Selecting Life Insurance To Best Suit Your Needs

When it comes to life insurance, the old saying goes, “Life insurance is sold not bought.”  With all these complex and overly expensive cash value policies out there, it’s no wonder they have to be sold; most consumers don’t understand how they work!  In this article my aim is to clear away the smoke and mirrors and help you to understand how these life insurance policies really work.  More importantly, my goal is to help you, the consumer, make more informed decisions when it comes to protecting yourself and your family with the right type and right amount of life insurance.

Life insurance essentially falls into two categories: Term and Permanent.

“Term” Insurance

“Term” insurance covers you for a specified guaranteed period of time.

A “Level Premium Term” policy, which is the most popular form of Term insurance, typically comes in durations of 10, 15, 20, 25, 30, 35, 40 years.  Term Insurance is pure insurance, meaning you’re only paying for coverage for that period of time.  Just like auto & home insurance, it is pure protection without any bells or whistles.  You are paying for protection only – should you pass away while still having financial responsibilities (raising a family, paying down a mortgage, etc.).  This no-frills type policy makes it the most affordable type of life insurance available.  Unlike auto & home insurance, the premiums of a Level Term policy are locked in for however long of a term you choose.  A 30-Year Level Term policy will have the same exact guaranteed premiums every year for the next 30 years.  The policy however, will increase in premium after the initial term is up should you want to still keep it.  I recommend that every couple of years you do an insurance needs analysis, to determine if your need for life insurance is still the same, more, or (in some cases) less.

“Return of Premium” (ROP) Term
With a Return of Premium Term policy your entire premium is returned to you at the end of the term.  For example with a 30-Year ROP Term policy, you will be refunded 100% of your premium at the end of the 30 years when your term expires.  At that moment the insurance company no longer covers you, and both you and the company part ways.

An ROP Term policy should not be considered an investment, as there is no growth or interest earned whatsoever on the returned premium.  What you are being refunded / returned is simply the total premium you paid over the term period you chose, no more no less.  This type of term policy however is not without its costs, as an ROP Term policy costs at the very least twice as much as a standard Level Term policy would.  Normally an ROP Term policy would not be my first recommendation, simply because of the significant price difference.  However, if your mentality is such where you absolutely can’t stand the thought of “throwing away” your premium dollars to an insurance company (you’re not alone on that idea), and would have no problem paying at least twice as much for the same coverage, knowing that in the end you’ll get every penny of your money back, then this policy can be a good option.

“Permanent” Insurance

Whole Life (Cash Value insurance / W.L.)
Whole Life insurance is a policy that has level premiums payable for the rest of your life (hence the name “whole life”).  In W.L. policies, a portion of your premium goes to pay insurance, and a portion goes into a cash accumulation component.  This savings component called “Cash Value” is designed to accumulate to approximately 50% of the policy’s face amount by age 65.  The face amount is the actual amount of coverage (death benefit) you are paying for.  Ex: a policy with a $100,000 face amount will have a cash value of a little less than $50,000 by the time the insured turns 65 years old.  The cash value will eventually equal the insurance face amount of $100,000 when the insured reaches age 100.  At this point the policy “endows” and the $100,000 of cash would be paid out to the insured (if still living).  The policy’s cash value can also be borrowed against.  

The problem with the cash value however, is that if any money is borrowed a few negative results occur.  First, you are taking a loan against your own money and must therefore pay interest (typically between 5-8%) to the insurance company (not to yourself as in a 401k), resulting in an increased premium.  Secondly, any money you borrow from the cash value component will reduce the death benefit / face amount that you purchased.  Ex: $100,000 face amount, borrow $10,000 from the accumulated cash value = a new death benefit of $90,000 with an increased premium.  My question is if I’m paying for two separate things, an insurance death benefit and a cash savings element, then why would accessing one affect the other?

Another item that’s often overlooked is the rate of return of cash value policies.  Whole Life cash value policies have very low rate of returns, historically between 1-4% after policy expenses.  This in my opinion makes these policies a lousy way to accumulate any long-term wealth.

