Wealth Planning News
Vol. IV, No. 9
Rent or Buy Insurance?
Put out of your mind for the time being the question of why you would want a bunch of money going to someone when you die. We discuss that in another issue. For now we focus on how to obtain life insurance.
There are two basic types of life insurance:
First, there is life insurance you can rent. The policy will pay if you die during the policy term. Because costs of such insurance go up in later years, the term must end some time before your normal life expectancy. Insurance professionals call this type of insurance term insurance.
Second, there is life insurance you can buy to pay if you want the proceeds paid for death at or beyond your normal life expectancy. Insurance professionals call this type of insurance permanent or whole life insurance of one kind or another.
All life insurance policies include some term insurance. What professionals call permanent or whole life insurance has a term insurance cost for the difference between the death benefit and the balance in your investment account in the policy. So-called term insurance is therefore included in all life insurance policies.
Factors to Consider
A key issue is whether the insurance proceeds will be needed if you live to or beyond your normal life expectancy. If proceeds will not be needed at or past normal life expectancy, you could just rent insurance for the time it is needed. But if the proceeds will be needed at or beyond your normal life expectancy, then you must buy the life insurance, not merely rent it. Why? The costs of renting insurance in your old age would just be prohibitive.
Another key issue is the duration of the need for the insurance. If the need is for only a short time, to cover that big operating loan for example, or to get the kids through the next 8 years of college in case you die, and if you have no long term need for coverage later, you should probably just rent the insurance. But if you need it for longer than ten years, or may need it later for some other purpose it may well be best to buy it. General rule: The longer you need the insurance, the more likely you should buy it instead off renting it.
Compare to Housing
If you rent a house you can have it for the lease term and build up no equity in the house. If you buy term life insurance you have the coverage for a term and build up no equity in the insurance policy.
If you buy a house, you pay for the right to use it, just as you would pay if you rented, but in addition you pay more to buy the equity in the house. Then you can have the house until you die. If you buy life insurance you pay for the term coverage, but in addition you pay more to build equity in the policy. Then you can have the policy until you die.
Someone who rents a house can easily walk away. Then the rents paid are gone forever. Rented insurance is similar. You can easily walk away and everything you paid for the rented insurance is gone forever.
You build house equity in two ways: (1) Each payment reduces the principal you owe on the mortgage; and (2) over time the house will likely grow in value. The combination of growth in asset value with reduced debt builds up a meaningful equity.
Your insurance policy equity account builds equity in two ways: (1) Part of each insurance premium is added to an equity account; and (2) the insurance company invests your equity account and the return on investment also builds additional policy equity. This insurance equity account compounds on a tax-free basis under our tax laws.
If you buy a house and make mortgage payments over a period of years, you will find that a progressively larger amount of each payment will be used for note principal. Your equity in the property grows ever faster because the note balance gets smaller and less of each payment is needed for interest on the note.
If you buy insurance (but not if you rent it) you may over time find that a progressively larger amount of each premium you pay is used for equity build up, because the amount of term life insurance inside the contract constantly goes down in direct proportion to the growth of your equity account.
Buy What Type?
If you buy instead of rent, what type to buy?
With old insurance policies you could be assured that the insurance company would invest your equity part of the policy at a set rate that was usually pretty dismal.
Sometimes the return was better if you had a policy issued by a mutual company that returned some of the insurance cost to you in the form of a policy dividend, since the insurance company would invest in the general economy and produce good earnings during many years, and could pass on some of those investment gains to policy owners. This concept is still valid with mutual companies, and so they may well allow you to buy insurance with better than minimal guaranteed returns.
The insurance industry developed a type of policy that gave you what is, in effect, a variable rate of return on an equity account, frequently tied to normal investment interest rates. In addition the term coverage part of the policy was allowed to be separate from the investment feature for added flexibility over the years.
Now you can have the choice of many types of investments, from traditional interest bearing securities to equity funds. You can change investment choices from time to time, and the return on investment can be as varied as your return on your other investments. Someone who sells this kind of insurance to you needs a securities license. After all, the sale involves investment securities. But this type of policy carries some risk of loss of your investment, so it is not for the short-term or older buyer.
We help you review the issue of when to rent or buy insurance, and if you buy we help design the type of insurance to buy.