The Dreaded Question of Insurance

One of the personal finance topics that many people desperately avoid thinking about is that of insurance, specifically life insurance.  The most prominent reason for this is because most people do not cherish the thought of their own demise.  Another reason is that there are many insurance products available, and many people get confused.

Life Insurance Basics

By and large, the two predominate forms of insurance are Term and Permanent policies.  As the name suggests, a Term policy lasts for a pre-determined length of time and then goes out of force.  Similarly, a permanent policy is designed to stay in force perpetually, building cash value until the benefit payout at the time of a person’s death.

Insurance agents frequently point out that most Term policies do not pay their benefit, and that permanent policies offer a better value.  (Not to mention dramatically higher commissions for the sales agent)  It is certainly true that permanent policies stay in force for longer, but it is also true that permanent policies involve a dramatically higher cost.  (Typically between 5x and 10x the cost of an equivalent Term policy)  The internal rate of return for whole life insurance policies are frequently in the low single-digits, and the variable policies with investment accounts typically have very high fees.

The Real Reason for Insurance

The end result is that insurance does a great job of protecting you against a catastrophic risk, but a terrible job of producing a return on investment.  If a person is purchasing a policy for the purpose of estate planning, then a whole life or similar permanent policy may make sense.  However, if the purpose of your insurance is to protect your family in the event of your untimely demise, the only time period you need to ensure is from now until when you have accumulated enough assets so that your family is still financially secure.

This is a dramatic departure from the rhetoric of most salespeople.  In an attempt to push high-commission products, some have concocted elaborate schemes with attractive monikers such as “bank on yourself” or other slick sounding systems.  In the end, all of these systems ultimately obfuscate the fact you will never earn more from an insurance product than the insurance company earns from your premiums.  (If you did, the company would quickly go out of business)

The guiding force behind your insurance decisions should be to protect what you cannot afford to lose against a catastrophic risk and leave the investing for a different conversation.

Eliminate the Middleman

Incidentally, one of the primary assets that insurance companies purchase with their premium dollars to earn returns is income-producing real estate.  The other main asset category is government and corporate debt obligations.  Thus, it stands to reason that the only returns you can earn from a policy with an insurance company must be the rate of return from these instruments, less the overhead and costs of running the insurance company.  (Which are frequently high)  People who are looking to achieve attractive investment returns should seek direct investment in funds, income-producing real estate, and other types of assets and avoid the ‘middleman’ costs associated with using insurance products as investment vehicles.

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