Life Insurance Brings Risks Of Its Own
Life insurance is an important consideration for any comprehensive financial plan. Over the years, the industry has developed many innovative products that address a number of financial planning needs, from risk management to business succession to estate planning. And in certain circumstances, a life insurance policy can offer a viable alternative to other investments vehicles like mutual funds. But for a product that is designed primarily to manage risk, a life insurance policy carries some risks of its own that are important to understand.
Life insurance is a complex product. Policies can take many forms, including term life, whole life, universal life and various combinations or variations of these basic types. The specific terms, conditions, riders and exclusions of each policy can be difficult to decipher, and make comparison among products and providers virtually impossible. With the diversity of products and the amount of customization available, it’s often difficult to determine the best fit for your situation. And therein lies the first risk of life insurance. Although an insurance agent can help manage the complexity, they also have a huge knowledge advantage when it comes to product and pricing.
Complex financial products require sophisticated pricing models, and life insurance is no exception. Pricing for typical life insurance policy must consider:
- Mortality risk (the risk that you will die during the policy term)
- Investment returns
- Company expenses
- Income taxes
- An adequate return to shareholders
Term life insurance, which provides coverage for a pre-determined period of time, provides the simplest, most cost effective way to manage mortality risk. Permanent life insurance products, like whole life and universal life, typically provide lifetime coverage and include an investment component that builds cash value for the policy holder. But policy riders, separate account management fees and surrender charges can add layers of hidden cost that weigh like and anchor on investment returns. If you are using life insurance partially as an investment vehicle, it is important to get a full understanding of these costs, and to compare them to the alternative of buying term insurance and investing the premium savings in an IRA or standard brokerage account.
If you think about the underlying purpose of life insurance and the time horizons involved, it should come as no surprise that life insurance companies will invest your premium dollars very conservatively. A variable life policy offers the opportunity to earn higher returns (at a cost), but whole life and universal life premiums typically go into lower-risk investments, like bonds or money market funds. These steady returns are great if the time ever comes to make a claim, but they are not particularly good for building a nest egg. The risk profile of most insurance investments is often far below the risk tolerance of the investor, especially when the investor is young. This introduces the risk later in life that investment returns will not be sufficient to offset the effects of inflation.
Finally, if you are researching life insurance policies, find out as much as you can about the company that is underwriting the policy. A life insurance policy is no good to you or your beneficiaries if the insurance provider goes belly-up during the policy period. Ask about their insurance ratings, look at the historical stability of the company and its cash flows, and understand how they will invest and manage your premium dollars. You also want to understand what type of conversion options the company offers, in the event that you would like to change the type of policy you have or convert to an annuity. These options vary from company to company, and from policy to policy. They are factored into the premiums you pay, and can make a big difference in your planning flexibility down the road.
Life insurance, in its various forms, can provide many valuable, and at times unique, benefits to policyholders and their beneficiaries. At the same time, however, it’s essential to understand the underlying risks, and to obtain advice that is as objective and balanced as possible. Approach with caution and you will find the solution that’s right for you.