In his best-selling book, Principles, author Ray Dalio, argues that you have to be “radically open-minded” in order to see things from a different perspective. Dalio, the billionaire founder of Bridgewater’s hedge fund empire, believes that to make good decisions, you must have the ability to explore different points of view and different possibilities—even if you don’t initially agree with them.
While Dalio’s wisdom is geared for managers, many of his principles apply to insurance.
Many people think of life insurance simply as protection against an early loss of life. Like auto insurance and homeowner’s insurance, you hope you never have to use it.
But the reality is that we all will pass away eventually; this makes it a certainty the loss will occur. Why not make a strategic choice for your family and start thinking about insurance as an asset that you will own for your entire life?
What’s the Difference?
The question comes up often in my line of work: what’s the difference between term insurance and permanent insurance?
Typically, I start with a discussion of the death benefit—not which policy is better or worse. The latter discussion puts people on the defensive, which prevents open-mindedness.
What the Death Benefit really boils down to is the “human life value.” For most, this represents your future earnings, or what would be lost in the event that you died unexpectedly. Because it’s important to consider what would happen to your family, and how they would replace that income, should such a tragic event occur.
As part of a solid financial foundation, I recommend having the maximum protection at the lowest lifetime cost.
Once you’re comfortable with this concept, only then is it pertinent to understand the two varieties of insurance that provide this kind of income protection.
This type of policy is the simpler of the two. It’s purely for the death benefit, and stays in-force over a fixed period of time. Let’s say 20 years.
I think of term policies as “if” insurance.
IF you die prematurely, during a specific term, the benefit will allow your family to replace the income you can no longer provide. It can be useful, especially during a term where you have young children, a partner who does not or cannot work, or another similar circumstance.
But here’s the thing: term insurance has lower premiums than permanent insurance because the likelihood it will be utilized is extremely low. Additionally, it doesn’t build up a cash value (see next section).
More than 90% of term insurance policies never pay out, because claims can only be filed in the event of premature death (i.e.—while the term is in-place). Once the initial term ends, premiums rise significantly because the risk to the insurance company also increases significantly. The reality is, many policies are cancelled when the risk is the highest.
The premiums may be lower, but in terms of pure-cost, that’s not exactly accurate.
Permanent insurance can be broken down into two sub-categories—whole life insurance and universal life insurance. Both can stay in-force on a permanent basis, but they are not created equally.
Whole Life Insurance
While premiums are higher, permanent whole life insurance is exactly how it sounds—permanent. As long as you pay your premiums, the policy will pay a death benefit when you pass. Though there seems to be a higher cost, your premiums are guaranteed to stay level. The insurance companies take on more risk when you’re older, so they weight the premiums to cover the policy for life.
In addition, whole life insurance comes with several guarantees on the cash value and death benefit, on top of the premium guarantees. Essentially, the company can’t go changing certain things on you. And, if it’s a participating policy, the cash value will earn dividends as well.
This type of insurance can be viewed as more of a strategic asset.
Universal Life Insurance
This type of insurance (UL, Variable, Indexed, etc.) is essentially annually-renewable term insurance, which also includes a side fund. Depending on the type of UL policy you have, that fund will either be a cash account or investment-based.
Unfortunately, this type of policy does not have the same guarantees. Because it offers “flexible” premiums and death benefits, you can pay what you want. Unfortunately, many people don’t realize that if they don’t cover the cost of maintaining the insurance, their policy can lapse. And with a policies like this, the maintenance costs can vary with the stock market.
Whole Life Insurance vs. Universal Life Insurance
With both accounts, the cash value accumulates in a tax-deferred manner, and can be leveraged throughout your life to finance anything significant (i.e. cars, education, business ventures, investments, etc.), without disrupting the compounding growth of the cash value.
