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The Truth About Life Insurance

Jun 19, 2008
Life insurance is necessary. However, most individuals do not carry enough of it. The idea behind life insurance is that we all die. If your spouse dies prematurely, a life insurance policy will make sure that there is enough income to make your family whole for the financial loss you've suffered. Pretty much every adviser agrees having life insurance is a good thing.

However, financial professionals often disagree about how much and what type of insurance one should carry. The perception is that term insurance is always the easiest and most cost effective. To this end, many advisers and financial "gurus" like Suze Orman and Dave Ramsey often suggest that their audience forget about cash value insurance and instead focus on good-sounding investments. In short...they hate cash value insurance.

Some financial advisors love cash value insurance, others hate it. Who's right? Who's wrong?

It's surprising that the financial industry is supposed to be the educator. I say that only because many of the financial advisors in my industry seem to be more concerned about what the next "hot" mutual fund is...or manipulating interest rate returns, eliminating or disguising fees and disregarding suitability with respect to their clients.

I say that in light of the fact that on both sides of the debate, neither is doing a very good job of defending their position. Many financial professionals are simply leaving out critical information, or appear to not have a very good grasp of how life insurance really works.

Their reasons for lying can be many. Now, there's nothing wrong with pointing out the shortcomings in a financial product. In the case of life insurance; however, the attacks being made are completely baseless. This is especially disheartening because most, if not all, of these attacks are originating from well known financial "gurus". Here are a few of the lies being spread around:

Lie Number One:

Don't waste your money on cash value insurance. It is a complete waste of money because the insurance company collects premiums from you for 20 years and then when you die you only get the death benefit. They keep all of your cash and your family gets ripped off. Besides, you could make more money by buying term and investing the difference.

Fact: Less that 2% of all term policies ever sold ever pay a claim. Which means: there is a 98% chance that your family will never benefit from a term policy. Term insurance may be the best type of insurance if all you are considering is the cost per thousand dollars of insurance. It is generally the worst type of insurance you can buy to insure your life if you are expecting your family to benefit from it (statistically speaking). You need to understand how life insurance companies position their products and how they make money.

You may have heard of the "law of averages". Well, insurance uses something called the Law of Large Numbers. The larger the group of people you are insuring, the more certain you can be about the number of losses.

Let's suppose you were to start an insurance company and you only had one customer - let's call him "Jim". You would be taking on an incredible risk by insuring just Jim. If Jim kicks the bucket, then you're on the hook for a lot of money that you may not have. You would be business very quickly (imagine: Jim gives you $20 for a $500,000 death benefit and then they die the very next day...where do you come up with $500K for Jim's family?). However, if you have thousands of customers just like Jim, then you have the unique ability to better control the risk you take by insuring Jim's life. No one can predict when Jim will die, but if you study a large enough group of people just like Jim, then you can begin to make very, very accurate predictions about the number of people just like Jim that will die in any given year. Given the accuracy of insurance companies in predicting deaths every year, what do their statistics tell us?

They tell us that term insurance just doesn't pay...well not for policy owners anyway. Most people live until age 65. After that premium costs spike dramatically. This is why I say that, on most accounts, permanent is cheaper, even though there are probably a few critics saying "no Dave, it's cheaper on all accounts". Oh yeah? Watch this:

Let's look at a male, age 25 and in good health with a wife and a child. In fact, let's call him Jim (again *cheesy grin*) finds that he needs life insurance He needs $250,000 in life insurance. A 30-year term policy should cost Jim about $370 per year until he reaches age fifty-five. After that, the premiums become unaffordable (as is the case with all term insurance) at $4,700 per year.

At age 65, he will have spent $58,780 on policy premiums. Keep in mind that this is money that the insurance company collected but never had to pay back. Since there's no cash value in a pure insurance (term) plan, the insurance contract pays off only when Jim dies.

What would have happened if he had, say, purchased the same amount of death benefit but used a universal life insurance policy with slightly higher but level annual premiums of $1739 every year to age 100? By his 65th birthday, 'ole Jimbo would have had a total premium outlay of $69,560 ($1739 x 40). But, he would have built up $157,000 of cash value inside the policy.

This money is part of the policy's living benefits, and can be used on a tax-free basis to supplement his retirement or left alone to continue growing. Some life insurance companies also offer an option to spend down up to 100% of the death benefit if you become chronically or terminally ill. If you haven't been able to accumulate a lot of money, this can be very helpful.

Lie number two:

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. If that bothers you, then don't buy whole life insurance. However, universal life insurance is, in actuality, a term policy with a separate savings account - often called 'the pot of money'. As such, you can easily determine the cost per thousand dollars of insurance, 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.

Be thankful that you pay some of the fees that you do. It makes saving and investing money a lot easier than having to fire a lawyer to negotiate every individual contract you sign. 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?

In the long run, you will usually get all of your money back that you put into a cash value policy and then some. You can even structure the policy so that it provides substantial cashflow in retirement. The only exceptions to this are variable life insurance contracts. There really aren't any guarantees on them.

Lie number three:

If you are smart with the money you have today and you get rid of your mortgage, 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: You may not need life insurance in 30 years to protect your children from financial ruin when you die. But you may need it to protect your beneficiaries (whoever they may be) from taxes. And, even if you are "smart" with your money, you can't predict the investment returns in a mutual fund (or a stock for that matter) inside of a 401(k) or IRA unless you are very good at researching stocks (hint: 99% of the general population is not). It takes years of practice, and even some of the best stock brokers and financial analysts don't always get it right. The stock market ebbs and flows, and goes through cycles of boom and bust. If your investments take a hit right before you are ready to retire, it doesn't matter how "smart" you were with your money.

Also, consider that dying isn't free. Ask a funeral director in your home town how much a funeral costs...and then ask him or her how much it should be in 10 years...20 years...when you expect to die. You will be amazed...and not in a good way. Also, ask any child whose parents left them any amount of money what they paid in taxes and if it was financially disruptive.

That cash value life insurance policy that your financial guru told you to ditch could have bypassed probate, provided an income tax free death benefit and, inside of a life insurance trust, completely avoided the estate tax thereby giving your heirs what they deserve.

Although many so-called experts try to compare life insurance to an investment, don't be fooled. Yes, life insurance, if properly structured, can build very strong cash values that rival investment products (my guess as to why the investment folks are upset). They try to tell you what a lousy investment cash value life insurance is. But comparing this type of insurance to investing is nonsensical. It's like asking "how many walkmans does it take to equal an Ipod?"...cash value insurance serves a different purpose from an investment. Each has their own different objectives.

So, should you buy term or cash value life insurance? That depends. What are you really looking for? If you are looking for an investment, then learn how to invest in stocks, bonds, no load mutual funds, options, and other financial derivatives. If you want a savings, then a properly structured permanent life insurance policy can fill that need very well.
About the Author
David Lewis is an independent financial adviser and provides objective financial information about life insurance, and other topics related to retirement & financial planning.
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