“Mutual” insurance companies who’s cash value policies pay “Dividends”
Life insurance companies that are “Mutual” companies offer policies that are called “participating” policies.  Insinuating that you the policyholder can participate in the company’s profits.  “Participating” policies distribute their profits in the form of a “dividend” to the policyholders.  Well, this isn’t exactly as truthful as an insurance agent for a mutual company would have you believe.  The fact of the matter is, the so-called “dividends” in these types of cash value policies are not the same as dividends from a stock or a stock mutual fund.  Insurance policy dividends do not directly come from a portion of the insurance company’s profits.  They are in fact a refund from an overcharge of premium; the tip-off is that these “dividends” are not taxable.

According to the American Council of Life Insurers:
“A participating policy allows the policyholder to share in the insurance company’s surplus. With this type of life insurance, a policyholder receives annual dividends representing that portion of the premium not needed by the company for death payments to beneficiaries, additions to reserves, or administrative expenses.”

Source: 2013 ACLI Fact Book (American Council of Life Insurers)

Another issue with whole life cash value policies are the surrender charges.  Should you decide to withdraw all of your cash value at anytime, you will not only forfeit your life insurance coverage, but you will also not receive the full amount of the accumulated cash.  Cash value surrender charges are typically an issue for the first 10-15 years, depending on the insurance company.

My final issue with cash value is if you never borrow your money, upon death the company keeps the amount of cash accumulated.  With a $100,000 policy that has accumulated lets say $30,000 of cash value, at your death the company will only pay out $100,000 (not $130,000) to your beneficiaries.  The only way to receive both the cash value and face amount death benefit is to choose death benefit option “2” or “B” (depending on the company) which cost significantly more in premium.  Reason being is that you are paying for an additional amount of insurance that grows parallel with the cash value.  The point is, with whole life policies the company never loses.

Variations of Whole Life Cash Value Insurance Policies

All the different and complex variations of whole life basically work the same as a standard whole life policy with the additions of a few or several features.

Final Expense Whole Life
These are just basic whole life policies that have small face amount death benefits that are commonly around $20,000.  Most final expense policies today are available in the range of a minimum of $5,000 up to a maximum of $25,000.

Limited-Pay Whole Life (10-Pay, 20-Pay, Payable to 65)

Limited Pay policies are basic whole life policies that have a shorter / condensed premium payment period.  The insurance actuaries do some calculations on life expectancy and then condense the premium from being payable to age 100 (Whole Life), to being payable to age 65 as in a "Payable to 65" policy.  There are also shorter pay periods such as 20 years for a "20-Pay Life", or even 10 years for a "10-Pay Life" policy.  After the payable period is up, you have a fully paid permanent life insurance policy.

The down side to Limited-Pay policies (aside from all the cash value issues mentioned earlier), is that because the pay period is greatly reduced, your payable premiums will be very expensive.  A Payable to 65 policy has a higher premium than an already expensive basic Whole Life policy.  A 20-Pay is more expensive than a Payable to 65, and a 10-Pay is even more expensive than a 20-Pay policy.  When you factor in the low rate of return of the cash value, the issues with borrowing the cash value, and the excessively high premiums to purchase these types of policies, you'll see that today there are far better options available than purchasing a limited pay policy.

Interest Sensitive Whole Life

A version of whole life that uses “current assumptions” for the cash value accumulation, based on the current fluctuations of interest rates set by the Federal Reserve.  Current assumptions are significant to interest sensitive life insurance policies (such as Universal Life).  When interest rates are high, cash value projections are also high.  However, when interest rates are low the projections are not as attractive.

Universal Life (aka Flexible Premium Life / Adjustable Life / U.L.)

A Universal Life policy is basically a whole life policy where the premiums can be changed or adjusted.  More money can be pumped into the policy to boost the cash accumulation, or less premium can be paid to make the policy a little more affordable, also reducing the cash accumulation.  If the policy owner ever stops paying premiums, an automatic loan will be made against the cash value to pay the premiums.  The danger of this feature is that eventually the policy can become drained of all cash, resulting in a requirement of a significantly higher premium to be paid in order to keep the policy from lapsing.

Variable Life (V.L.)
A Variable Life policy is a whole life policy where a portion of the cash value is invested in “mutual fund sub-accounts” (variation of a mutual fund).  The policy provides a guaranteed minimum face amount death benefit, and will also allow the death benefit to fluctuate along with the value of the mutual fund sub-accounts.  Variable Life policies are considered a securities product, and as such must be sold with a prospectus by an investment licensed-representative.

