Subject: Insurance - Life

Last-Revised: 30 Mar 1994
Contributed-By: Joe Collins

[ A note from the FAQ compiler: I believe that this article offers sound advice about life insurance for the average middle-class person. Individuals with a high net worth may be able to use life insurance to shelter their assets from estate taxes, but those sorts of strategies are not useful for people with an estate that falls under the tax-free amount of about a million dollars. Your mileage may vary. ]

This is my standard reply to life insurance queries. And, I think many insurance agents will disagree with these comments.

First of all, decide WHY you want insurance. Think of insurance as income-protection, i.e., if the insured passes away, the beneficiary receives the proceeds to offset that lost income. With that comment behind us, I would never buy insurance on kids, after all, they don't have income and they don't work. An agent might say to buy it on your kids while it's cheap and they're healthy - but run the numbers, the agent is usually wrong, remember, agents are really salesmen/women and its in their interest to sell you insurance. Also - I am strongly against insurance on kids on two counts. One, you are placing a bet

that you kid will die and you are actually paying that bet in premiums. I can't bet my child will die. Two, it sounds plausible, i.e., your kid will have a nest egg when they grow up but factor inflation in - it doesn't look so good. A policy of face amount of $10,000, at 4.5% inflation and 30 years later is like having $2,670 in today's dollars - it's NOT a lot of money. So don't plan on it being worth much in the future to your child as an investment. In summary, skip insurance on your kids.

I also have some doubts about insurance as investments - it might be a good idea but it certainly muddies the water. Why not just buy your insurance as one step and your investment as another step? - its a lot simpler to keep them separate.

So by now you have decided you want insurance, i.e., to protect your family against you passing away prematurely, i.e., the loss of income you represent (your salary, commissions, etc.).

Next decide how LONG you want insurance for. If you're around 60 years old, I doubt you want to get any at all. Your income stream is largely over and hopefully you have accumulated the assets you need anyway by now.

If you are married and both work, its not clear you need insurance at all if you pass on. The spouse just keeps working UNLESS you need both incomes to support your lifestyle (more common these days). Then you should have one policy on each of you.

If you are single, its not clear you need life insurance at all. You are not supporting anyone so no one cares if you pass on, at least financially.

If you are married and the spouse is not working, then the breadwinner needs insurance UNLESS you are independently wealthy. Some might argue you should have insurance on your spouse, i.e., as homemaker, child care provider and so forth. In my oponion, I would get a SMALL policy on the spouse, sufficient to cover the costs of burying them and also sufficient to provide for child care for a few years or so. Each case is different but I would look for a small TERM policy on the order of $50,000 or less. Get the cheapest you can find, from anywhere. It should be quite cheap. Skip any fancy policies - just go for term and plan on keeping it until your child is own his/her own. Then reduce the insurance coverage on your spouse so it is sufficient to bury your spouse.

If you are independently wealthy, you don't need insurance because you already have the money you need. You might want tax shelters and the like but that is a very different topic.

Suppose you have a 1 year old child, the wife stays home and the husband works. In that case, you might want 2 types of insurance: Whole life for the long haul, i.e., age 65, 70, etc., and Term until your child is off on his/her own. Once the child has left the stable, your need for insurance goes down since your responsibilities have diminished, i.e., fewer dependents, education finished, wedding expenses done, etc

Mortgage insurance is popular but is it worthwhile? Generally not because it is far too expensive. Perhaps you want some sort of Term during the duration of the mortgage - but remember that the mortgage balance DECLINES over time. But don't buy mortgage insurance itself - much too expensive. Include it in the overall analysis of what insurance needs you might have.

What about flight insurance? Ignore it. You are quite safe in airplanes and flight insurance is incredibly expensive to buy.

Insurance through work? Many larger firms offer life insurance as part of an overall benefits package. They will typically provide a certain amount of insurance for free and insurance beyond that minimum amount is offered for a fee. Although priced competitively, it may not be wise to get more than the 'free' amount offered - why? Suppose you develop a nasty health condition and then lose your job (and your benefit-provided insurance)? Trying to get reinsured elsewhere (with a health condition) may be very expensive. It is often wiser to have your own insurance in place through your own efforts - this insurance will stay with you and not the job.

