Thursday, September 17, 2009

Life insurance

At its most basic, life insurance is a very simple contract that represents a wager on when a person will die. From the perspective of the person taking out the contract, the purpose of the contract is usually to provide financial protection to dependent family members in the event of death of the insured. From the insurance company's perspective, it is a business that relies on a combination of life expectancies of a number of policy holders and investment returns on the premiums to generate a profit.

Where life insurance gets complicated is the variations (and the ridiculous and archaic legal documents which I will ignore).

Life insurance comes in three basic forms which can be summarised as follows:

1. term life: you pay a premium and if you die during the term of the contract (usually annually), the designated beneficiary will be paid the face amount of the contract;

2. whole life: you pay a recurring premium and are insured for life with the added benefit that if you are still alive when you reach a specified age, the policy will mature and you will be paid a guaranteed minimum cash value. There are several variations to these types of policies and the other forms of permanent life cover such as universal life cover and limited pay;

3. investment linked insurance plans: these are essentially a whole life insurance contract bundled with an investment savings scheme and sold as a single product.

As a general proposition, if you need to provide for dependants in the event of your death, a term life policy is a good idea. It's cheap and you are not locked in for more than the term of the contract. The downside is that your premiums are not fixed (they may go up each year) and the insurance company is not obliged to offer you a renewal each year (although some will commit to doing so).

Whole life is is generally a bad idea because the premiums are higher, the rates of return are awful and there is a lack of flexibility - you will lose a lot of your money if you cancel the policy before maturity. As a general proposition, you can achieve a much better result by taking out a term policy every year for as long as needed and investing the difference elsewhere.

An investment linked insurance scheme is almost always a bad idea. Term life renewed annually with the difference in premiums being reinvested should produce a much better result.

The key message is that insurance should never be viewed as a form of investment. Put differently, if whole life and investment linked polices where such great investments, why would insurance companies engage an army of people to sell them? The agents who sell policies earn massive commissions from the sale of whole life and investment linked polices - commissions which come out of the policy holder's pocket.

If you ever have the misfortune to be cornered by someone peddling whole life or investment linked policies, just asking two simple questions will demonstrate why these things are the modern equivalent to the medieval practice of buying indulgences:

1. how many years before I can surrender the policy and get back at least the total amount which I have paid in? You will either be given a number which will horrify you or be fobbed off with some nonsense about it being a long term plan;

2. how much commission will you get out of it? You will either be told a number which is close to a year's premiums (there is some variation here) - and remember that this is your money. Alternatively, they will shamelessly dodge the question.

The thing to remember about life insurance is that it is a tool to protect dependants in the event of your death - it is not a form of investment.

7 comments:

James said...

Absolutely agree.

You only need term life and not the other whole of life, etc.

It needs to cover (as a minimum) all outstanding liabilities/debts.

traineeinvestor said...

James

Very good point. I did not focus on how much coverage you need.

In my case, I need enough to cover the mortgage on the home and one of the investment properties (not all of them). After the home mortage is paid off, I can probably drop the coverage.

Cheers
traineeinvestor

Andrew said...

Very timely post. Just sorting out insurance now. Walked into the bank and get offered Whole Life. A friend also pointed out this is a bad idea and almost never sold in more "mature" financial markets.

@Trainee / James - do most people only opt for the minimum? I am being told that the policy needs to cover living costs for family for very many years - yet you're both saying just debts and liabilities.

Any more thoughts on this?

traineeinvestor said...

Hi Andrew

My reply got quite long so I have put it in a separate post: http://aprivateportfolio.blogspot.com/2009/09/life-insurance-how-much.html

Cheers
traineeinvestor

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Great post. You have explained the life insurance policy in such a nice way that in the first read I understand it fully. I am going to take a Term Life policy as I do find it the best option of all the three. Thanks a lot for helping me out.

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