INSURANCE PART V—PERMANENT INSURANCE

This week, as promised, we will continue to explore the types of life insurance protection available as we strive to protect ourselves and our loved ones during these very uncertain times.?Last week we looked at Term insurance.?As promised, we will now look at various types of Permanent Life Insurance. However, before we do, let’s recap the basics.

REMEMBER THAT INSURANCE IS PROTECTION

?Although there are many types of insurance, they all have one thing in common—the peace of mind that comes from knowing that money will be available to meet the needs of your survivors, pay medical expenses, replace your home and belongings in case of loss, and cover personal or property damage to your car or caused by your car.?Therefore, the principle of all insurance is the same: PROTECTING PEOPLE AGAINST POSSIBLE FINANCIAL LOSS.

WHOLE LIFE/PERMANENT INSURANCE

These policies are supposed to provide a built-in savings program and protection.?You normally buy a fixed amount of insurance.?The premiums pay for protection AND for a low-interest tax-free savings account.?However, it is important to note that there is actually no investment.?The cash surrender value (CSV) is the property of the insurance company from the moment you begin to build it.?When you die, the beneficiary receives only the face value (death benefit) of the policy.?Since, when you die, the maximum the insurance company is responsible for paying is the death benefit, then it only has to pay the difference between the total death benefit and the CSV.?In other words, as the cash value of the policy grows, the insurance company's liability shrinks.?The insured is now paying part of his own death benefit!?Looked at this way, we can see that a whole life policy is nothing but an overpriced decreasing term insurance policy because it can be ten times more expensive than a term policy offering the same coverage.

Please note that in the first five years CSVs are usually very small, so the amount refunded if you cash in the policy early will most probably be less than the total premiums paid.?This is because often 50% to 60% of the first year’s premium goes to pay the insurance agents’ commissions.

Another ‘benefit’ in a whole life policy is the idea that you can borrow the amount of your cash value.?Is this such a great deal??Isn't it YOUR money in the policy??Would you consider it a benefit to pay for the privilege of borrowing your own money from accounts at a bank, credit union or unit trust??Also, if you borrow on the policy, you increase the chances of leaving your dependants unprotected since when you die the insurance company pays the death benefit minus the cash value borrowed.

Whole life is therefore the worst of the three types of insurance policies and should be avoided.?As Ramit Sethi notes in his book “I Will Teach You to be Rich ”, “There are certain keywords that are major red flags when it comes to investing, including “whole life insurance …”.?Those words mean, at best, you’re almost certainly overpaying and at worst, you’re being scammed.”

Let’s now take a look at Endowment and Universal Life policies

ENDOWMENTS

Endowments are a form of Whole Life insurance.?However, they mature or endow after a specified period.?Local insurance companies offer between 10 and 25 year endowment plans.?These can be used to fund a child’s education, assist with retirement, house repairs, or replace appliances before retiring so you do not have to touch your retirement lump sum.?Policies like these are also attractive to persons in the protective services, like the army, who retire at 45 because they can use these plans to fund a business venture.

However, they are expensive, i.e., the return on investment is low, and the shorter the term the higher the cost.?Therefore, it is important to take inflation into account especially if you are working with a 25 year plan.?I must emphasize that most of these plans take about 5 years before they start to build cash.?What is good about these plans, however, is that you can sleep at night knowing that the full face value is Guaranteed either on maturity or death.?

UNIVERSAL LIFE

Universal Life (UL) insurance combines term insurance with an investment plan and are usually more flexible than traditional whole life policies.?The first part of the premium goes to pay the cost of term insurance for your chosen death benefit.?The balance is put into a tax-deferred investment plan.?You are allowed to choose the amount allocated for the investment portion and can decide to increase or decrease that amount by increasing or decreasing the annual premium.?You can also choose to accept a specified rate of return, or you can choose to invest in an assortment of mutual funds and accept their return.

