How many times have you uttered the words: “I wish I had more life insurance”?
Most people I know don’t really think too much about insurance until or unless they need it. With life insurance, you need it when you’re dead, so there’s no mulligan on this one. At the same time, there’s a lot of mixed up, jumbled, information out there on the web. That’s why I decided to put together a good buyer’s guide on what types of insurance are out there, and which ones you should buy. This guide will change and evolve over time as the market changes, so bookmark it and check back every year or so.
Life Insurance Basics
The easiest way to think about life insurance is that it’s a form of “borrowed savings.” Sometimes, I call it “leveraged savings,” but that can sound a little too complex depending on the audience. What you’re doing is paying an insurance company a small amount of money for the use of a very large amount of money in the event that you need it. How do you know (and more importantly, how does the insurance company know) when you need this money? It’s spelled out for you in the contract you sign.
For life insurance, you (or rather, your heirs) need the money when you die. It’s a particularly useful contract because it’s purchased with the assumption that you haven’t yet saved up enough money to pay off all of your financial liabilities. Whatever debts you have left when you die need to be paid. The insurance policy provides that money – hence the need for it.
Purchasing a policy effectively transfers the financial risk of your death away from you and onto an insurance company. It’s like playing hot potato with your debts.
Most of the time, you will be both the insured person named in the policy and the policyholder (also called the “policy owner”). The policyholder owns the contract and is responsible for paying all of the contract premiums. The insured person named in the policy is the person whose life is insured. When the insured person dies, the policy pays a death claim (called a “death benefit”).
This death benefit is paid to a beneficiary who is named in the contract by the policy owner. In other words, when the person insured by the insurance contract dies, the contract terminates and the beneficiary gets the money stipulated in the insurance policy.
Life insurance was originally designed as a way to help pay for burial costs. However, today, life insurance is used for a lot of stuff that has nothing to do with paying off a funeral home debt. For example, a business might purchase a policy to protect itself from the financial loss of one of its key employees. Usually, the business uses the money to find, hire, and train a new manager. Individuals often use life insurance to replace a lost income when one spouse dies, but many people are now using rich cash values inside the policy to help supplement weaker retirement savings and pension plans.
In my own business, my (business) clients use it as a way to reduce operating costs, provide cash benefits to executives, reduce the cost of other types of insurance, and fund future research and development as well as business expansion projects. Life insurance can also be used to accelerate mortgage, and other debt, payoffs and even provide reliable current income prior to retirement.
Important Policy Provisions That You Should Know About
All life insurance contracts include suicide provisions to prevent insurance companies from having to pay claims on policies where the insured has committed suicide within the first two years of the policy. Insurance companies also require that there be an “insurable interest” between the policy owner and the insured (to help prevent a conflict of interest between the owner of a policy and the person being insured).
An “insurable interest” just means that the person buying insurance (the policy owner) must have a personal and economic interest on the life of the person he is insuring. So, for example, you could buy insurance on the life of your spouse but not the life of some random stranger. You have a personal interest in the life of your spouse (presumably) but you don’t have a personal or economic interest in the life of a stranger.
Financial advisers and insurance agents often divide insurance into two different types: term insurance (temporary) and cash value insurance (permanent). While most insurance agents tell you that term life is cheap, and whole life is expensive, this is not technically accurate. Both term and whole life share the same basic cost structure with key differences in the distribution of costs. Evidence of this is almost always uncovered in the net payment cost index of every policy. Understanding these differences, however, is still important.
Term Life Insurance
Term insurance is temporary or “pure” 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 ends. Term policy 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 percent 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.
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.
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 that is designed to grow in value over time and provide money to pay for the death benefit when you die.
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 with a level death benefit option selected).
A unique feature of cash value policies is that the cash value is allowed to grow income tax deferred. The money can then be withdrawn or a loan can be taken against the cash value if it is ever needed during your lifetime. The 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. The major difference is that life insurance cash values grow tax deferred inside the policy and can be accessed on a tax-free basis, unlike other savings options.
Whole life 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. This also ensures that the insurer meets its contractual obligation to provide for a cash value that equals the death benefit amount at your age 100.
On top of the basic, guaranteed, interest rate, insurance companies also have the option to pay excess interest through one of several methods:
- The Participating Rate: First, a whole life may pay dividends 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, or they may be used to pay premiums due on the policy.
- Current Assumption/Current Interest Rates: Another method to credit excess interest to a whole life policy is to tie the cash value performance, in part, to current market interest rates. As these rates fluctuate, the whole life policy’s cash value may be credited with more or less interest.
- Equity-Indexed or Variable Interest: Finally, whole life may be credited with interest tied to the performance of a stock market index. The insurer may allow part or all of the premium to be invested either directly into the stock market or into a proprietary equity-indexed strategy. The direct investment in the market typically allows some of the premium to be invested in the insurer’s separate account consisting of mutual funds. An equity-indexed strategy requires the insurer to take full control over the investment strategy. You are paid based only on the upward movement of a stock market index. All market losses are ignored. The insurer is able to do this by using a very precise mix of bonds and index call options.
