Whats More Important, Safety or Profit?

Jul 28, 2000 (Updated Aug 13, 2000)

Life Insurance is a vehicle of protection. The main purpose is to provide some level of risk-protection, and to provide for your loved ones when you die. However, some people will tell you otherwise, particularly insurance agents. Because Life Insurance has enormous potential for profit (if no one died, they’d make 100% profit minus their overhead), insurance agents will twist around facts and figures to make whatever it is they’re offering you look attractive.

Before I get into too much detail, let me introduce the three types: term, variable and whole life insurance. You can classify them into two categories: temporary and permanent, with term falling into the first category, and variable and whole into the latter category.

So who needs it?

Personally, I think that people are motivated to purchase life insurance plans for two reasons. The first reason is as an investment (invest x dollars, get x dollars + y% of x dollars). That’s the wrong reason to get life insurance. There are plenty of other investments that offer a better return than a life insurance policy. If anything, the return you get should be viewed as a side benefit. There is a small exception that I can mention, but I will mention it at the end.

The real reason to purchase life insurance is to provide for the loved ones you have left behind. A main component of this is your dependents. If you’re married, it is your husband or wife. If you have kids, it is them who you hope to leave something behind in case you pass away unexpectedly or even expectedly.

The other reason to purchase a life insurance policy is to cover your own costs. Someone needs to pay for your funeral, plot, as well as any other costs associated with your passing. So why should you be selfish and let others take that responsibility for you? Your insurance policy will make sure your significant other, your kids, your parents, or whoever you designate as your beneficiary will not have to worry about the financial burden to add on to their already painful personal loss.

So now, onto the insurance.

Term Life: Constantly Changing
If you’re unfamiliar with life insurance, this is a good way to figure out Term Life Insurance. Basically, picture yourself purchasing auto insurance. If you’re 30 yrs old, w/ no prior tickets or accidents, and driving a family vehicle, your auto insurance premiums would be low, right? That’s because you’re in a low risk level. The insurance company doesn’t have to really worry about you getting into an accident (i.e. they’d have to pay a claim), so they charge you less. Now, if you’re 18, just got your license, and you’re driving a Ferrari, you’re better off not driving for awhile, because you’re in a high risk category, so the premiums will be sky high.

Well, if you apply the risk principle to Term life insurance, you’ll see that the low risk category is filled with younger people with little or no health problems. The high-risk category is filled with older people with a long medical history. Thus, you’re paying low premiums the younger you are, and high premiums as you get older.

The good thing is that most term policies are renewable. But don’t expect the premiums to stay the same or lower; because you will continue to get older, the premiums will continue to rise. Interesting fact that I cannot quote (because I cannot remember the source) went something like this: 5% of all term life insurance policies will ever pay a claim. Why? The reason is because young people usually buy term life insurance (because it is cheap). But they end up not being able to afford it when they’re older (when it gets more expensive), so they cancel it at a time when they need it the most.

The System: 1
You: 0

What kind?
Anyway, here are the three types of Term Life Insurance
-Annual Renewable Term (ART): The cost goes up as you get older, and as the name says, it is renewed each year with (typically) a higher cost attached.
-Level Term: It is the same as ART, but it locks in a specified cost for a period of 5, 10, 15, or 20 years. In the long run, Level Term will cost less than ART.
-Decreasing Term: You pay the same premium each year, but instead, your benefit decreases each year.

I would probably go with Level Term life insurance. But remember, everyone’s situation is different; there is no standard solution for everyone, so consider how much you need your benefit (payout) to be, as well as how much you’re willing to spend. Lastly, consider how long you contemplate carrying this insurance policy with this carrier.

Whole Life: I Wish It Were A One-Time Payment Instead
You pay $300 a year for term life insurance when you’re 25 only to find out they’re charging you $5000 a year when you’re 70. And you’re mad. So if you could turn back the clock, you might have gotten whole life insurance instead.

Whole Life is a one-time deal. Once the details are down in writing and everything is signed, nothing changes. It’s like a Level Term policy, but the period spans your whole lifetime. It consists of a fixed:
-cost of the policy (per year)
-death benefit
-future cash value
-interest rate that the policy earns so that it can attain that cash value

So it is good that you’re probably getting a rate somewhere in the middle of both extremes (the $300 and the $5000 in the previous example), and it is guaranteed every year. Secondly, the cash value will build up, while at the same time, you will pay less in premiums.

