Over the years, many products have changed, but few concepts have changed. The concept of life insurance has been the same since it’s formal creation almost 200 years ago. A family considering insurance today should ultimately view insurance in the same way – as a way to protect a family’s lifestyle when an untimely death occurs.
Once you understand that concept , you understand 90% of the products and from there, you should much more competently make a purchase decision. Insurance rarely can outperform equities or bonds investments over a ten year horizon. The pricing of insurance products, however, does include implicit rates of returns – you will pay for the amount of benefit that you receive. The benefit can come in the form of proceeds to a beneficiary when you pass or in the form of proceeds you receive while you are alive.
What are all of the factors that effect insurance premiums? Generally, factors include type of product, your age, your habits (smoking, drinking), the amount of coverage, and your health.
There are four general types of life insurance products, and each is detailed below.
- Term Insurance – The cheapest option and shortest to end. This product is called ‘term’ because the length that it is in effect is a term of time, ranging from 1 year to 30 years. A straight term policy is quite cheap relative to the other options below, but if you don’t die during the term, the money has given you no economic return. If you take a 20 year term when you are 25 for $1mm of coverage, you will pay around $40 per month. This premium is guaranteed to stay the same as long as you continue paying it. Therefore, if you pay for the full 20 years, you pay $9,600 in total premiums. This only takes you to age 45, at which time you might want another policy. If you get the same policy, it might cost around $250 per month, taking you to 65 years old. At the age 65, the same policy might cost $750 per month. Because of changing needs, many buyers of term layer policies on top of each other, buying a 10 year, a 20 year, a 30 year, and finally a ‘permanent policy’. Most professionals, including myself, agree that this is the best strategy for life insurance.
- Universal Life Insurance – This is a ‘permanent’ insurance product, meaning that it isn’t tied to a term of time. The suggested premium is also called the ‘guideline’ premium. The guideline premium is based on interest rates staying the same over the course of your life. If rates rise, you will need to pay a lower guideline premium based on those new rates. If rates fall, you pay a higher guideline. At this time, rates are very low, so the UL policies are only being credited a small amount relatively speaking. The idea behind UL policies is: a 25 year old buys a UL $1mm for $300 per month. This buys you a term policy with the face value and at the same time, the interest rate (traditionally based on floating rates) credits the policy with ‘cash value’. In the first few years, the cash value is very low because you pay the insurance company front-loaded fees. While you have the $1 million coverage, the cash value doesn’t accrue to be positive for many years. In later years, you have three options. You can either take a loan against the policy (see below), you can continue to build up a higher cash value or you can have the cash value pay premiums for you. If rates rise, the interest you receive will be higher and you can in theory have the policy pay for itself earlier than you expected.
- Whole Life Insurance – This is a ‘permanent’ insurance product also. There is only one premium, designed to stay fixed forever. A whole life policy is very dependent on the company that you buy the policy from. ‘Mutual’ companies are theoretically owned by whole life policyholders, in the sense that the dividends issued by the company go to the policyholders. Publicly traded companies need to satisfy stockholders in addition to WL holders. A whole life has many guarantees, which is why many shoppers prefer them to UL policies. A 25 year old buying a $1mm WL policy will pay $500 per month, and similar to UL, the cash value will not accumulate for years while frontloaded charges eat away.
- Cash Value – The excess over ‘mortality charges’ (i.e. expenses for insurance costs) accumulate in the policy over time. This allows something like a return on premium for the policyholder. The cash value can be accessed similar to a Home loan – you pay a variable interest rate that is fixed once you take a loan. The loan can be paid back whenever you want, however, and just like a home loan, the proceeds are tax free. Many professionals agree that if a person ‘needs’ an insurance policy and makes over $200k per year (beyond the limit of a roth IRA), he or she should consider a WL. Personally, I think no insurance policy should be bought for any reason other than protection from an untimely death.
- Annuities – Technically, this is protection more for old age than for an untimely death. It can do both though. Essentially, you pay an insurance company a lump sum premium and the company will pay you a guaranteed income for the rest of your life. In exchange for the interest that the company generates on your money, they will pay you interest credited to the income stream. The rates are traditionally fixed when you buy the annuity, so rate changes over time do not beneift or hurt you. If you buy the annuity when rates are low, and then rates rise after you buy, you will still get the original rate of interest. You can structure annuities to be life only or to pay you and your survivor(s) such as a wife. You make more yearly on the income stream if you choose life only. Otherwise, you take a 25% or so discount by having a survivor receive your payout if you pass away. That means if you take life only, you get, say, $4000. If you take a joint annuity, you get $3000 and your survivor(s) gets $3000 also. There is a common strategy of buying a life only annuity and buying life insurance at the same time. In this way, you have a higher payment from the annuity, and the life insurance is usually both cheaper and provides a higher death benefit.
As stated in the beginning, understanding that the concept of life insurance is to protect a lifestyle and nothing more, you can easily decide which is the preferred product.