A friend recently asked about a life insurance policy with a guaranteed cash buildup far in excess of what he could earn on a CD or long-term Treasury. What did I think?
During my working career, I had many insurance companies as clients. When I asked similar questions, I always got the same response: with any “combination” product — that is, an insurance policy with an investment component — consider each part individually.
Property and casualty insurance
Most people buy property and casualty insurance to protect themselves in case of a catastrophe.
I had a friend who became disoriented and ended up going the wrong way on a one-way street. Realizing his error, he sped up, hoping to get to the next intersection. A car turned onto the boulevard, a major collision followed, and he killed three people. The cost of totaling two cars was minimal compared with the lawsuits and pricey settlements that followed.
Most of us buy automobile insurance every six months. We insure against a potential catastrophe even though the probability is slim. We know the unlikely could happen, so we protect ourselves. There is no investment component; it is pure insurance, and the cost is easily understood.
Life insurance also hedges against a catastrophe. Life insurance companies employ leagues of actuaries — the professional odds makers — to pinpoint when someone with your characteristics is likely to die. If the policy is big enough, the company may even require a physical examination before determining the right premium for the amount of coverage you need.
Most of us bought life insurance at a young age to protect ourselves and our families. While your anticipated expiration date might have been decades away, you still bought it. The potential cost to your family if you didn’t was too high to ignore. The risk of the primary breadwinner leaving his family with a major loss of income is catastrophic.
Anyone who has attended a class reunion can recount the tale of a young class member who lost his life in some sort of mishap. Every time this happens, it reinforces the need for life insurance. Any insurance agent will tell you that the best time to sell life insurance is after a family member dies. Fear of the unlikely is running high, and folks are eager to protect themselves.
The only way to turn life insurance into a good investment is to die before your expected mortality. While some folks do just that, out of every 100 policies the insurance company sells, the vast majority pay their premiums and their spouses are quite happy to never have to file a claim.
Just because it might be a bad investment doesn’t mean it’s a bad idea. Quite the contrary — most people feel it’s prudent.
An annuity is the opposite of life insurance. You generally pay a one-time premium, and the insurance company agrees to send you a check every month for the rest of your life. Actuaries know your expected mortality and set the rates accordingly.
Annuities generally don’t require a physical examination regardless of the amount. If they did, people in good health and with a family history of longevity would end up with lower monthly benefits.
Are annuities a good investment? It depends on when you die. Anyone who has outlived his expected mortality and is still receiving a check would say “yes.” It may or may not turn out to be a good investment, but it may still be a good idea.
Things get much more complicated when insurance companies try to add an investment component to the policy. My insurance-company clients also made it clear that the more complicated the product, the higher the commission for the agent.
A prudent buyer looking into a combination product from an insurance company should first separate the insurance portion from the investment portion of the premium, so he knows how much each portion costs. Then one can compare the cost of insurance coverage and run the numbers with the investment portion.
If the investment component wouldn’t be worthwhile on its own, don’t be fooled by a fancy wrapper or an insurance agent’s bravado.
This last one, annuities, seems to generate a great deal of interest from today’s seniors. It’s not surprising since all of us are looking for steady, reliable income in a world where CDs pay next to nothing and the thought of going back to work makes us shudder. Annuities are one of the most complicated financial products available and leave many seniors with more questions than answers. To help you figure out what to look for in an annuity—or indeed if one is even right for you—we’ve put together a new report called Annuities De-Mystified: Three Simple Tools for Choosing the Right Annuity. Click this link to get your free copy.