Life insurance has become this excruciatingly difficult topic for most people. I have some ideas as to why, but I don't think we need to get into that just yet. First, let's get a "plain English" understanding of what life insurance really is.

Life insurance is a financial product that you buy 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.

The necessity of life insurance today is based around the idea of a family with one or both spouses working outside of the home, and that if one of them dies, the other will be left with financial obligations that will not be able to be met. Life insurance is supposed to fill that gap.

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 people buy?

The debate between which is better - term or cash value/permanent life insurance - is seemingly a "never ending battle". For various reasons, most stock brokers, mutual fund managers (and the agents who sell their funds), as well as many popular financial "gurus" like Suze Orman, Ric Edleman, and Dave Ramsey presumably (according to their many published books and comments on national radio and television) hate cash value life insurance.

That's too bad, because in most cases, if you are young, it's the cheapest form of life insurance over the long-run - despite what anyone says (and I'll prove it again in this article). Again, I stress the youth aspect. Buying permanent insurance when you are young, say in your 20s and 30s is a good idea. OK, here we go:

Common Lies, Attacks, & Misconceptions:

There are a few misleading statements that keep cropping up whenever I am reading an article about life insurance.

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". Because the best always implies "for whom, and for what purpose?".

Term insurance can be the best type of insurance if all you are considering is the cost. After all, it's pure insurance so the mortality cost is rather low which translates into those dirt cheap premiums you see advertised on T.V. and plastered all over the web.

But it is generally the worst type of insurance you can buy to insure your life if you want it to pay off, at least statistically speaking. Sure, you could die tomorrow. That's 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 (or even a good cheap one). 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.

The industry inside "secret" is that only roughly 1% of term insurance policies ever pay out a benefit. That's not something life insurers advertise though, and for good reason. They're making a lot of money on selling term life insurance. Now, that's not to say that term is a ripoff. It isn't. You are paying for coverage and you're getting it.

But, it's like buying the cheap blenders at Walmart and expecting them to perform like a Cuisinart.

Some people debate this 1% statistic and argue that it must be closer to 20%. It doesn't really matter either way. 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.

That said, it all depends on the context. If you want the “best” kind of insurance, and by “the best” you are considering only the cost per thousand dollars of insurance, then term insurance can be the better buy, but it isn't always the better buy. It is cheaper per thousand dollars of insurance on most accounts than permanent insurance, but is less likely to be in force when you die. If you need this type of insurance to cover a mortgage or a fixed loan contract or something, it can be worth spending a little bit of money, even if it never pays off.

However, as a way to insure the bulk of your income if you die unexpectedly, I would probably lean towards the permanent insurance policy, even though there are probably a few critics saying "no Dave, term insurance is cheaper on all accounts".

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.

When I think of people being “cheated” by an insurance company, normally I think of something in the industry called “concealment”. A warranty in the world of insurance 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. 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.

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. This is just one example of many where the “poor and helpless” individual is in reality the scam artist - not the insurance company.

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:  With whole life insurance it is often difficult to determine how much the death benefit is costing you. But that is largely a non-issue. However, if it does bother you, then buy a universal life insurance policy. A UL policy is, in actuality, a term policy with a separate cash account - often called ‘the pot of money’.

Basically, what this means is that 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. This is a point that is really driven home by the anti-cash value life insurance crowd.

A fact that many of these folks somehow neglect to mention though is that all financial products carry some type of commission, load, fee, or expense charge. The only way to really avoid paying commissions (yes even on alleged "no load" mutual funds) is to circumvent the system that gives you easy access to financial markets.

You would have to approach a company directly and buy their stock with no middle men involved (quite an impossibility in today's world). The only problem with this approach is that if you were to do this, it would be a lot more expensive than today's structure (think of the lawyers you would have to hire to negotiate a contract directly with a company, the upfront costs of having to buy enough stock to make it worth it for the company involved, and the costs of finding a buyer when it's time to sell the stock - plus all of the extra time involved).

