Friday, September 25, 2009

My Thoughts on Life Insurance - Why I prefer term life insurance over whole life and universal life

Back when I worked for Dundee Wealth, as an "independent" financial advisor, I submitted the following for approval (to be posted on my Dundee Securities webpage).

I'm guessing, they were not too pleased with one of their independent advisors going rogue on them (I was going rogue, but in the good sense, if there can be such a thing as a good rogue), and they kindly rejected my request.

Now, these opinions are just that, my own personal opinions in regards to life insurance. Not everyone (or anyone, for that matter), may see things the same way.

So, do your own research, know both sides of the life insurance debate, and then draw your own conclusions; that is the best advice I can give you when it comes to life insurance.

Here now, is what I asked them to approve back in April 2007:
(you can decide for yourself whether this is good advice or not)
My core belief about life insurance, or any type of insurance for that matter, is that its main purpose should be to protect the insured against a very highly unlikely event that, if it were to occur, would cause significant financial hardship to the insured or to his or her dependents.

If the event (death, disability, critical illness, need for long-term care) would not cause significant financial hardship, insurance is not required.

If an event IS HIGHLY LIKELY to occur, I do not believe that this type of risk can be economically transferred to an insurance company. The cost of insurance would just be too high.

With an event that is highly likely to occur, people must take personal responsibility to protect themselves against its financial impact by regularly setting aside savings and building up a personal financial reserve so that they have a sufficient emergency fund that will carry them through these types of situations if they were to occur.

You can read more about my beliefs on this topic under the Disability, Critical Illness, and Long-Term Care Insurance web page.

Now back to life insurance.

Where I may differ from others is in my belief that term life insurance is usually the only type of life insurance most people need, if they need life insurance at all. Very few people actually need permanent life insurance (whole life or universal life).

Because the likelihood of unexpectedly dying young is so low, people should only have to part with a very small amount of their hard-earned money to protect themselves against such a financial catastrophe. The cost of life insurance should be relatively minimal because the probability of collecting on the insurance policy is highly unlikely (and that’s a good thing).

One thing to remember is that insurance is a zero-sum game. What people pay in the way of premiums goes towards three things:

1. paying for the company’s operating costs (including salaries, bonuses, and commissions)
2. providing an adequate return on investment for the company’s shareholders, and
3. paying for claims

Insurance products are usually priced to take all of the above into account. So a fair amount of the premiums that people pay go towards covering operating costs and providing a reasonable profit for the shareholders of the company. The life insurance company does serve an extremely useful purpose: how else would we go about getting life insurance coverage we actually need?

Now, Who Needs Term Life Insurance?

Unfortunately, the reality is, life insurance is a necessity for a lot of people.

If you have someone who is financially dependent upon you, you probably need term life insurance.

Ask yourself:

Would my death cause financial hardship for anyone I care for?

Would my family be able afford to have the life experiences, the memorable moments and the opportunities that I look forward to being able to provide for them (family vacations, extra-curricular activities, university costs, etc.)?

Your responsibility
is to make sure that you have the right amount of the right type of life insurance coverage and to keep the cost as low as possible. You don’t want to be over-insured, under-insured or improperly insured.

I whole-heartedly believe in term life insurance because, to me, it makes complete sense. Now, there are a few rare occasions where whole life or universal life is a better risk-management solution for the client, but I believe that these are the exceptions to the rule, and will cover off these exceptions a little bit later.

For most people, after they reach a certain age, while still emotionally devastating to their loved ones, their death would no longer result in financial hardship for anyone. I believe, that as soon as financial hardship is no longer a concern, and assuming you’re still fairly healthy (your doctor sees no reason why you wouldn’t have at least a normal life expectancy), life insurance, of any kind, is no longer needed, so I would then recommend that clients cancel their term life insurance policies. That is why term life insurance is the perfect solution for most people. It’s cheap, and you only pay for it as long as you need it.

When life insurance is no longer a necessity, I believe you should use the money you save on premiums for living life to the fullest. I’ll talk about this in more detail below.

So, no, you’re not wasting your money with term life insurance, even though you religiously pay your premiums, knowing full-well that there’s very little chance of ever receiving anything in return. That’s the way insurance should be!

