Life insurance is one of the most profitable insurance products that you
can sell a consumer. So, naturally, insurance companies got clever in recent
years and started to sell it under dozens of different formulations. Mortgage
insurance, credit life insurance, accidental death insurance, key man coverage,
travel insurance, funeral insurance -- all of these and more are specialized
forms of life insurance. There are so many different configurations it is
enough to make a poor Fool's head spin.
The simplest way to deal with all the noise of the sophisticated names and
the marketing plans is to cut down to the most basic element of the policy
-- what causes the insurance company to pay up? Any time the pay-off comes
when someone dies, you are dealing with life insurance.
Any life insurance policy has:
-
an "owner" who is paying for the policy
-
the "insured" that the policy covers
-
the "death benefit" that stipulates how much is to paid in the event of an
untimely demise while the policy is in force
-
... and the "beneficiary" who gets the money
Life insurance, then, is a form of insurance that pays a fixed amount of
money to beneficiaries if a specific person dies during the period where
the policy is in force and premiums have been fully paid. In all of the above
forms of life insurance, the only differences are who the beneficiary
is and how the person covered has to die. With mortgage insurance,
for instance, the beneficiary is the bank that gave you the mortgage, which
is why they try to make you buy the stuff. With travel insurance, the hitch
is that you have to die while you are traveling -- if you die five minutes
after you deplane, on your way back to your house, you may not be covered
at all.
Term Life Insurance
Term life insurance is a temporary form of life insurance that lasts over
a given period of time specified by the policy. The simplest type of life
insurance, term simply requires that you pay a set premium on some sort of
a regular basis to be covered. The amount of that premium depends on both
the amount of money stipulated as the death benefit and the statistical
likelihood that you will die. Term life insurance is a wager between you
and the company that is covering you that you will not die during the period
you are covered. Unlike most wagers, however, this is one you actually want
to lose. If you "win" the wager, some beneficiary gets the death benefit...
meaning you have, unfortunately, died. If you "lose" the wager, the company
keeps your premiums and you go on and live your life.
Just because nothing that involves insurance can ever be simple, there are
three main types of term life insurance. The first, level term, is the most
commonly advertised. This is a form of term insurance that locks in the premium
costs for up to twenty years in some cases. The "level" is because the costs
stay level instead of rising as you get older. Level term is often the most
cost effective form of term insurance, as it allows you to lock in a price
in today's dollars that will not change as long as you pay the premiums on
time. The amount of the premiums is determined by how much coverage you get
and what sort of condition you are in when you sign up.
Annual renewable term (ART) is a type of policy where as you get older and
the likelihood of you dying increases, the premiums also increase. Although,
just like level term, the policy renews each year as long as you pay the
premiums, the premium gets bigger by an amount specified in the contract.
These policies tend to be much cheaper than level term in the early years
but get much more expensive as time passes. Although you should not throw
out annual renewable term from your insurance deliberations completely, simply
adding up what you would pay over the lifetime of both types of policies
should give you a decent indication of which will be cheaper for you.
The final type of term insurance, called decreasing term, is actually like
annual renewable term, except instead of the premium going up each year as
you get older, the death benefit shrinks by a given amount. With decreasing
term you end up paying the same each year but the amount of coverage you
can buy with that money shrinks at a predictable rate. Again, depending on
how much this costs relative to your other choices and what the benefit is,
it can actually make sense for some individuals. Take a family where the
burden on the parents to provide in case of death diminishes over time as
the children get older and can support themselves. When you are down to only
providing for a spouse as the kids finally leave the nest, the smaller death
benefit might actually be just right.
Permanent Insurance -- First There Was Whole Life
Rather than simply covering someone over a given period, the insurance industry
has also crafted a range of life insurance products that will cover you forever.
Somewhat reassuringly dubbed "permanent" life insurance, these policies charge
you a fixed amount of money per year that will cover you for your entire
life. This annual cost starts out well above what you would have to pay for
term insurance, but actually gets more and more reasonable as you get older.
What the insurance company does with that payment is where permanent life
insurance gets much of its allure. Insurance companies use a portion of the
payment to cover what term life would cost, and the remainder is set aside
in an accumulation account.