Now, how much insurance? One rule of thumb is 5x your annual income. What agents will ask you is 'Will your spouse go back to work if you pass away?' Many of us will think nobly and say NO. But its actually likely that your spouse will go back to work and good thing - otherwise your insurance needs would be much larger. After all, if the spouse stays home, your insurance must be large enough to be invested wisely to throw off enough return to live on. Assume you make $50,000 and the spouse doesn't work. You pass on. The Spouse needs to replace a portion of your income (not all of it since you won't be around to feed, wear clothes, drive an insured car, etc.). Lets assume the Spouse needs $40,000 to live on. Now that is BEFORE taxes. Lets say its $30,000 net to live on. $30,000 is the annual interest generated on a $600,000 tax-free investment at 5% per year (e.g., munibonds). So this means you need $600,000 of face value insurance to protect your $50,000 current income. These numbers will vary, depending on interest rates at the time you do your analysis and how much money you spouse will need, factoring in inflation. But the point is that you need at least another $600,000 of insurance to fund if the survivng spouse doesn't and won't work. Again, the amount will vary but the concept is the same.

This is only one example of how to do it and income taxes, estate taxes and inflation can complicate it. But hopefully you get the idea.

Which kind of insurance, in my humble opinion, is a function of how long you need it for. I once did an analysis of TERM vs WHOLE LIFE and based on the assumptions at the time, WHOLE LIFE made more sense if I held the insurance more than about 20-23 years. But TERM was cheaper if I held it for a shorter period of time. How do you do the analysis and why does the agent want to meet you? Well, he/she will bring their fancy charts, tables of numbers and effectively lead you into thinking that the biggest, most expensive policy is the best for you over the long term. Translation: lots of commissions to the agent. Whole life is what agents make their money on due to commissions. The agents typically gets 1/2 of your first year's commissions as his pay. And he typically gets 10% of the next year's commissions and likewise through year 5. Ask him (or her) how they get paid.

If he won't tell you, ask him to leave. In my opinion, its okay that the agents get commissions but just buy what you need, don't buy some huge policy. The agent may show you compelling numbers on a $1,000,000 whole life policy but do you really need that much? They will make lots of money on commissions on such a policy, but they will likely have sold you the "Mercedes Benz" type of policy when a Ford Taurus or a Saturn sedan model would also be just fine, at far less money. Buy the life insurance you need, not what they say.

What I did was to take their numbers, review their assumptions (and corrected them when they were far-fetched) and did MY analysis. They hated that but they agreed my approach was correct. They will show you a 12% rate of return to predict the cash value flow. Ignore that - it makes them look too good and its not realistic. Ask him/her exactly what they plan to invest your premium money in to get 12%. How has it done in the last 5 years? 10? Use a number between 4% (for TBILL investments, quite conservative) and 8-10% (for growth stocks, more risky), but not definitely not 12%. I would try 8% and insist it be done that way.

Ask each agent these questions:

  1. What is the present value of the payment stream represented by the premiums, using a discount rate of 4.5% per year (That is the inflation average since 1940). This is what the policy costs you, in today's dollars. Its very much like paying that single number now instead of a series of payments over time. If they disagree with 4.5%, remind them that since 1926, inflation has averaged 3.5% (Ibbotson Associates) and then suggest they use 3.5% instead. They may then agree with the 4.5% (!) The lower the number, the more expensive the policy is.
  2. What is the present value of the the cash value earned (increasing at no more than 8% a year) and discounting it back to today at the same 4.5%. This is what you get for that money you just paid, in cash value, expressed in today's dollars, i.e., as if you got it today in the mail.
  3. What is the present value of the life insurance in force over that same period, discounted back to today by 4.5%, for inflation. That is the coverage in effect in today's dollars.
  4. Pick an end date for comparing these - I use age 60 and age 65.

With the above in hand from various agents, you can see fairly quickly which is the better policy, i.e., which gives you the most for your money.