I prefer the use of Whole Life Insurance, because of the guarantees that it offers:
- The premiums are guaranteed to be level (unless you voluntarily add Paid-Up Additions)
- The cash value account has a minimum guarantee each year
- The amount of death benefit has a guaranteed minimum, but grows with your cash value
In fact, whole life insurance policies shift most of the risk to the insurance company. The reason? Death is a guaranteed event, and a whole life policy covers your whole life. The company will be paying a claim, so long as you keep your policy.
Although typical Universal Life policies can offer some added flexibility, the policy holder takes on more risk. This is because costs within the policy can fluctuate drastically, and the cash is subject to risk depending on where it’s invested.
Comparing the Three
Term life is most valuable on the day you purchase it. Every day thereafter, term life loses value, as your death benefit stays the same while you continue to pay a premium. It’s finite. Whole life is the opposite. It starts off slower than term at the outset, but it becomes more valuable and efficient over time as all the cash value guarantees continues to rise each year.
When you think about it, whole life is a lot like your mortgage—each month, more and more of your monthly payment goes toward principal (cash value) as time goes by. For universal life policies, there are no guaranteed cash values, but there is a guaranteed interest rate. For policies that are tied to the stock market or a stock index, there are no guarantees of the cash build up and are subject to increased risk.
Although term and permanent life insurance each have their pros and cons, in reality, they can meet different needs at each stage of life. Term insurance can be incredibly useful in insuring to your full human life value, for example.
Tailoring Life Insurance to Your Needs
When it comes to your insurance, I like to remind my clients that it’s not a set-it-and-forget-it decision. Although term and permanent life insurance each have their pros and cons, in reality, they can meet different needs at each stage of life. Term insurance can be incredibly useful in insuring to your full human life value, for example.
Your needs will change over time, and as they do, so should your insurance.
When you’re young, healthy and fresh out of school, term insurance may be the best route. It’ll allow you to cover your full “human life value” without premiums that seem daunting when you’re starting out. The great thing about term insurance, is that if you get convertible insurance, you can easily turn it into a whole life policy when your cash flow permits.
This stage of life is actually the best for starting a policy—the younger you are, and the better your health is, the better your premiums will be. You’ll be able to lock in those premiums at a good rate to protect your number one asset…YOU!
As you progress in life, ideally you’re able to save more money. A permanent policy is one of the best places to store “safe” money long-term. Not only is it protected from volatility, but you can utilize it while still allowing it to earn compound interest at competitive rates. This is done through policy loans.
With permanent life, cash will always be available when you needed.
This is also the time of your life that you might be starting retirement planning, and insurance is a great asset for retirement. The right kind of policy can help reposition your assets so they’re available tax-free for life. Yes, you read that right.
The right policy can also increase your investable dollars, and enable you to transfer those assets to your heirs when you die—with minimal expense or hassle.
As you reach your 60s and 70s, insurance can become an integral part of your legacy planning and charitable giving. Structured properly, a permanent policy can help you optimize your other assets, and actually receive more income. Not only that, but it can extend the life of more volatile accounts, like stocks. Integrating your insurance with your investments significantly improves both accounts than if used independently.
Long-term care insurance, which can act as a rider on whole life insurance, comes into the discussion as both a form of healthcare and as a legacy planning tool.
Ultimately, life insurance is a valuable asset at every stage. It is not, however, simple. It causes a lot of confusion. Here are four common mistakes to avoid.
- Trying to take the cheapest route possible, based only on the premium
- Not obtaining enough death benefit to secure your human life value
- Thinking short-term, and not taking into account the full costs of a policy over your lifetime
- Not utilizing a mutual insurance company. Using a mutual company makes you, the policy owner, a partial owner of the company itself. This makes you eligible for profits of the company, in the form of annual dividends (if using whole life insurance).
There is a lot to think about when it comes to life insurance. In fact, this is really the tip of the iceberg. There are lots of acronyms, and lots of math. But the underlying principles are simple.
You want to contribute an optimal amount of money on a regular basis, for a maximal amount of peace of mind.
When structured correctly, you’ll have safe and consistent tax-advantaged growth, liquid cash, and the ability to efficiently pass on wealth to the next generation.
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