Permanent policies have the interesting side effect of storing value because
of that accumulation account. In a "whole life" policy, the money in the
accumulation account earns a specified amount of interest each year. Depending
on how fast the cash value of that accumulation account grows, your annual
premiums can actually go down over time. When the accumulation account gets
big enough, the actual interest earned can pay off the annual premiums entirely,
meaning you don't need to put any more money in the policy. Additionally,
the policy always has a cash surrender value at any point equal to the money
that has been spirited away in the accumulation account over the years. This
growing cash value is what is used to convince many people of the mistaken
belief that "whole life" and other forms of permanent life are not just
insurance, but an investment.
If this sounds too good to be true, it might be. Given that insurance companies
are conservative beasts by nature, the interest rate paid in whole life accounts
tends to be fairly low -- well below what the long-term bonds and stocks
where the insurance company will invest the money will pay. If the insurance
company makes more on the cash accumulation account than it promised to pay
you, it gets to keep the difference. Because the rate they promise is normally
extraordinarily low, over long periods of time the insurance company can
make a heck of a lot more in interest than it has promised on the cash
accumulation accounts. So, despite the fact that the cash surrender value
of the "whole life" policy is growing, it is growing at a slower rate than
other comparable investments and also having a good portion of its value
consumed each year to pay off the fixed premium.
Universal Life -- Consumers Catch On
As more consumers started to notice that the interest rates paid on their
accumulated cash in the whole life account were fairly low, insurance companies
were forced to tweak this profitable product in order to continue selling
it. Being the creative marketing forces that they are, insurance companies
designed products that confuse Fools by blurring the distinction between
permanent life insurance and investments. The first step towards this was
the development of "universal life" insurance, which eradicated the one obvious
inefficiency of whole life insurance. In years where the insurance company
earned more money on the accumulation account than they promised, they would
pass that along to the consumer.
This little tweak made universal life suddenly appear to be a much better
deal than whole life. While the policy still obligated the company to pay
a minimum interest rate, if they earned more on it than they promised they
would pay more. The consumer suddenly had a guaranteed downside and a
theoretically unlimited upside. However, by allowing the interest rate to
fluctuate, insurance agents were suddenly free to play around with the
assumptions on how fast the policy would grow when pricing the product. Unlike
whole life, the interest rate of which was fixed, when insurance agents
sold universal life they got to make assumptions about what sort of return
the customer would earn. If this assumption was too high, then customers
found themselves in the unfortunate position of having to pay more per year
than originally assumed.
No More Guaranteed Annual Premium for Universal and Variable Life
Universal life destroyed the guaranteed annual payment because it introduced
a new variable factor -- the rate of return. This was one of the most attractive
components of whole life and made universal life a very different product.
In fact, you did not even need unscrupulous insurance agents assuming ultra-high
rates of return to create problems. In the '70s and '80s, when bond yields
were above 10%, many people who bought universal life were promised annual
premiums that in today's world of sub-6% yields look outrageously high. This
is not to say that some insurance agents jack up the rate of return assumptions
to sucker people into buying insurance products they cannot afford, because
they do. When the bills come for higher premiums than you expected, your
choices are don't pay and cancel the policy, or pay to keep it in force.
If you think that universal life sounds like a much more risky deal than
it first appeared, an even less guaranteed version of permanent life insurance
called "variable life" also exists. By transferring the money from the
accumulation account into mutual funds, these policies play off of the mutual
fund craze of the '90s and further attempt to confuse people into thinking
that buying life insurance is also a way to invest. Unlike universal life,
however, variable life does not even guarantee a minimum rate of return.
You get the same return that the mutual funds get. If the funds decline in
value, you have to pay even more in annual premiums to make up the difference.
With each iteration, permanent life has gotten farther away from the notion
of setting the annual payments in stone and increased the risk that you might
not be able to afford the premium one year, thus negating the whole policy.
Both universal and variable life can be made to appear to have very low annual
payments if you assume very high rates of return initially, something many
an insurance agent is probably tempted to do in order to make the sale. When
consumers are considering universal or variable life, they need to be very
careful to double check if the assumed rate of return is reasonable. Given
that insurance companies invest disproportionately in bonds, a rate of return
much higher than the 30-year Treasury (quoted every day in the Wall Street
Journal, in Investor's Business Daily or on CNBC) for universal is probably
too high. For variable, it all depends on what kind of funds the money is
being put into -- the individual mix of stocks and bonds in the fund will
determine the potential return. Given that mutual funds by and large trail
the S&P 500, rates even close to its 10.8% annual return since 1926 are
probably too high, as well.
See Also
