What type of life insurance is "the best"? Well, it depends on what you mean by "the best". Term life insurance offers very low premiums relative to the death benefit being bought. But, the probability of payout is low. Permanent insurance carries substantially higher premiums, but offers a living benefit through a cash reserve account. Many people look at this as a perceived cost-benefit analysis. They look at the premiums and assume term life is the way to go. Why bother purchasing permanent insurance if it costs more? For this, a (very) brief history lesson is in order.
From Term To Whole Life To Universal Life And Back
The idea that life insurance is a temporary need-also called the theory of decreasing responsibility- really struck a chord with A. L. Williams and his company, Primerica, in 1977. Williams interpreted the theory of decreasing responsibility as meaning "everyone should own term life insurance." Williams was a high school coach turned insurance agent who didn't like how his father's whole life policy was performing and thought that there had to be a better way.
Williams observed that whole life insurance represented a bundled product. As such, there was no distinction between the amount of money going to pay for insurance, and the amount of money going to the cash value portion of the policy. This actually works in favor of the policy holder, but that wasn't the way Williams saw it.
For Williams, this whole life product represented a problem that had to be solved. Not trained as a professional financial adviser, Williams wanted to have costs broken down and thought in simple terms of "insurance" and "investment", ignorant of the fact that insurance and investing are intimately related. Williams saw whole life insurance as a roadblock to his vision.
Whole life, according to Williams, was a "bad investment" that had to be replaced with a "good investment." With this motive, he built his company on the practice of convincing his new customers to extract the cash values of mutual life insurance policies to fund dubious investment strategies.
By 1979 a brokerage firm called E.F. Hutton formed its own life insurance division, seized Williams' idea, and in the early 1980s twisted his "buy term and invest the difference" philosophy into creating the first Universal Life insurance product, which was a 1 year renewable term insurance product with a separate side fund that invested in a money market mutual fund.
Universal Life insurance was initially designed under the inflationary interest rates of the 1980s, and pitched by E.F. Hutton as an alternative to investing in the financial markets. By 1984, many insurance companies followed suit fearing competition could wipe them out. But by the early 1990s, interest rates began falling to all time lows. By unbundling the cost of insurance to form Universal Life, E.F. Hutton completely overlooked the reason whole life succeeded: its built-in guarantees.
In contrast, Universal Life offered no guarantees on cash value or death benefit, shifting insurance risk back to the policy holder, and leaving the policy severely vulnerable to interest rate fluctuations. Under more conservative interest rate assumptions, these policies were not able to survive and many policy owners faced a tough decision - infuse their dying policy with more cash to try to keep it alive or let the policy lapse losing everything they had put into it.
...and thus came the more recent attacks on life insurance companies for selling permanent life insurance that wasn't worth the paper it was written on.
Understanding The Argument for Term Life Insurance
The idea of buying term insurance is that you will invest the difference - the difference being what you would have spent for the same coverage on a permanent policy. As a practical matter, I am not convinced that most people actually do that (or do it consistently).
However, for those that do invest the difference, the investment of choice is some type of equity fund (or stock). Bonds are a moot point because if an investor were to invest in bonds, they would be mirroring a permanent life insurance product.
The largest problem with investing in equities as a core strategy is the hypothetical returns that a financial adviser projects. The hypothetical returns, even when using Monte Carlo software to randomize the returns, is still a hypothetical projection. These hypotheticals are not based on any rational analysis but on either historical performance within a cherry-picked historical "window" or a random set of returns.
Additionally, all of the hypotheticals produced today by financial advisers and mutual fund companies use average rates of return instead of actual compound growth rates. Averages can be "massaged" higher than true growth rates. And, even if they're not, the average rate doesn't reflect the actual growth.
An investor can average 8% and only actually make 4% or 5% before taxes and fees. Likewise, they could actually make more than 8%, or they could end up with less than their principal investment. It's a total gamble because the investor is often speculating on the price of the stocks inside their mutual fund, and on the price of the fund itself, instead of actually analyzing the fundamentals that drive stock prices and the business's profits.
