Life insurance options - Why? When? What type?!

If nothing else, 2020 has really shown us how unpredictable life can be, highlighting the benefits of life insurance to provide peace of mind and financial security to loved ones left behind to pay for childcare, college and any other expenses. Life insurance can be a good way to protect your downside, whilst simultaneously investing and growing your nest egg.

The 2 main types of life insurance are term and whole life insurance. 

Term life is the simplest. It provides coverage for a specific time horizon (eg 10, 20, 30 years) during which time you pay fixed premiums. If you pass away at any point during the term, the stated benefit is paid out to the benefactors. Other than that, there is no other cash value you accumulate. So if you live to the end of the term, you have no other value to show for your insurance. 

Whole life insurance can be thought of as having 2 components: an insurance component which provides coverage for life with a guaranteed payout as well as an investment component which accumulates value over time. The investment component offers a guaranteed return on the cash value, which accumulates tax free. During the early years of the policy, the cash value is small as more of the premium goes towards administrative fees and insurance costs. Over time the amount of premium put towards cash value increases. 

To assess the savings component of whole life insurance, compare the difference in premiums between whole life and longest term life you can find, as this is an estimate of the amount you are investing. Then compare the rate of return, net of fees, on this invested amount with other alternative investment returns (eg equity funds, fixed income securities). As insurance companies are lower risk than overall equity markets, we would expect that returns would be lower. Typically you would see that returns are relatively low due to high fees associated with whole life insurance.

Which type of insurance should be considered and what are the pros and cons?

Term life insurance: Suitable for most individuals and families looking for coverage for a fixed period of time

Pros: 

• guaranteed premium payment amount and guaranteed death payout amount to beneficiaries 
• low cost (could be 1/10 of the price of whole life insurance)
• simple to understand
• provides coverage for a finite period which may be useful if you don’t need insurance later in life in retirement
• the savings from not buying whole life insurance can be invested in other tax efficient vehicles like 401(k), IRA, 529 plans.

Cons: 

• if you want additional coverage once the term comes to an end, the cost of buying coverage increases with age. 

Whole life: May be suitable in certain circumstances, such as for someone wanting lifelong coverage AND who is a younger, high income earner, who has already maximized 401(k), Roth, 529 plan limits. For those who have a nest egg of diversified assets and are looking for further diversification, whole life insurance may work, especially if they are risk averse.

Pros: 

• guaranteed premium payment amount and guaranteed death payout amount to beneficiaries
• fixed rate of return on cash value which grows tax deferred, 

Cons: 

• high cost (eg could be 10x cost of term life to fund the insurance cost, higher administration costs and savings component) 
• inflexible as due to the need to continue paying the premiums for life which may prove tough during periods like a job loss
• insurance coverage may not really be needed later in life once you are retired and have little debt
• the savings component is typically higher cost and lower return than mutual funds or other marker investments. 
• tax efficient savings can instead be achieved via other vehicles, such as 401(k) plans, IRAs and Roth IRAs for retirement and 529 plans for education.

Whilst we are on the topic of life insurance, I should mention there is also a third type of insurance called universal life, which is similar to whole life in that it provides coverage for life and has an investment component. One key difference between universal and whole life is that whilst the investment component of universal has a minimum guaranteed rate of return, like whole insurance, it could also perform better depending on market conditions. Another key difference is that universal life insurance premiums are variable and can increase over time whereas for whole life the premium is fixed.