The main drawback with Whole Life is due to its main feature: everything is guaranteed. So because the interest rate is guaranteed, which insurance company would want to lock in a high interest rate if it cannot produce that type of return? Thus, the interest rate for most Whole Life policies are very low, in the range of 5-7%. Can you get returns higher than this in the open market? Of course you can.

Somewhat Bonus Topic: Universal Life
Well, universal life insurance is another type of permanent insurance that is very similar to the whole life policy. What’s the difference? The interest rate is not guaranteed. It is suddenly turned from say, 7%, into a range, between 4% and 15-20%.

The good news is that there is a minimum interest rate. You’re guaranteed a minimum return, but it will not be as high as whole life rates. In addition, there is no cap for the maximum interest rate. Anyway, what this all means is that when the rate is at the minimum, you’ll probably be paying high premiums. And when the interest rate is high and your return is good, your premiums will drop.

One problem that has happened since the days of the 80s, when there was high inflation; those 15% returns were a “given”, and people expected to be paying low premiums. But when the interest rates dropped (the insurance companies could not easily make those types of returns), many people found they could not afford the higher premiums that accompanied it, and they lost their coverage.

Variable Life: Too Many Variables
Variable Life is another type of permanent insurance that makes an about-face on the whole concept of whole life insurance. There are no guarantees. This type of policy invests your excess premiums into mutual funds.

The upside is that your accumulation account (cash value buildup) can grow at a faster rate than whole life or universal life. The downside? You can be losing money. If your mutual fund goes down in value, so does your accumulation account. If your fund crashed dramatically (stock market crash, etc.), your policy could be cancelled for lack of sufficient funds. So why risk it? I personally do not like variable life policies.

And the winner is…
There is no clear-cut winner, because everyone has his or her own preferences. The loser, however, is variable life. That’s my opinion.

My conclusion is that insurance should be bought for insurance purposes only, not for investment purposes. You’d buy into mutual funds and stocks and other financial instruments for that. If profit is what you’re really looking for, don’t buy insurance.

A winning strategy, in my opinion is this: Buy term life insurance, and invest the rest of the difference (between what it would cost you for a whole life insurance policy) into stocks or mutual funds. In the long run, the returns should surpass the returns you could make in a whole life or universal life policy. This will provide you with the insurance protection that you need without having to worry about the returns, because the profit you make on your seperate investment will more than make up for the return that you are losing. It is a profit-driven choice.

In general, the longer you intend to keep your life insurance, the better off you are with a permanent life insurance policy. If you’re going to keep it less than about 8 years, term life is the way to go. If you’re going to keep it more than 12 years, permanent life has the lower cost. In between 8 and 12 years, you have to decide on your own. Do the math. =P

Bonus Section: The Only Way I Know To Utilize Life Insurance as an Investment
The only way you should use your life insurance as an investment is to use it as an insurance trust. You would be using this in your estate planning, and the intention is to protect your money a step further than a bypass trust.

The type of policy you would be purchasing is the second-to-die policy, which insures the lives of a married couple, the policy would be owned by the trust (specifically called the Irrevocable Life Insurance Trust), and the policy would name the trust itself as the beneficiary.

Step 1: One (of the two people married) passes away.
Step 2: The policy does not take effect yet, because it is the “second-to-die”
Step 3: The second person passes away.
Step 4: The death benefit is paid to the trust, which is then distributed to the couple’s children.

*The policy’s premiums are only a fraction of the amount (percentage-wise) you can save in estate taxes by using this method.
*In addition, this method helps when one person is “uninsurable”, because it provides insurance coverage for both people, provided that the other person is in relatively good health.
*Lastly, you can transfer your existing insurance policy to the trust, which in effect will lower your estate tax liability, while providing money for your kids to pay off your estate taxes when you die. Note: When you transfer a policy to the trust, try not to pass away for three years; otherwise the IRS will rule the transfer “in contemplation of death”. That will make the move worthless, because the IRS will levy taxes on the death benefit.

The End.

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