More cool whole life iterations an insurance company can offer:
- Graded-Benefit Whole Life - Graded-benefit whole life allows you to get life insurance if you have a medical condition that would otherwise prevent you from buying insurance. Basically, the insurer will allow you to buy the face amount (the total death benefit) over time. In the first year of the policy, benefits are “graded,” meaning you don’t have the full benefit yet. If you die before full benefit maturity, your heirs only get the graded benefit that’s earned thus far. So, on a $150,000 policy, if your benefits start out at $50,000, your heirs would only get $50,000 if you died. It’s not great, but it’s better than nothing.Over time, the death benefit increases so that by the 3rd, 4th or possibly 7th year, you have the full death benefit.
- Graded Premium Whole Life - Graded premium whole life lets you buy the insurance and rig the premium payments so that they’re cheaper in the early years of the policy. So, for example, you might only pay half of what you normally would pay for the first 10 years of the policy contract. After that, your payments gradually increase to the full payment. Actuarially (mathematically), your total premium outlay will be the same as any other straight whole life plan so you’re not getting jipped in any way. It’s just a flexible way to pay for the policy.
- Indeterminate-Premium Whole Life - Let’s say you want really cheap whole life and you think there’s a company out there that can afford to charge you less than everyone else. Indeterminate whole life might be your savior. It’s a policy where the premiums are based entirely on the insurance company’s expenses, mortality experience, and other costs. So, if your insurer runs a tight ship, you could see your premiums drop substantially over time. The contract specifies a maximum premium that you only pay under a worst-case scenario. Otherwise, you pay a premium that’s less than the guaranteed maximum with the potential for it to go down from there. Sometimes, it won’t budge though – especially if the insurer is having a hard time controlling internal costs. Sometimes, it will increase. But, it will never go higher than the guaranteed max premium stipulated in the contract.
- Limited-Payment Whole Life - This is probably my favorite type of whole life. The insurance company figures out what it would cost to provide you with coverage for your whole life and then allows you to pay for it on a truncated time table. So, for example, a 10-pay whole life means that your required premium payments are made over the course of 10 years. Beyond that point, no further premiums are required and you get to keep your insurance policy forever. A 20-pay whole life requires you to pay premiums for 20 years. Life paid up at 65 requires that you only make payments to your age 65, and life paid up at 85 requires you to pay until your age 85 – that, and the life paid up at 95 aren’t as cool but still represent policies that are considered “limited pay.”
- Minimum Deposit Whole Life - This policy is for you if you don’t have a lot of money to spend on premiums. Basically, as soon as you make the first premium, cash value starts building in the policy. Then, that cash value is used to pay for future policy premiums. This keeps the death benefit level, but it also reduces your total out of pocket costs. I don’t actually see this one very often, but I think it’s a cool concept for young people just starting out.
- Single-Premium Whole Life - This is the outlier of the bunch. Unlike other whole life policies, this one only requires one premium payment. In that sense, it’s sort of like a limited pay policy. The downside is that the IRS reclassifies this type of policy as a “modified endowment contract” or MEC. Because of that, you lose the most important aspects of the tax benefits associated with the cash value (which is only important if you plan on drawing cash value for any reason during your lifetime). Money will accumulate tax-deferred, but you cannot withdraw or borrow from the policy prior to age 59 1/2 without paying a penalty. Also, all cash value withdrawals are subject to ordinary income tax. Major suckfest right there.
Universal life 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.
Here is a visual illustration of how the whole thing works:
This is the classic “bucket analogy” taught to just about every life insurance agent. My drawing is a bit crude, but I hope you get the gist of it.
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 function optimally 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. 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 cut the premium to zero and let the policy’s cash value pay for the cost of insurance for the rest of the policyholder’s life. If insurance charges spike, the policyholder 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 may elect $100,000 when you start the policy. However, if you decide you only want $75,000 later on in life, you may reduce your face amount to this level. 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 beneficiary receives just the death benefit amount when you die. The increasing death benefit option allows your beneficiaries to collect the death benefit plus the cash value that builds up over your lifetime.
The benefit of the level death benefit option is that the cost of insurance will decrease over time as the cash value builds up against the death benefit. The difference between the cash value and the death benefit, called the “net amount at risk,” is decreasing under this death benefit schedule. Because of this, the policy’s costs will decrease over time (assuming all investment return and insurance charge projections are accurate). The benefit of the increasing death benefit option is that your beneficiary may receive far more than the face amount of insurance if the underlying investments of the policy perform well.
- 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.
