May 11, 2022
Sid Roy
We had another very informative session on a topic that interests me a lot – life insurance investments. This is partly because I was exposed to life insurance pretty early on in my life, but the topic of life insurance investments was new. I am guessing the same is true for most of you.
We started the discussion with something almost all of us understand – simple term life insurance. It is meant to provide a financial cushion to family members if an earning member expires unexpectedly and thus the family loses its main source of income. We pay a premium on a periodic basis for this pay-off. At the end of the term, we have a choice to get another term insurance, subject to insurability requirements and new premium amount. Typically, one would have a term life insurance covering the primary earning years of their employment. Therefore, the primary purpose of this is to provide income replacement in case of unexpected demise during these years. The benefit goes to the family left behind.
So far so good, not that hard to understand. Now, one of the issues of term life insurance is that the best-case outcome – that the insured person doesn’t die – also makes the premium paid seem like a net loss. This is especially true at the end of the term when many cannot get a renewal of the policy due to changes in health conditions and the increased premium.
The whole life term insurance addresses the above situation by promising a payout. With this type of product, the business model of the insurance company changes. In the term life insurance situation, the people who got payouts were smaller compared to the overall insured population. In the whole life insurance scheme, everyone insured gets a payout. The risk pooling in effect for term life insurance no longer exists thus leading to much higher premiums. That however is little redemption for the person paying the premium since it certainly does not benefit him or her. It is a very hard sell to convince someone to pay substantial sums every month when they themselves do not benefit.
To attract more people into such insurance schemes, insurance companies introduced the concept of a cash value as part of the insurance in addition to the payout. As part of your insurance, the premium that you pay partly goes to build up something like a savings account or what is usually known as the cash value or a general account. This creates something tangible for the insured. The premium does not seem to be completely lost and there is a guaranteed payout. There are some added benefits – one is the ability to tap into the cash value in different ways, another is the tax advantaged treatment. One way to tap into cash value is to take a loan if there is a financial emergency from the cash value. Another way is to surrender the insurance policy and still get the cash value. Both the loan and the final payout are federal tax free. This is an important benefit compared to taxes associated with investment accounts.
So, to sum it up, these products provided the insured added flexibility to deal with changes in life situations and make changes late in life. This is whole life insurance policy in a nutshell.
Now, that we finished discussing the two basic variants of life insurance, it is time to look at some more variants. The whole life insurance addressed some important issues, but the premium remains fixed. The next variant is the universal life insurance in which the insured gets more flexibility to address financial hardship situations. With universal life insurance, the insured has options to change both the premium and the payout depending on the need. The goal is to help the insured adjust and continue in some fashion to get some benefit. We wondered about the name universal life insurance since the main attraction seems to be flexibility it gives to the insured.
Hopefully, you are following along the evolution of the product, and you might be expecting another twist. You would be right. Now the attention turned to the cash value attached with the insurance. This cash value part is effectively put in a low risk, savings account accruing very little growth. This can be seen as sub-optimal especially because of two reasons – inflation and long duration. In this type of insurance, part or all of the cash value would be invested in the market. This definitely brings in more growth in the account but along with the potential risk of loss of cash value. There are typically options to be flexible about the degree of risk by designating the portion to be allocated to market and the portion allocated to savings account. This is variable universal life insurance. In case you missed it, the product evolved to address what seemed like rational needs but is getting more and more complicated. In addition to the above complications, there are lots of fees and administrative costs to be paid. Due to this structure and plethora of fees, you might notice it is just getting harder to assess the product with your other investments.
At this point, we discussed why would we anyone buy this product given so many complications. The suggestion – was to go back to the purpose of the investment. You have a number of options for the different purposes you have in mind for your investments. So, it goes back to basics – compare the investment portion of the life insurance product with a regular investment account in terms of ROI. Consider if you can do better with a combination of fixed term life insurance and an investment account.
The final word here – there are lots of things to consider in terms of fees, admin costs, effective rate of return and headache involved in making any changes once you have bought into this kind of products.
I think you will agree that we covered a lot of ground in this session of Ask-Learn-Share. Hopefully, you found it useful as well. See you in the next session!