There are several issues that I have with this type of policy.  While variable life policies provide a higher long-term return than their standard whole life cash value counterparts, the returns are greatly diminished by all of the various fees associated with these policies.  For this reason, real mutual funds tend to outperform their sub-account versions.  By the way, you do not actually own those sub-accounts, the insurance company does.  This is different when compared to you purchasing shares of an actual mutual fund.  Also, if you withdraw the cash value when you retire, any amount of cash that has accumulated to greater than the total premium paid will be taxed.  Over the years, I've come to find out that these policies were often (and wrongly) sold as retirement plans.

Another issue is with the death benefit.  You are not guaranteed the full face amount that you are paying for.  You may have purchased a $250,000 policy but the guaranteed face amount may be only $50,000.  Yes, your $250,000 death benefit has the "potential to grow" to $500,000, but it also has the potential to decrease to well below $250,000.  Hence the minimum death benefit guarantee of $50,000.  My feeling is, it’s never a good idea to play Russian roulette with your life insurance.  

Variable Universal Life (V.U.L.)
Variable Universal Life policies provide a combination of all the features of U.L. and V.L. policies as described above.  Variable Universal Life policies are also one of the more expensive types of cash value policies.

Equity-Indexed Universal Life (Index UL, IUL, EIUL)
An Equity-Indexed U.L. is a universal life policy that has two components to the cash-value.  A minimum guaranteed fixed rate (generally no less than 1.5%, more so depending on where the Fed has interest rates at), and an “indexed” account option.  The indexed option “mirrors the performance” of the S&P 500 Index (or other indexes), it does not actually invest in the index.  There are also "Caps" (maximums) and "Floors" (minimums) on the interest that you can earn, so you won't get the full mirrored return of the actual index. This can be good when the market is "down", but not so good when the market is "up".  The cash value does grow tax-deferred, however the amount that has accumulated to greater than the total premiums paid will be taxed upon withdrawal.  Just like all cash value policies, there are surrender charges on any withdrawals during the first 10 to 15 policy years (varies by company), and all policy loans (charged interest) will reduce the death benefit.  Index UL policies aren’t very cost effective either, the various policy fees make the indexed option far more expensive than investing in an actual index mutual fund.  While an Index UL policy is technically considered to not be a security (as it only mirrors the performance of an index, not invest in it directly), some insurance companies only allow their investment-licensed representatives to sell them.

Guaranteed-No-Lapse Universal Life (Non-Cash UL / GUL)
A Guaranteed-No-Lapse Universal Life insurance policy is designed to function as a permanent Term policy, meaning there is no expiration of coverage all the while building no cash value.  The level premiums are specifically designed to fund the policy exactly enough to keep it in force and never lapse.  You can choose several options in regards to coverage duration, typically in the ranges of age 95 to age 121. GUL's are the most affordable type of permanent insurance; as long as you pay you are covered.  While these types of policies do cost between 2½ to 3½ times more than standard Term insurance policies, they are still half the cost of typical cash value whole life policies.  These “Permanent Term” policies fill in the empty gray area between Term and Whole Life, as these policies really are pure protection that lasts for the rest of your life.  

Conclusion 

Most coverage needs can be best met with a Level Premium Term Life policy. For permanent coverage needs (such as for Estate Tax planning or Business Succession planning), I strongly recommend the Guaranteed No-Lapse UL over any kind of cash value policy.  If you are looking for long-term cash accumulation, you would be far better off putting your money in pure investment products, such as a diversified mutual fund portfolio that's held in a tax-deferred account (401k, SEP-IRA, Roth IRA; or a 529 Plan for education funding).  If you’re interested in wealth accumulation with some guarantees, or creating a future retirement income stream then you might want to consider going with a low-fee annuity product. Split funding, which is keeping your life insurance and investments separate, is always the most cost-effective way to go.

As for coverage amount, for income replacement a good rule of thumb is to have between 8 to 12 times your annual salary.  However, your total assets, liabilities, net worth, monthly living expenses, and specific circumstances are also a deciding factor. I'd advise having a "life insurance needs analysis" completed to find out your exact coverage need.

 *This blog is strictly the opinion of Michael A. Malleo and not those of