Be thankful that you pay some of the fees that you do. It makes financial markets easy to access. As for cash value life insurance, it all depends on the company and the contract. A life insurance contract can be set up to maximize the death benefit (maximizing the cost of the contract), or it can be set up to focus on cash accumulation (minimizing expense charges to .5% - 1% of the interest earned over the life of the policy). The expenses associated with a permanent life insurance contract can be made just as efficient and in some cases more so than what the  antagonists suggest as an alternative - which is usually some type of mutual fund - without sacrificing the practicality of owning the contract. But again, why are the antagonists trying to compare the cost of insurance to an investment?

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:  This is a joke. It didn't help the "smart" investors in the 1930s, in the '80s, in the 90s, in 2000 and it certainly didn't help them in 2008. The truth is, you may not need the death benefit in 30 years to protect your children from financial ruin when you die.

But by that time you've built up a significant cash savings inside the policy that you can use to supplement your retirement. Whatever is left of the death benefit you may need for burial expenses and to protect your beneficiaries (whoever they may be) from taxes - if any.

What happens when you die? Your beneficiary will receive the value of your retirement plan. 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 cash values are tax-free, they can help offset the taxes you pay on these accounts.

On top of that, any of your investments without a named beneficiary will have to pass through probate, and will incur fees from whatever lawyers are involved on top of taxes. Probate can, depending on your circumstance, also take quite a while to complete. What do you do for the 6 months or a year while you wait (and need the money)?

The cash value life insurance that your financial guru told you was evil and that you didn’t need could have prevented all of this by bypassing probate, providing an income tax free death benefit and, inside of a life insurance trust, completely avoided the estate tax thereby giving your heirs, your favorite charity, or your church 100% of the money you wanted to give them.

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: I love this one, mainly because it's easy to disprove. 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.

First, who starts saving money with a time horizon of 3 years? Secondly, this is a dishonest comparison 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).

Even if you stretch it out over 30 years, you are going to get a net effective yield close to what you would get with a good dividend paying whole life. Now, Dave is always complaining that whole life insurance only returns maybe 2% or 3%. It doesn't add up does it? Especially when dividend paying whole life policies can return between 5% and 6% over 30 years. I go over this in more detail in my post about buying whole life vs buying term and investing the difference.

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.

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.

No, 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, and the anti-cash value crowd is silent when this is brought up.

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.

U.S. Government bonds are considered to be very safe because they have the power to tax, and also as long as the Government can print money through the Federal Reserve mechanism, then they can never go ‘bankrupt’ and they will always be able to pay out the stated interest on the bond.

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.

By investing in both types of bonds, an insurance company can make a meaningful guarantee to the policy holder that actually has substance.

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: To be honest, this can be a tad bit complicated. And, the antagonists have used this opportunity to confuse everyone else (including themselves) instead of explaining how the withdrawal and loan provisions work in a cash value life insurance policy. Apparently it's easier to throw your hands up in the air and call something "stupid" than to sit and think (and explain) how something actually works.

Insurance companies charge you interest for taking policy loans because they have to. First, Government (IRS) regulations mandate that a loan must look like a loan, and therefore interest must be charged. Secondly, because it is a loan, the proceeds are free from income tax as long as the policy remains in force. You never have to pay back the loan, but if the policy ever lapses, any outstanding loan is considered taxable income.

Moreover, when a loan is taken from cash value life insurance policies, it is charged a "fair" rate of interest. From here, the company normally gives you two options. First...

Let's say that you had a cash value life insurance policy with $100,000 of cash value. You want to take a $50,000 loan. The insurance company gives you a check for $50,000 against the value of your life insurance policy's cash value (which is $100,000), which is sort of like getting a loan against the value of your home. The money from your policy is never actually given to you.

Instead, the insurance company takes $50,000 from your life insurance policy, and places it in a fixed interest account that essentially counteracts the interest that they have to charge you to make it a "legally binding" loan in the eyes of the IRS.

In other words, they give you a $50,000 loan, charge you 4% for the loan, and then take $50,000 from your policy and place it in an interest bearing account which earns 4%. Pretty slick, right? The effect is that the loan is a "wash" - in fact these loans are often called "wash loans" or "preferred loans" by life insurance companies.

