A Tale of Insurance
You may find yourself sitting across from a friend or friend of a friend that is trying to sell you life insurance. The pitch will sound compelling, and if you are married, you can be certain a love or guilt component will be part of the sales presentation. The salesperson will look at you inquisitively, cock their head slightly and say the classic line, “Carlos, if something were to happen to you, wouldn’t you want Stephanie to be financially secure?” It’s over. There is no way out. How do you answer that? As I, and everyone that has ever heard this line, bob our heads up and down in agreement, the next line, like a boxer’s knockout punch follows. The salesperson says, “Not only will you be taking care of Stephanie in the event that something happens, it is also a pretty good investment.” You look lovingly into your wife’s or husband’s eyes and say to yourself, “How did I go so long without this product?” I need life insurance.
The rest of the sales presentation is quick, because very few people, including the insurance salesperson, understand the math. You are presented with an illustration that shows you investing way more money every month than you can afford, and it shows it growing to a gazillion dollars that will let you own multiple mansions by the time you are 65. After a few civilized discussions back and forth between you and your spouse, and after asking the obligatory question, “Can we afford so much every month?” The salesperson counters with, “How can you not afford it?” You sign on the dotted line and the salesperson leaves. You are now the proud owner of a permanent life insurance policy, and the salesperson is counting their commission.
As the salesperson walks out the door, you have mixed emotions. On one hand, you have protected your spouse. You love your spouse. On the other hand, it is an entirely unsatisfying experience because a few minutes before you had this extra money every month to do as you pleased, and now it is gone. You are thinking of what you can no longer do with the money. Gone is that new car or fancy vacation or whatever suits your fancy. To make matters worse, you look cheap as your spouse exhibits reverse buyer’s remorse and says, “Maybe we should put more money into this investment,” while simultaneously you are thinking it shouldn’t even be called an investment, but an expense instead. Why else do you look cheap? You look cheap because the insurance sales strategy is designed to appeal to your emotions and not your logic. The salesperson shows up and pitches an unreasonably high monthly payment because their job is to sell you the highest possible payment. It is typically way more than you can actually afford. If you say yes, they earn a very tidy commission, but if you lower the amount they “recommend,” then you appear to be cheap. This is your typical “he went high and you went low” interplay. It is as old as time, but it works. What happens next? Within a few years, you realize you made a mistake and then you do what you should have done in the first place. You buy a term insurance policy and stop making payments on your permanent insurance policy until it becomes worthless. You chalk it up as a learning experience. So if all you want to do is protect your family, avoid this costly purchase. When in doubt, buy term insurance.
The scenario I’ve described above plays out in living rooms across America and most of the developed world every day. It is effective. However, it is your responsibility to be better informed. The product that this couple just bought is terrible. It is costly, there are better, cheaper alternatives, it is unlikely that it will deliver what it promises and in most versions, though not all, it is not an investment worthy of consideration. This tale is for the innocent, because if you haven’t heard the pitch yet, it will be playing in a theatre near you in the not too distant future.
Before I give you my recommendations on insurance, we need to understand it a little bit better. There are two types of life insurance. The first is called term and the second is called permanent. Term insurance has no investment component because it does not have any value at the end of the term. It is pure insurance since if you are still alive at the end of the term, the policy has no cash value. I consider term insurance a commodity product. This means prices are competitive. Don’t spend too much time shopping around for a term policy because they are all about the same as long as you are looking at reputable insurance companies. It is readily available, and if you have a life insurance need, it is what I recommend. Permanent insurance is a hybrid. It is one part life insurance and one part an investment. It is permanent because it has no term limit. Insurance folks aren’t creative when naming things, but you get the point. The assumption is that as long as you make the agreed-upon monthly payments, the permanent policy should remain in force. It doesn’t always happen, however. I blame shady insurance practices when this happens, and it’s why, throughout these tales, that I recommend you only deal with expert advisors. So term insurance means, “for a while,” and permanent insurance means, “until the day you die.” Term insurance will never have a cash value, while permanent often promises to make you rich. The reality is that very few—and I mean very, very few—permanent policies actually deliver. Most owners stop making payments on their policies and they eventually lapse, which means they have no value.
However, I don’t want to knock the value of a permanent policy completely. I have seen some designs in which the returns are competitive, with returns one would expect to earn from quality bonds. Yet, it is the exception, and I will tell you why. Let’s walk through the first few years of a permanent life insurance policy from your perspective. If you cancel your permanent policy or stop making payments, as most young couples do within a few years of purchase, it will have no cash value. You will get nothing back. You have effectively purchased a very expensive term policy. How can this be, you might ask? How can I pay an insurance company a monthly amount that is many times more than I would pay for an equivalent term policy and if I stop making payments, I have no money in my investment account? The answer is the permanent life insurance salesperson. He or she has “earned” most of the difference between what you think you should have and what you actually have. The commission the salesperson receives for selling a permanent life insurance policy is approximately equal to the entire amount that you pay in the first year. It seems an outrageous amount to pay someone, yet it is the traditional business model of most insurance companies. There are cheaper alternatives in the early years of a permanent policy, but I don’t think they are worth pursuing. What is worth pursuing is the purchase of a term policy if you need one. Avoid a permanent one when all you need is a death benefit.