If you research life insurance on the internet, you’ll find many websites that compare term and permanent life insurance. Most sites that make a compelling case for whole life or universal life insurance may be biased, in that they want to sell you permanent life insurance, which is much more profitable for them to sell compared to low-cost term life insurance.

For more detailed definitions of the different types of life insurance available, click on the link below:

Types of Life Insurance

Below are a few website articles that I believe offer a more unbiased opinion:

Suze Orman - Why It Pays To Review Your Life Insurance

Cash Value vs. Term Life Insurance

Term or Permanent Life Insurance? - Ask The Experts

Term or Whole Life?

Which Life Insurance is Best?

Couple should rejig insurance to reduce debt

The Great Debate - Term vs. Whole Life

ROP (return-of-premium) - A Better Life Insurance Policy?

Term Insurance - The Permanent Benefit

Remember, people have differing views and beliefs on the purpose of life insurance. So research the differing opinions to help you determine what type and what amount of life insurance is right for you.

The Exceptions To The Rule

Other than the two exceptions below, I believe that for estate planning purposes, most people usually do not need whole life or universal life insurance coverage as much as they may have been led to believe.

Disabled Child or Other Disabled Dependent Who Will Need Financial Support Throughout His or Her Lifetime

One specific estate planning situation where whole life insurance is completely appropriate is if you have a disabled dependent who will remain dependent on you throughout their lifetime. For this person, you need to have the financial resources available so that they will be properly cared for when you are no longer there to provide for them. If you do not already have sufficient assets to provide this, whole life insurance is a must.

To Fund A Buy-Sell Agreement If You Co-Own A Small Business

Another situation where whole life insurance is advisable is to fund a buy-sell agreement between partners or co-owners of a business if there is a possibility that the buyer may not have the cash required to uphold their end of the buy-sell agreement.

Estate Planning and Leaving a Legacy

As an overall risk management strategy, I believe that it is better to ensure that you have the right amount of life insurance coverage through a term life insurance policy. And then, you’re better off to use the money you save in premiums from buying term instead of whole life or universal life insurance and investing it separately. These separate investments can then be kept to pay any income taxes that become payable upon your death or they can be used at your complete discretion to pay for anything else you wish to do during your lifetime.

With term insurance, you’re paying less in premiums because you're only paying for the pure life insurance you need. You then have the opportunity to make conscious decisions about how you invest your money that otherwise would have gone to pay higher whole life or universal life premiums.

Now, it is easy to see the emotional appeal of whole life and universal life insurance. After all, who doesn’t want to leave their grandchildren a little something to remember them by? Why throw away your money into a term life insurance policy that most likely will not payout a red cent to your beneficiaries? Why not buy whole life or universal life where you get a guaranteed payout?

The thing to remember with whole life and universal life insurance is that you only get the insurance payout upon death. And this payout has probably been fully-funded by the additional premiums (compared to term life premiums) you’ve paid.

But, what if you want to help your children or grandchildren while you're still alive?

I believe that if you have achieved financial independence, why not enjoy your hard-earned wealth and share it with the people, the causes and the charities you care for most while you’re still around to enjoy the great feeling that comes with making a real difference in people’s lives. Is this not a better option than continuing to plow money into higher insurance premiums that will allow you to accomplish these same goals, but only after you’re gone?

Wouldn’t it be much more enjoyable to actually experience these special moments?

To actually feel the gratitude from your loved ones for helping them financially when they most needed your help. Especially if they are young families who may be struggling to make ends meet. Maybe you could help your children with a down payment on a home or help them save for your grandchildren's university education.

To actually see how much all that you’ve worked so hard to save and pass on is appreciated by the people you care for most – and by doing so, enabling them to enjoy a little more of what life has to offer. Maybe you would be able to help them enjoy some of life's little pleasures while your grandchildren are still young (and share the experience and build the bonds and memories that will last a life time). A family vacation with the children and grandchildren might just perfectly fit the bill.

Isn’t that what it’s all about?

These “giving” moments will be some of the most enjoyable experiences you’ll ever have. And they’ll be some of the very special memories you and your loved ones will cherish for the rest of your lives!