There are certain factors, however, that make a universal life insurance policy unattractive.?These include:

1. The cost of the term insurance in a universal life policy is usually quite high.
2. The deductions for commissions, management fees, mortality charges and other expenses can be quite high and are hard to find because they are not clearly stipulated in the policies.
3. Most universal life companies have huge surrender charges and the companies with the lowest up-front first-year fees normally have the biggest surrender charges.

EVEN WITH THESE FEATURES, A UL POLICY MAY STILL BE AN OPTION FOR THOSE OF US WHO PREFER TO BE FORCED TO SAVE AND DO NOT WANT EASY ACCESS TO THESE SAVINGS.?Also, in the absence of attractive tax-deferred investments, the after-tax return may be more attractive than comparable investments.

You should note that UL Plans were designed in a high interest rate environment and, unlike Whole Life policies, unbundled their charges, so as clients aged mortality charges increased.?The investment portion of the plan was supposed to keep the policy alive on the assumption that increasing mortality charges would be matched by increased earnings from increasing cash values.?However, as interest rates declined and mortality charges increased, a lot of the policies did not have enough cash value to keep the policy in force, thus requiring higher premium payments from the policyholders.

I truly believe that term is the best type of life insurance for most of us.?You are always better off separating your insurance from your investments and seeking the best deal on both.

BUY TERM AND INVEST THE REST

Please do not forget that risk of financial loss is the reason for all forms of insurance whether homeowner's, motor vehicle, life, disability, or medical.?And the only purpose for insuring life is to provide income for dependents after your death.?Term life insurance is like auto or homeowner's insurance, the premium is paid to protect your beneficiaries when you die.?If you live beyond the period covered, you get nothing.?Term life insurance therefore meets the life insurance objective at the lowest cost.

On the other hand, whole life is the worst of the three types of insurance policies and should be avoided.?These policies are very expensive and fool you into believing that you are buying protection and a low-interest tax-free savings account.?However, we now know that there is no investment. ?You are actually contributing to your own death benefit because as the cash value of the policy grows, the insurer’s liability shrinks.

Let’s look at two scenarios:

SCENARIO 1: NO LIFE INSURANCE OR LIFE INSURANCE?

Let’s look at two worst case scenarios for either of these two options for John, a 40-year-old male.

Option 1.1:?Client Chooses a Whole Life Insurance:

John chooses a whole life insurance policy for $500,000. ?He cannot afford it for long, so he cancels after two years.?The whole life policy costs John about $5,690 per year, so he is out of pocket $11,380 and since his account has no cash value, he has no savings or life insurance.

Option 1.2:?Client Chooses Term & Invest:

John chooses a 20-year level term policy for the same $500,000. ?He loses his job and is short of money, however, since the policy is only $340 per year and he has $10,700 which was not spent on the whole life policy, he has the freedom to choose whether or not to pay the premium.?Which option would you choose?

SCENARIO 2:?$500,000 DEATH BENEFIT OR $545,767 IN SAVINGS?

Let’s now review the worst-case scenarios for John when he is much older.?He is 70 and dies.?Using the above two scenarios: a whole life insurance policy vs a 20-year policy, which would have expired by age 70.

Option 2.1:?Client Chooses a Whole Life Insurance Policy:

The client sadly, dies at age 70 with a whole life policy in force.?He has faithfully paid each premium in full on time.?When he dies, his estate receives the full $500,000 death benefit.?However, since the premiums were high the client saved nothing more.

Option 2.2:?Client Chooses Term & Invest:

John dies at age 70 without insurance because he chose to let the 20-year term life insurance policy expire after the rates skyrocketed.?However, John saved $107,000, from 20 years not paying whole life insurance premiums, before any interest.?Adding interest at 7% per annum would yield about $234,678 at year 20.?At year 30, due to the magic of compounding, that money plus an additional 10 years of interest plus the 10 years’ worth of savings from not paying the $5,690 annual whole life premium, would yield about $545,767 in savings, which he can leave his family, $45,767 more than the death benefit on the whole life policy.

Next week we will look at how you should calculate the amount of insurance to purchase.

Cheers, Nigel?

Nigel Romano, Partner, Moore Trinidad & Tobago, Chartered Accountants