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. 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). How could anyone possibly offer something like this, and more importantly why? I’m glad you asked.But, before I get into the nitty-gritty details, please understand that these products are incredibly complex. If an agent tells you that they’re simple, he’s lying to you. I’ll explain all these complexities in a moment, but I just want to give you a fair warning first.OK, so a little history on these things. Early attempts at equity indexing involved annuities. However, later, this idea expanded to life insurance, bank CDs, and corporate notes. Initially the index that these annuities were linked to were interest rate indices, like the 10 year U.S. treasury note index, rather than an equity index – such as the S&P 500 stock index.When we are talking about an equity index, all an index represents is a number used to measure the general behavior of stock prices by measuring the current price behavior of a representative group of stocks in relation to a base value. The Dow Jones, for example, measures 30 of the largest and most established companies in America; often referred to as “blue chip” companies. It consists of companies like Walt Disney, Wal-Mart, and Microsoft. The S&P 500, on the other hand, measures 500 large cap companies, most of which are American.
To make an equity indexed contract work, there needs to be two components: bonds (or bond-like instruments) and index call options. A bond is a debt instrument – a loan if you will – made by the Government or a corporation to another party, usually an institution like a bank or a life insurance company. These pay a fixed rate of return.
If the bond is going to pay (i.e. if the debtor – the Government or the corporation – does not default on the bond) it will pay the stated interest rate. There is no variance. Government bonds are widely used and deemed to be “good as gold”. Whether that title is actually deserved is another matter. Very few individuals or institutions fear that the Government will go bankrupt or be unable to pay the interest on its outstanding bonds, and that’s all that matters for the purposes of this humongous guide.
An index call option is a stock option. A stock option is the right – but not the obligation – to buy or sell stock for a preset price (which is set when the option is purchased). There are two types of options: call options and put options. A put option is the right to sell stock at a preset price, and a call option is the right to buy stock at a preset price. So, for example, if you thought that a company’s stock was set to gain value, but you weren’t 100% sure that it would, you could buy a call option for much much less than buying the actual stock. Essentially, you are able to control a large amount of stock with very little money up front. You don’t actually own the stock and you don’t ever have to buy the stock, which is what gives you protection if the stock doesn’t do as well as you expected. However, there is an expiration for every option. And…the longer the expiration date, the more expensive the option will cost (i.e. a 3 month call option may cost $500, but a 1 year call option may cost $750).
An index call option is a call option on a stock index – usually the S&P500 stock index. Banks and insurance companies are able to use a very precise mix of bonds (to guarantee the contract owner’s principal plus a small amount of appreciation) and index call options (to capture the upside potential of the stock market) to produce a new type of contract that gives the contract owner the upside potential of the stock market, without any of the downside risks associated with a direct investment in the stock market.
To make sure that these institutions have the money needed to credit the promised interest to the contract, the issuing bank or insurance company enters into an agreement to purchase counter-balancing investments (i.e. bonds or bond-like instruments) through what is called a ‘counterparty’ – a company that acts similar to a reinsurance company. The insurance company or bank also purchases the index call options through counterparties to ensure that all of the obligations of the index contract can be fulfilled. This is known as “hedging”.
While equity indexed contracts do provide a guaranteed minimum, the guarantee is usually weaker than in traditional ‘declared rate’ contracts, like bank CDs, but this is because the focus is on the upside potential of the contract. If fixed rates are higher or comparable to indexed returns and you would like to take advantage of fixed rates, some contracts provide the option to switch to fixed rate returns that mirror current bank CDs or annuity contracts.
Insurance companies and banks are willing to offer indexed returns because they are obviously making money with this approach. They can afford to credit you with the interest gains, because just like every other financial product, these contracts also have their own expenses and administrative charges.
Variable life insurance works by allowing you invest some or all of your premiums into the insurance company’s separate account. Premium payments are fixed, but there are no explicit guarantees on the performance of your policy. Your policy’s death benefit and cash value is driven entirely by the underlying mutual fund investments. If your policy’s cash value reaches $0, your policy terminates and you lose your life insurance.
A Word About Buying Life Insurance
I’m not going to lie to you. Buying a policy is actually a bit difficult. That’s why agents get paid such high commissions for the sale of a policy. 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).
You can try to use an online calculator, quoting software, or simply pick an arbitrary amount of life insurance that you “feel” is the right amount. However, the risk with taking such a slap-dash approach is that you could be purchasing too much or too little insurance.
For example, such factors as personal financial goals, age, annual income, if you plan on retiring and if so when, total debt (including mortgage debt), number of children, your investment experience, your expected pension benefits, expected social security benefits, and so on must all be taken into account when purchasing life insurance. Even after all of this analyzing is done, you still need to figure out whether you can pay for the policy over the long-term and how to budget for it during good times and bad.
References for this post:
Mittra, S., Anandi, S.P., & Crane, R.A. (2007). “Practicing Financial Planning for Professionals (Practitioners’ Edition), 10th Edition”. Holly, MI: Rochester Hills Publishing
Black, K. Jr., & Skipper, H.D. Jr. (1994). “Life Insurance”. Englewood Cliffs, NJ: Prentice-Hall, Inc.
…and my 9 years experience in the business._________________________
April 9th, 2014 | by David | 1 Comment