurance agent or broker for a detailed analysis of both short-term and long-term expected performance of your policy. In most cases, you shouldn’t be sacrificing long-term cash value growth for early access to your cash values.
In general, the best policy designs will incorporate some form of term life insurance (called “blending”) which will lower the overall cost of the policy and allow you to build up cash value very quickly. However, it is possible to design non-blended whole life which performs just as well as blended whole life — it all depends on the issuing insurance company, the flexibility in design options given to the agent, and the skill level of the agent designing your policy.
While it does take time to see net positive returns in a whole life policy, your patience will be rewarded. Most people who buy whole life insurance (and keep it for 20 years) are happy with their purchase — they often see benefits that were not immediately apparent in the early years of the policy.
Universal Life Insurance
Universal life insurance is arguably the most complex insurance option on the market.
This is because of the fact that the insurance company requires that you share the risk associated with the operation of the policy.
Universal life insurance (also called “UL insurance” or simply “UL”) consists of a one-year annual renewable policy and an investment account. The insurer collects deposits and allocates them to a cash value account. The company then subtracts all costs associated with the policy. Finally, it credits interest based on one of several methods that you select at policy issue.
Your investment choices for a universal life policy vary. In general, you may choose between an interest rate tied to current interest rates, investment returns derived from the insurer’s separate account, or an equity-indexed investment strategy managed by the company.
The insurer also pays a guaranteed minimum interest rate regardless of what interest-crediting option you choose. If or when the policy’s cash value account reaches $0, due to poor policy performance, excessive policy loans, or high policy costs, your policy terminates and you lose your life insurance.
In my experience, that minimum rate is almost always 2 percent, but some policies are now coming with a 3 percent minimum guarantee.
The insurer also promises you a guaranteed maximum insurance charge (i.e. a maximum amount it will charge you for insurance coverage). However, these policies are designed to work at interest rates above the minimum guaranteed interest rate and below the maximum insurance charges.
One of the cool things about universal life is that you can change your premium payments, death benefit face amount, and death benefit schedule at any time. Any. Time. Pretty cool, right?
In fact, one of the most popular ways to purchase UL policies is to pay ridiculously high premiums for the first couple of years and then just let the policy “coast”…letting the policy’s cash value pay for the cost of insurance for the rest of the policyholder’s life.
If insurance charges spike, you can always just reduce the insurance death benefit until the charges are low enough for the cash value to support the policy indefinitely.
Basically, as long as there is enough money in the cash value account to pay for insurance charges, then there are no “required” premiums, per se.
As I mentioned earlier, you may change the face amount of insurance you purchase at any time. For example, you can start off with $100,000. However, if you decide you only want $75,000 later on in life, you can reduce your face amount to this level with a stroke of the pen.
You may also increase the face amount above the original face amount, but you’ll often need to undergo additional health exams to ensure that you are still insurable.
Finally, the death benefit schedule options for universal life consist of a level death benefit and an increasing death benefit.
A level death benefit means that your death benefit remains mostly level for the life of the policy. If the cash value exceeds a certain level, however, it may “push” the death benefit higher. The increasing death benefit option means you generally start with a lower death benefit amount than under a level death benefit option, but your death benefit increases each year you experience positive growth in the policy.
In both cases, your beneficiaries collect the full death benefit of the policy when you die. Some websites, financial advisors, and insurance agents will tell you that the increasing option allows your beneficiaries to receive both the death benefit and the cash value of the policy. This is technically incorrect, as both level and increasing death benefit policies are comprised of pure insurance and cash value. The total death benefit is a combination of the cash value and the pure insurance (term insurance) amount.
There are several ways insurers credit interest to universal life policies:
- Interest-Sensitive Universal Life – Oh great. It’s life insurance with feelings. No, no. Interest-sensitive UL policies are “sensitive” to interest rates in the marketplace. So, the interest that’s credited to your cash values will fluctuate based on current market interest rates. Some people don’t like this because the policy’s cash value doesn’t perform very well when interest rates are low.For example, if the Federal Reserve Chairman lowers interest rates and then praises his decision because it’ll lower mortgage rates, it screws with your insurance policy, because it also influences these rates.
- Variable Universal Life – Variable UL policies are sometimes written out in longhand as “Flexible-Premium, Adjustable Variable Life Insurance” or “Flexible-Premium Variable Life Insurance.” It’s easier to just call these things “Variable Universal Life” or “VUL,” for short.VULs combine elements of the traditional interest-sensitive UL and add the ability to allocate premium dollars to investment sub-accounts.These sub-accounts are pretty much the same thing as mutual funds. So, think of it as a life insurance policy with a cash value savings that you can invest in mutual funds.The cost for these products varies, but it’s usually pretty steep all around, regardless of where you buy it. You’re paying for the cost of insurance, a premium load/sales charge, and a fee on the sub-accounts.That doesn’t mean it’s necessarily a bad deal. If you earn 12 percent from your mutual funds, and the total of all fees is 3 percent, you still made 9 percent, which is very respectable.The cost for these products varies, but it’s usually pretty steep all around, regardless of where you buy it. You’re paying for the cost of insurance, a premium load/sales charge, and a fee on the sub-accounts.That doesn’t mean it’s necessarily a bad deal. If you earn 12 percent from your mutual funds, and the total of all fees is 3 percent, you still made 9 percent, which is very respectable.
