A Tale of Insurance

English:

English: (Photo credit: Wikipedia)

A Tale of Insurance

“The Pitch”

Sometime before the age of 25 you will probably 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 rest assured that there will be a love component to the sales presentation. You will hear the classic, “Carlos, if something were to happen to you wouldn’t you want Stephanie to be financially secure?” As I and everyone that has ever heard this line bobs their head up and down in agreement, the next line, like a boxer’s knock out punch follows, the salesman says “Not only will you be taking care of Stephanie, in the event that something happens, it is a pretty good investment.” You are knocked out. You look lovingly into your wife 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 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 at an astronomical rate 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 the obligatory can we afford so much every month countered by the salesman “How can you not afford it” you sign on the dotted line and the salesman leaves. You are now the proud owner of a permanent life insurance policy and the salesman is counting their commission

As the salesman walks out the door you are left with 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 left thinking of what you can no longer do with the money. Not only is it gone and not only do your future prospects for a vacation, new car or whatever suits your fancy look diminished, you look cheap. You look cheap because the salesman showed up and pitched or depicted an unreasonable monthly payment. Their job is to sell you the highest possible monthly payment. This means the insurance strategy is to go high with the illustration and then work down to a level that you can afford. It works. Of course within a few years you will cancel the policy and all your money will be gone. So avoid this purchase if you possibly can.

The scenario I’ve described above is being played out in living rooms across America and most of the developed world every day. It is effective. It is your responsibility to be better informed. The product that this couple just bought is terrible. It is costly, there are better cheaper alternative, it is unlikely that it will deliver what it promises and it is not an investment worthy of consideration. This tale is in the section marked 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 is not considered an investment 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. Term insurance is competitively priced. It is readily available and if you have a life insurance need like so many people do, is the preferred route to take when purchasing life insurance. Permanent insurance is considered an investment because since the policy is permanent, it has no term. So term insurance means for a while and permanent insurance means till the day you die. Term insurance will never have a cash value while permanent promises to make you rich but the reality is that very few and I mean very, very few permanent policies actually deliver.

In the last sentence I imply that permanent insurance might, if all the stars align, have a cash value. Let me explain. In most cases, if you cancel your permanent policy within a few years of purchase it will have no cash value. You have upon reflection 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 I have no money in my investment account? The answer is the permanent life insurance salesman. He or she has most of the difference between what you think you should have and what you actually have. The commission that the salesman receives for selling a permanent life insurance policy is approximately equal to the entire amount that you pay in the first year. It’s an outrageous amount to pay someone yet it is the traditional business model of most insurance companies. Is there a solution? The answer is yes. It is called no load permanent insurance and there are many reputable companies that sell it. However, I can say without equivocation that for those that just need life insurance a term policy is the preferred route.

Many permanent insurance providers, like the mutual fund industry did almost two decades ago, have moved to distributing no load permanent insurance. This means that if you change your mind after a few years you aren’t stuck with the huge upfront charge. This effectively means that the permanent insurance industry is now divided into load and no load permanent insurance. The difference in cost between the two is significant in the early years. I have seen no load permanent policies that after 3 years of making payments or paying premiums, if you change your mind, the policyholder gets almost all their money back. I then compare what they would get with the loaded version and they would get nothing back. This is significant because despite the phrase permanent in the lexicon of insurance sales the reality is that people do change their minds. When purchasing a permanent policy you should allow for the possibility of changing your mind.

So who needs insurance and what type should they purchase? My philosophy is that life insurance should be purchased to avoid disaster. If you are single and die chances are that no one will suffer economic hardship from your death. The same is probably true if you are married without children. If you fall into one of these two 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 you 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. What about the other 5%?

The remaining 5% fall into various little subgroups. The distinction here is not one of marital status or children. This 5% group is unique in that they are not wealth building; they are already wealthy. So the question becomes do wealthy people need life insurance? Let’s look at my philosophy. It states that life insurance should be purchased to avoid disasters. 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 survivors will avoid disaster? The answer in most cases is once again yes. Most wealthy people are self insured and except for those that have their wealth tied up in illiquid investments 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. It is in these cases and these cases only that I recommend permanent life insurance. When I do however, I recommend the purchase of no load permanent life insurance. The no load version is such a superior product to the high cost, commission generating version that I can’t see why anyone would pay more for less.

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 you don’t need life insurance unless your wealth is illiquid because you are self-insured. If you are wealthy and decide to purchase it anyway to maximize what you leave your heirs, do yourself and your heirs a favor and buy the no load variety in case you change your mind. If you own a permanent policy I suggest you look at switching to a term policy.

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3 Comments

  1. This blog’s great!! Thanks :).

  2. Great post, in my life I have had quite an adventure with insurance companies.

  3. As an industry veteran for nearly 40 years, I agree that much permanent life insurance is mis-sold by agents with the complicity of misinformed clients. However, there are mistakes galore here. the commissions for most all term insurance are virtually the same perccentage relative to first year premiums – which is where most commissions are paid. Second, much ‘term’ life insurance today is built on a universal life mainframe which costs the insurance less in capital/reserves to support long term guarantees. This main frame can design a term plan for virtually any number of years — not just 10, 20, or 30. A term plan could be designed with guaranteed premiums to age 80 or 90 very easily and such a contact would have little or no cash value component. Emphasis is strictly on guaranteed, low premiums. But, in addition, a permanent policy might have more utility than the author knows about, since some contracts today allow for the access to the death benefits –NOT merely the cash values — to help pay for medical expenses from long term care, for critical illness such as heart attacks, strokes and cancer, etc. So while the ‘cash’ value of the policy might be very low, the client could still access a half million dollars -tax free- for a significant heart attack and a 3 vessel bypass operation. As we all get older, and since most people don’t have an emergency fund of $300K or $400K for medical expenses, and since Medicare is now starting to deny many expenses for legitimate illnesses, having life insurance you don’t have to die to use could be a very good thing especially for aging baby boomers. You need to come into the 21st century. Your stuff is good, but 10 years behind the times.

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