Speculation is not inherently bad. However, it's not a good core strategy. I'm also not convinced that most people are willing to learn how to invest to make investing outside of an insurance policy work better than just combining the insurance and savings component into one contract and using that approach. Even if a person were to adopt a more rational approach to investing, investing is not easy. If it were, there would be no need for professional investors. There's a really good chance that an investor could fail miserably, even if they have all the knowledge available to them to go out and start investing on their own.
Term insurance covers a short-term probability of death. When I say short-term, I mean anywhere between 10 and 30 years. Maybe I should say "temporary"; 30 years may seem like a long time, but in the insurance business, it's not. Consider that most people buy term insurance when they are least likely to die - between the ages of 30 and 45. After age 60, term insurance is very expensive and after 65, it's nearly unaffordable. At age 85, for the most part, you simply can't buy it (you're considered "uninsurable").
Some term policies don't offer a guarantee. What I mean is, the policy can be repriced before the term is up. Other term policies terminate at the end of the term while others convert to annual renewable policies at usually unaffordable rates. Unfortunately, this is the point when people usually discover that they'd like to continue coverage, but can't.
But perhaps the most telling problems of term insurance come from consumers themselves. What A.L. Williams and E.F. Hutton never realized is the reason that cash value insurance came about was not because of some evil scheme hatched by life insurance companies. Many policyholders actually had become disenchanted with their term policies.
You see, after faithfully paying their premiums for many years, they were eventually forced to drop coverage because when the term ran out, the renewal premiums were too high. Coincidentally, they had to drop their coverage just as they were nearing the age when death became likely. To add salt to the wound, term insurance didn't offer any sort of refund for premiums paid. So, policy holders paid in and many of them got nothing in return. With today's lifespans, 99% of term policy owners will never see any payout from their life insurance (and neither will their families).
To solve the term dilemma, some very savvy actuaries devised a way of increasing and leveling out the premium payments to give policy owners lifetime coverage at a slightly higher premium. The premiums could be level and guaranteed for the life of the insured and coverage could be extended out to age 100. Think of it as a budget plan for insurance (similar to how gas and electric companies offer budget plans - you overpay in the summer and underpay in the winter and pay a level, fixed utility bill). Policyholders would overpay for their insurance in their younger years and underpay as they got older.
These first "term to age 100" policies were the early attempt at whole life insurance. They were designed to earn interest and build cash value to age 100 at which point the death benefit and the cash value would equal each other. The cash value did serve a purpose when those policies were first designed.
In essence, when you bought insurance, you were going through a process of self-insuring. The older you got, the more money you built up in your cash value. The more money you built in the cash value, the less risk the insurance company took to insure your life.
When the death benefit and cash value equaled each other, there was no risk on the part of the insurance company. It's true that cash value insurance was never originally designed to act like a commercial "savings account", even though the products have evolved over the years to accommodate more and more flexibility. Whole life, as a practical matter, functions as a long-term savings product with leverage being provided by the death benefit (should you die prematurely).
In essence, you are still working towards a process of self-insuring but with a great deal of liquidity and flexibility in the policy - which is exactly what most insurance agents and financial advisers tell you that you should be doing with your savings. The problem is, many advisers are telling you to self-insure with financial products that aren't designed to do that for you (i.e. mutual funds, stocks, etc.).
While I think there are many good reasons to move towards a process of self-insuring in certain instances, I am reluctant to say that I think that an individual should absorb every risk that insurance is designed to cover. In the case of modern life insurance, being able to retain, transfer, and/or control your current and future expected savings using one simple contract has become a unique and powerful feature of cash value life insurance.
The fact that some advisers either don't get it, or simply don't understand the benefits of such contracts, baffles me sometimes.
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This entry was posted on June 20th, 2008 by David C Lewis, RFC. Edits may have been made to keep this entry current. · 39 Comments · Insurance & Savings, Philosophy In Financial Planning