Is there a low-cost solution if you are so inclined to purchase permanent insurance? The answer is yes and no, depending on how one defines low-cost. It is a trick question. Let me explain. People should only invest in permanent policies when it is the best solution. This means they fully expect the policy will “never” lapse and “will pay” a death benefit to the beneficiary when the insured individual or couple passes away. They “never” expect to cancel their policy. What does this mean specifically? It means there are some permanent policies that have more cash value in the first few years than others. However, if someone needs permanent insurance and has the resources to pay for it, then the first few years are meaningless. They simply don’t matter. What matters is whether the policy can deliver. If you need permanent insurance and fit the criteria, then I suggest you shop around and find a policy or policies that can deliver. How can you tell if a permanent policy is right for you? If you are looking at illustrations, and one of your criteria becomes, “Look dear, this policy has more money in the first one to five years than this other one, in case we change our mind,” then you should not purchase a permanent policy. Either someone has a permanent need or not. There is no in between. Most people do not, and it’s why I recommend they should purchase term. If you have a permanent need, however, focus on what the policy will deliver.
When is permanent insurance a smart decision? I typically recommend it in two circumstances. In most cases, it is for the high-net-worth family so they can pay their estate taxes. In other cases, it is for individuals or couples who have a strong risk aversion and are looking for a lower but steadier rate of return on their capital. These risk-averse individuals or couples often look upon insurance as an investment. They come in two varieties, the informed and uninformed risk-averse investor. The informed invest in these types of policies knowing they would more than likely accumulate significantly more wealth in other investments but, for a multitude of reasons, they want to reduce risk, or they look upon insurance as a source of diversification. The uninformed invest in these types of policies because they don’t know better, since, in my opinion, there are better investment alternatives.
So who needs insurance and what type should they purchase? My philosophy is that you need insurance when you must financially take care of loved ones. If you die, it provides them with a cushion to get on with their lives. A single person with no kids should avoid it. If you are single, with no dependents, chances are no one will suffer economic hardship from your death. The same is probably true if you are married, without children, carry little debt and your spouse earns an income sufficient to maintain their lifestyle. If you fall into one of the above categories, you don’t need life insurance, but if you feel compelled to purchase it anyway, make sure it is a term policy. If you have children and are still in the wealth-building stage of your life, then you should, without a doubt, purchase term insurance. Get enough to replace your income for at least 10 years. With these three categories, I’ve probably included more than 95% of Americans. This means most people either don’t need life insurance or need term insurance. This still leaves a significant number of people.
The remaining 5% fall into various categories. The distinction here is not one of marital status, children, legacy or philosophy. The purchase of life insurance becomes a personal and often emotional or irrational choice. It is something people either want or not. Individuals in this 5% group are unique in that they are probably not wealth building; they are either already wealthy or looking for alternative investments in a quest to diversify their portfolios and consider permanent insurance an asset class. So the question becomes, do wealthy people need life insurance? Let’s look at my philosophy. It states that you need insurance when you must financially take care of loved ones.” So you may ask, aren’t wealthy people essentially self-insured? If something happens to them, don’t they have enough money so that their loved ones will be fine? The answer in most cases is once again yes. Most wealthy people are self-insured, and except for those who have their wealth tied up in illiquid investments, they have no need for life insurance. So why do so many wealthy people buy life insurance? The answer is simple. They don’t need it, but they want it. They want it to make sure that when they die that they can pass on as much after-tax wealth as possible to their heirs or charities. They want it so that if they choose, they can borrow against their policies someday at favorable after-tax rates.
Let me give you some examples of why anything other than term insurance is such a personal and often emotional or irrational choice. In the early 1990s, my parents had an estate tax problem. The classic solution, and financially correct solution in my opinion, was for them to purchase a permanent life insurance policy on their joint lives. When I suggested we investigate this approach, my father wouldn’t consider it. He said he had no problem paying estate taxes once he and my mother were gone. He reasoned that this country had been good to him, so he had no problem giving back. In another case, I asked him about investigating long-term care insurance in the event either he or my mother needed to go into a nursing home. His answer was an emphatic no. He said he was self-insured, and if he had a policy of this nature, it might give his children the false impression it was OK to place him in a nursing home. This was something he was always against, and so a purchase like this would send out a false message. Other people have the exact opposite reaction to the same set of circumstances. They would purchase a joint policy for estate purposes as well as long-term care insurance. Go figure.
In summary, if you’re building wealth and don’t need life insurance, don’t buy it. If you do, then a term policy is your best solution. If you are wealthy and want to protect your estate from taxes, buy a permanent policy from an expert. If you just can’t stand risk, you might also consider a permanent policy, but once again, buy it from an expert because policy design is critical. If you currently own a permanent policy and you should own a term policy instead, consider switching. Don’t continue to throw good money after bad.