The other option the insurance company would give you is similar to the idea above, with a small twist. You take a loan against the value of your policy - same as above. However, instead of taking the $50,000 out of your policy and placing it in a special account to counteract the interest they charge you, they simply leave the entire cash value intact and earning interest based on the contract provisions.

This is usually most beneficial when your policy is earning interest that is generated from a combination of bond rates and dividends (as in a dividend paying whole life). Because both the interest crediting and loan rates are based on bond rates, the interest charged and the interest earned are typically very close. Due to the dividends payed on such policies, it is not uncommon for the interest credited to the policy to be more than the interest charged on the loan. In effect, you are earning money even when you are taking on a loan from your policy.

So, yes, you do have to borrow the money. Is it really costing you anything? 99% of the time, no. The 1% of the time when it does cost you money, it turns out to be a much cheaper rate (about 1-3%) than what you would ever get from a bank or credit card company. Keep things in perspective.

The other option is that you can simply take withdrawals from your insurance policy. 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 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.

Conclusion

All in all, it sounds like I am a something of a cheerleader for cash value insurance, but it's not all glitz and glam. Surprisingly, the one fact that none of the critics of cash value insurance bring up is the issue of company structure problems.

What I mean is, the company you purchase your life insurance from should not necessarily be cheap on their pricing, but they should definitely be structurally sound. That's an issue I have with "gurus" recommending low cost companies. 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.

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 benefiting 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.

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 essay, 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.

Remember that every financial product has a purpose, and while not every product is good at what it is supposed to do, cash value life insurance does live up to its promise: permanent insurance protection with a long-term savings component.

If you want to keep reading, I've got yet another article about life insurance. Feel free. I don't mind.

Comments

[Michael Strella]

Dear writer:
This is the best discussion of the merits of whole life as a guaranteed leverage and savings tool that I have ever read.
Old fashioned uncommon sense is genrally far superior to the redefined gospels of the new guru's. The so called guru's of investments say what they say with a hand in your pocket and expect you have the attention span of a squirrel. Sound bites are for people who want to follow conventional wisdom down the drain.
Thanks,
Mike

[David C Lewis, RFA]

Thanks for your opinion about life insurance Henry. I think I have addressed all of the issues you brought up either in the article above (you must have missed it), or elsewhere on my blog.

[Henry F. Glodny]

Hi. I followed your link from a Money article.

Sorry, but I was having trouble separating where the sales presentation ended and the analysis began.

Buying life insurance is a form of risk transfer. And of course, it makes sense, but depends on the risks being managed.

But the amount of coverage one needs will vary dramatically over the course of one's life.

It is not static.

Therefore, Term is infinitely more flexible.

A young married person with a family to support, as sole income earner, may have a huge risk to fill.

Having the proper amount of term coverage at this stage of life is much more important than having a lesser amount of whole life. Affording the proper amount of coverage is the important thing.

Protecting future earnings, so junior goes to college is the critical point. Supporting junior when he's 25 is not.

That only a negligible percentage of these policies pay off, is shocking?

Hello?

Because I have not filed an auto or homeowner claim in the last twenty years, does that make the accumulated amount I paid in auto and homeowner premiums wasted? Of course not.

I have had clients who were not properly covered by the whole life policies they were sold in the past. Thankfully, nothing bad happened.

But neither did anything good happen, either. The accumulated cash values are a relative pittance.

They could have been more adequately covered by term AND have had their mortgage paid off by now.

And where's the Commissioned Based Product Salesperson (CBPS) who sold them their policies? I wonder where he's vacationing this year?

Too bad he wasn't a fiduciary, as all people calling themselves advisers should be.

[Rich]

Great article. I really appreciate the author's objective, unbiased viewpoint.

[David Lewis]

Contact my office. I believe I can help you.

[CB]

I need to get information on decreasing accidental death insurance for my home. Is this a good investment. I have tried to get term insurance in the past but was rejected because I am a diabetic. What advice can you give me on this. It seems to be reasonably priced per month and no medical checkup is needed.