Life Insurance – What’s The Catch?

Life insurance is an important part of any financial plan. It is designed to provide financial resources for a family in the event that a member’s premature death would cause financial hardship for the survivors. However, life insurance is often used for a variety of creative purposes beyond its intended design, and therein lies the catch.

A critical element to insurance to keep in mind is how it is priced. The cost of an insurance policy is determined by the probability the insurance company will have to pay off the policy. Thus, a healthy 25 year old single woman with a steady job will probably pay less for life insurance than a 65 year old male smoker who likes to go hang gliding.

Life insurance comes in two basic types: Term and Permanent. Term life insurance provides insurance coverage at a fixed price for a given term, typically five to 20 years, after which the insurance can still be renewed – but at an extremely high cost. Term insurance is pure, no-frills, basic life insurance and is generally the lowest-cost and most efficient way to cover a need for a given, definable period of time. For example, my term insurance policies are intended to provide for my children’s education and to cover my mortgage if I die before I can finish paying for them.

Generally, the younger you are, the cheaper it is to life insurance. So the same 10 year term insurance policy would be a lot cheaper for a 30 year old than someone who’s 70, because the probability is much higher the company will have to pay out on the older person’s policy. It is also priced for the period you own it. A 20 year term policy will generally cost more than a 10 year term.

Permanent insurance is intended to last throughout your entire life and to pay off at your death. Unlike term insurance, permanent insurance blends a savings-like account with the insurance policy. Also, the premiums are significantly higher than for term insurance. Because it is expected to last throughout your entire life, it is priced to cover the cost of insurance not only when you are 30 but also when you are 80.

And that is the essence of the catch in permanent life insurance. Each premium payment you make on a permanent insurance policy is made up of several components. A big chunk (seven to 10 percent) goes to the agent who sold the policy as a commission. Another part goes to pay for the current cost of insurance for that year of the policy. The rest goes into the cash value ‘savings’ component of your policy.

The catch is that the cost of insurance goes up each year, so the cash value is needed to help pay the higher costs in later years. Think of a permanent policy as a savings account plus lots of one-year term policies. As you get older, those annual term policies get more and more expensive. At some point, the premiums you pay won’t cover that cost any more. That’s why the higher early premium payments are saved to grow and cover future insurance costs.

This will generally work as long as 1) you’ve earned enough in your savings account for it to grow, or 2) you have continued to make the planned, scheduled payments over the life of the policy, or 3) you have NOT borrowed against the cash value of the policy.

And there’s the catch. Every insurance policyholder I have ever spoken with has been told at some point that they could either borrow tax-free against their cash value or make premium payments that are lower than the planned amount. And almost every time I see that, I see a policy where the cash value is bleeding down to nothing. When that happens, the policy generally needs to be cancelled, and that “tax-free” loan you took becomes a taxable distribution of any earnings on the policy. You’re also out the insurance policy you had planned on.

The bottom line: insurance is best used to manage the risk of premature death. No matter what the agents who sell it might say, it is poorly suited for use as a savings or investment plan. And for most people, the death protection isn’t even necessary once the kids are through college and you’ve paid off the big debts like your mortgage.

This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Rick and his family live in Mission Hills.

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