- Equity-Indexed Universal Life – If you’ve sat through a life insurance pitch recently, you’ve probably heard of this one. The new kid on the block, and everyone’s favorite policy these days, is the Equity-Indexed Universal Life Policy, or EIUL. Sometimes, we call this an “IUL,” but it’s the same thing.Here is the simple – perhaps oversimplified – version of how these products work: if the stock market gains 10%, you earn 10 percent on your policy’s cash values (minus the fees in the contract, up to the interest rate cap and participation rate set in the policy). If the stock market loses 10%, not only do you not lose money, you actually make a guaranteed fixed rate of return – usually 2 or 3 percent (but only if you get bubkas for 5 years in a row).Sound too good to be true? It’s not. The insurer is not giving you unlimited upside potential here. They generally cap your earnings at an interest rate which allows them to effectively hedge their promises to you. Most professional guidelines state that you should not expect more than 1% interest gains over a traditional or “current assumption” (interest-sensitive) universal life policy.
Should You Buy Universal Life Insurance?
The Good: The big advantage here is product flexibility. Almost anything and everything can be changed without too much trouble. Premiums can increase, decrease, and you can even stop paying premiums altogether if you want. As long as there’s enough cash value to pay for the cost of insurance, your policy will remain in force.
The Bad: All that flexibility becomes its own downfall. The product is hopelessly complex for all but the savviest consumer. The insurance company is allowed to change expenses and interest crediting usually at-will. They can do this because the nature of the contract trades all of the guarantees of whole life insurance for flexibility.
Despite what some agents argue, universal life is always a riskier purchase than whole life. Every state insurance commissioner, and every life insurance actuary, knows this, which is why universal life insurance is generally considered an alternative to whole life.
The Verdict: I consider universal life “supplemental permanent insurance.” There are a few times when universal life makes sense. One of those times is when you just want a permanent death benefit and don’t care about cash value accumulation. Guaranteed Universal Life is perfect for these situations. Single-Premium Universal Life is another good one (again, as long as cash values aren’t as important as the death benefit).
Equity-Indexed Universal Life is being touted as the “next big thing” these days. It’s not. I used to sell this type of product, but only if the company had a decent guaranteed minimum rate or favorable guaranteed interest rate options in the contract. But, it’s becoming so difficult to find a contract I feel good about these days that I’ve completely scrapped it as an option for my clients. There is a bunch of added risk, and the returns over whole life have, for the most part, failed to materialize.
Before You Actually Buy Life Insurance…
Do not rush into anything.
Buying a life insurance policy is actually a bit difficult to do on your own without a competent agent or broker helping you. It's difficult because choosing the right life insurance company is difficult. Life insurance companies don't all sell the same products. Some are better managed than others. Certain products and product features are only available with certain companies. And, even if you're only buying a simple term life policy, the right company can make all the difference when it comes time to file a death claim or sell the policy for cash.
That’s why agents and brokers get paid such high commissions for the sale of a policy (yes, even for term life insurance).
Even if you could figure out how to buy a single policy all by yourself, I’d advise against it.
There’s a lot that goes into figuring out just how much insurance you need, not to mention the work involved in running quotes and figuring out whether or not the policy is a good deal over the long-term (i.e. some insurance companies build their products for a certain age group, and agents often need to compare multiple prices to figure out which company is going to give you the best deal over 20 or 30 years – the answer isn’t always as simple as looking at the premium payment).
This is true, even for term life insurance. My (now former) business partners recently ran into a case where a 70+ year old woman had a term life insurance policy which was set to lapse. She didn’t want to pay the premiums anymore and her financial planner had advised her to simply drop the policy.
That would have been a huge mistake. My partners were able to sell her policy on the secondary insurance market and she recovered over $250,000 in premium payments.
Not all term policies can be sold, however. In fact, most cannot. So, it’s helpful to know in advance, what your prospects are for recouping your premiums if you decide you no longer want your insurance policy. As you can see, there’s no such thing as “simple insurance”… not even when it comes to a term life insurance plan.
You could also choose the wrong type of policy and have it affect other parts of your financial plan. A good insurance plan sits “underneath” an investment plan. It should never compete with it. In fact, it should augment it, reduce investment risk, and enhance overall portfolio returns.
But, most consumers (and even a lot of financial planners) don’t understand this.
I’ve seen people rush to buy a low-premium term policy, which backed them into a corner with their investment plan. They essentially torpedoed a good savings plan (and lost a lot of money) because they chose the wrong insurance policy.
And, that’s why it’s almost impossible to get it right on your own.
Want To Know More About Life Insurance Before You Buy A Policy?
This mini-guide is merely an introduction to life insurance, and a small part of a much larger, comprehensive buyer's guide. To learn more about life insurance, and how to integrate it into your financial plan, read the rest of The Definitive Life Insurance Buyer's Guide.