Wealth will eventually be passed on. Why deny yourself all the great feelings that come from giving?

It’s just not the same experience when your loved ones just get a cheque from your life insurance company. The magical moments that rightfully belong to you and your loved ones, never get shared and are lost forever. That’s not right!

Estate Planning and Income Tax

Whole life and universal life insurance are often offered as solutions to potential cash/liquidity problems that may arise for an individual’s estate if assets cannot or will not be transferred on a tax-deferred basis to a spouse.

Unless rolled over to a spouse, upon death, an individual’s final tax return must include capital gains based on the fair market value of all assets owned at time of death. Also, the entire remaining value of a person’s registered savings (RSP, RIF, etc) must be reported as income on the final tax return. This can result in a very large amount of income tax that must be paid to the government in the very near future. If the estate does not have the cash resources to pay the income tax, then assets may have to be sold to raise the cash required, and that may not have been the individual’s wish. He or she may have wanted to pass on specific assets to specific individuals.

I look at things in a different way when assessing this type of scenario to ensure that clients choose the right life insurance/risk management strategy.

The fact is, if you were to die unexpectedly, low-cost term life would have been the best insurance for you to own as it would have given you the most bang for your buck. And if you live longer than a normal life expectancy, all that the whole life or universal insurance will provide is a relatively lower-yielding savings vehicle, and you have to die before you can receive the cash.

Life insurance is not designed to provide people with a cash windfall.

I believe that if you’re considering whole life or universal life insurance as an estate planning solution, it’s essentially just a choice between paying now or paying later. But, the longer you live, the lower the actual rate of return on your investments (the additional premiums paid for a whole or universal life policy compared to a term life insurance policy) becomes.

Remember, the premiums people are required to pay for any type of life insurance are always based on probability (actuarial charts). One thing is for certain, the premiums collected, as a whole, by any insurance company (whether through premiums or through the earnings those premiums generate) must always be greater than what it pays out, as a whole, in the way of claims.

Again, life insurance is a zero-sum game – as a whole, a group of insured people will get out of it, a little bit less than what they put into it.

If you believe that you will live at least to what is considered a normal life expectancy, a whole life or universal life insurance policy cannot somehow magically provide a greater source of cash for your estate than you could have accumulated yourself had you saved the additional premiums as part of a separate savings plan.

Something else to think about: If people live to normal life expectancy, what assets do most of them usually own at the time of their death?

• They may own their home. They may own a family vacation home.

• They may have some savings outside their registered plans. They may have already spent or gifted away much of these savings (for example on things like family vacations, helping children with down payments, or donating to their favourite causes or charities).

• Their registered retirement savings may also be considerably depleted by now.

If their home is to be sold, the proceeds will be completely tax free and, in most cases, will be much more than sufficient to pay all income taxes owing.

Even family vacation property is often sold as it becomes too difficult for siblings to jointly own and agree upon how to equitably share the benefits and the responsibilities of joint ownership as they all may have different priorities, values and financial resources.

I wonder how many estates, where whole life or universal life insurance was purchased to protect against cash/liquidity concerns, actually ran into the anticipated cash crunch that was the basis for the purchase of the policy in the first place?

So, personally, I do not believe that cash concerns are as prevalent an issue for estates as one might be led to believe. And if they are not, then doesn’t what I’ve said above, under “Estate Planning and Leaving a Legacy”, about making the most of your wealth while you are still around to experience the difference it makes in the lives of those you love most, make even more sense?

How Permanent Insurance Works

What you must understand is this, with permanent insurance, part of the larger annual premium you pay goes towards paying the very same term insurance (pure life insurance) portion of the policy. It is only the additional amount you pay each year, that works, in a sense as a savings account that then guarantees an insurance payout upon your death.

Remember, all that permanent insurance is, is a term insurance policy with an investment component that gives you a conservative rate of return based on life expectancy. It is by no means, any type of magical investment vehicle. Remember, in the end, the insurance company must still collect more in total premiums (and the investment income earned on these premiums) than it pays out in total benefits.

Yes, you can get tax-deferred growth with a universal life policy, but then again, the downside is that you can’t do anything with this money until you’re dead. Well, you can, but if you withdraw the cash surrender value while you are still alive, the tax-treatment is much worse than what would have been the case had you just bought term life insurance and invested the savings (difference between the cost of term insurance and universal life insurance) separately. And there may be hefty fees to pay as well.