By the way, inflation is slippery and sneaky. All too often we see $500,000 of insurance and it sounds great, but at 4.5% inflation and 30 years from now, that $500,000 then is like $133,500 now - truly!

Have the agent do your analysis, BUT you give him the rates to use, don't use his. Then you pick the policy that is the best value, i.e., you get more for your money. Factor in any tax angles as well. If the agent refuses to do this analysis for you, get rid of him/her.

If the agent gets annoyed but cannot fault your analysis, then you have cleared the snow away and gotten to the truth. If they smile too much, you may have missed something. And that will cost you money.

Never agree to any policy unless you understand all the numbers and all the terms. Never 'upgrade' policies by cashing in a whole life for another whole life. That just depletes your cash value, real cash available to you. And the agent gets to pocket that money, literally, through new commissions. Its no different that just writing a personal check, payable to the agent.

Check out the insurer by going to the reference section of a big library. Ask for the AM BEST guide on insurance. Look up where the issuer stands relative to the competition, on dividends, on cash value, on cost of insurance per premium dollar.

Agents will usually not mention TERM since they work on commission and get much more money for Whole Life than they do for term. Remember, The agents gets about 1/2 of your 1st years premium payments and 10% or so for all the money you send in over the following 4 years. Ask them to tell you how they are paid- after all, its your money they are getting.

Now why don't I like UNIVERSAL or VARIABLE? Mainly because with Whole Life and with TERM, you know exactly what you must pay because the issuer must manage the investments to generate the appropriate returns to provide you with the insurance (and with cash value if whole life). With UNIVERSAL and VARIABLE, it becomes YOU who must decide how and where to invest your premium income. If you guess badly, you will have to pay a higher premium to cover those bad decisions. The insurance companies invented UNIVERSAL and VARIABLE because interest rates went crazy in the early 80's and they lost money. Rather than taking that risk again, they offered these new policies to transfer that risk to you. Of course, UNIVERSAL and VARIABLE will be cheaper in the short term but BE CAREFUL - they can and often will increase later on.

Okay, so what did I do? I bought both term and whole life. I plan to keep the term until my son graduates from college and he is on his own. That is about 10 years from now. I also bought whole life (NorthWestern Mutual Life, Milwaukee, WI) which I plan to keep forever, so to speak. NWML is apparently the cheapest and best around according to A.M. BEST. At this point, after 3 years with NWML, I make more in cash value each year than I pay into the policy in premiums. Thus, they are paying me to stay with them.

Where do you buy term? Just buy the cheapest policy since you will tend to renew the policy once a year and you can change insurers each time. Check your local savings bank as one source.

Suppose an agent approaches you about a new policy and wishes to update your old ones and switch you into the new policy or new financial product they are offering? BE CAREFUL: When you switch policies, you close out the old one, take out its cash value and buy a new one. But very often you must start paying those hidden commissions all over again. You won't see it directly but look carefully at how the cash value grows in the first few years. It won't grow much because the 'cash' is usually paying the commissions again. Bottom line: You usually pay commissions twice - once on the old policy and again on the new policy - for generally the same insurance. Thus you paid twice for the same product. Again - be careful and make sure it makes sense to switch policies.

A hard thing to factor in is that one day you may become uninsurable just when you need it, i.e., heart attack, cancer and the like. I would look at getting cheap term insurance but add in the options of 'guaranteed convertible' (to whole life) and 'guarranteed renewable' (they must provide the insurance). It will add somewhat to the cost of the insurance.

Last thought. I'll bet you didn't you know that you are 3x more likely to become disabled during your working career than you to die during your working career. How is your short term disability insurance looking? Get a policy that has a waiting period before it kicks in. This will keep it cheaper. Look at the exclusions, if any.

These comments are MY opinion and not my employers. All the usual disclaimers apply and your mileage may vary depending on individual circumstances.

Sources for additional information:

  • Consumers Reports printed an in-depth, three-part series in their Jul/Aug/Sep 1993 issues.
  • Many sites on the web offer life insurance quotes. Here are a few that have been rated highly by consumer advocates. Also see the article in the New York Times of 1 August 2001.
    Insweb.com, NetQuote.com, Insure.com, Term4sale.com.

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