Now, the idea that one can "hide" investment income from the government has a very strong appeal to those who believe they are already paying too much income tax. While it's true that universal life insurance can be an attractive way to shelter investment earnings from taxation, this product is in no position to compete with the advantages offered by Registered Retirement Savings Plans (RRSPs). Money in an RRSP not only grows tax-free, but the contribution can be fully deducted from income — not so with universal life policies, which shelters only investment income.

Personally, I do not believe that anyone with debt should be buying life insurance that comes with an investment component. Only after you are financially independent (you've maxed out on your RRSPs, RESPs, and IPP contributions and fully funded your retirement with sufficient additional non-registered savings) should you even consider this option. And, even then, you might first want to give wealth transfer and philanthropy (which is often why many of these permanent insurance policies are taken out in the first place, isn’t it) some serious thought.

Why Access To A Cash-Surrender Value Is Really A Non-Issue:
(again, these are only my personal beliefs - you may or may not agree)

• The need to access the cash surrender value should never be a reality, because permanent insurance should only be an option if you’ve already achieved financial independence, therefore, you should never need to borrow against the cash-value.

• You need to remember that you don't actually get to use your savings interest-free. You only get to use the cash-surrender value as collateral for a loan, on which you pay interest. And, if the loan is still outstanding at the time of your death, the outstanding amount is deducted from the face value of the insurance policy payout.

• I don’t believe that it is prudent financial planning to own a whole life or universal life policy if you still have a mortgage outstanding on your principal residence. Yet, if your principal residence is mortgage free, in an emergency, you could always borrow against your home, so access to the cash surrender value again becomes a non-issue. And the rate of interest charged on a loan against your home would most likely be significantly less that the rate charged on a loan against the cash-surrender value of your insurance policy.

Permanent Insurance As A Forced-Savings Strategy – My Thoughts

One thing to keep in mind is that with a whole life insurance policy is that if you were to die, your beneficiary would most likely only receive the face value of the policy. The terms of the policy usually state that the beneficiary is not entitled to the cash surrender value that has build up inside the policy.

Also, if you are considering permanent insurance as a forced-savings strategy, it’s a good idea to remember that people who have trouble saving to begin with aren't likely to continue shelling out high premiums for insurance.

Roughly 12 percent of those who buy whole or universal life policies allow them to lapse within the first year, according to Limra International, an insurance research firm. An estimated 40 percent drop their policies during the first 10 years, usually because of the high premiums, says Robert Hunter, director of insurance for the Consumer Federation of America. Depending on how soon the policy lapses, consumers lose their whole investment or get back a small fraction of the money invested.

But even if you diligently keep paying the premiums, the fees involved may result in this strategy not being the most efficient way of saving.

Over the first 10 years of a policy, the sales and related costs can equal more than a year's worth of premiums, or several thousand dollars, says James Hunt, an actuary affiliated with the Consumer Federation. Moreover, many cash-value policies carry back-end loads and fees -- typically lasting 10 to 15 years, but sometimes 20 -- that lessens the cash you receive if you opt to surrender the policy.

And if you do surrender the policy, in effect taking out the built-up cash, you'll pay income taxes at higher-than-ordinary income tax rates.

In Conclusion:

Before you purchase any life insurance, do your homework and make sure that you purchase the right type of insurance policy and the right amount of coverage based on your individual circumstances. Being properly and adequately insured is critically important and really is a must. What you don’t want is to be over-insured, under-insured, or improperly insured.

I'll say this, one last time, people have differing views and beliefs on the purpose of life insurance. So research the differing opinions to help you determine what type and what amount of life insurance is right for you.

Life insurance plays an important role in many of the comprehensive financial plans and investment strategies I design and work with clients to implement.

My approach to selling life insurance is pretty straight forward; if it's needed, always provide the most appropriate type, and amount, of life insurance coverage, at the lowest cost possible.

Go confidently in the direction of your dreams! Live the life you’ve imagined.

Live! Love! Laugh! Learn! Leave a Legacy!

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