Thursday, December 8, 2011

Life Insurance


Dear Investor Juan,

I am writing to you because I'm somewhat new to this financial literacy thing and I want to know if it is possible to know your two cents about life insurance? Almost all the articles I've read about financial literacy says that the first step is getting protection (life insurance) or maybe after budgeting and saving but before investing. I think you've already scratched the surface about this topic on some of your articles. And from what I understand, you prefer term over traditional and VUL or "buy term invest the difference". Lastly, maybe you could recommend a life insurance product here in the Philippines or what features to look for when getting a life insurance. Again, thank you for your time and God speed on your future endeavors.

Kind regards,


Dear Aaron,

Most probably you have already read my introductory post several weeks ago about insurance, but for the benefit of those who haven't, I will start this post with a definition. In the simplest sense, insurance is a contract between two parties: one party, insurance company, promises to pay specified amounts to the other party, the policyholder, conditional on the occurrence of future events such as death, car accidents, or pirate attacks; in return, the policyholder, pays the insurance company insurance premiums for this transfer of risk to the latter. There are three major types of insurance that we all should be familiar with: life insurance, health insurance, and property and casualty insurance. I will limit my discussion to life insurance in this post and just talk about the other types in future posts.

Life insurance, as the name suggests, insures against death: the life insurance company pays the beneficiary of the life insurance policy in the event of the death of the insured. Life insurance doesn't benefit the policyholder personally, but rather his or her dependents. So in a sense, life insurance would be more important to those with families and other dependents than to those who are single with no dependents.

There are two primary types of life insurance: term life and cash value life insurance. Term insurance is the simplest type: you pay the premium for the amount of coverage that you want (i.e., the number of years and for what amount) and lose coverage when your policy lapses and you choose not to renew. You don't "earn" anything with term life so it does not have any cash or investment value (which isn't saying it does not have any value).

The other class of insurance--cash value or permanent life insurance--is generally a combination of term life insurance and an investment product that has a cash or investment value. Usually, policyholders have an option to withdraw from this value, borrow against it (i.e., use it as collateral for a loan), or just let in mature and receive a "bullet" payment or a schedule of payments.

We can also classify cash value life insurance even further, based on whether the cash value is guaranteed or variable and whether the required premium is fixed or flexible. The four combinations and their general characteristics are presented in the table below.

Guaranteed Cash Value
Variable Cash Value
Fixed Premium
Whole life insurance
- Guaranteed build up of cash value
Variable life insurance
- Policyholders are allowed to allocate their premiums among several investment accounts
Flexible Premium
Universal life insurance
- Greater separation between term insurance and investment components
- Premium payments are flexible, but there is a minimum initial premium
Variable universal life insurance
- Same as variable life but premiums are flexible

Everything looks dandy. So why do I advise against cash value insurance?

In general, I recommend just buying term life and investing on your own for two main reasons:

1. You lose flexibility and liquidity with cash value life. Back in the day when there was just term life insurance, people would buy it for several years, not die, realize that they're just losing money, and eventually cancel the policy. So in the 1800's some guy named Henry Baldwin Hyde came up with cash value life insurance to prevent people from cancelling their policies (since with cash value life, you lose your investment if you cancel too early). With the term life + DIY investment option, you can cash out on the investment part any time you want, even at little or no expense.

2. Cash life policies cost too much. Why? Because you pay someone to do something you can do yourself, arguably better, for much less.

So there. If you think you need it, then buy term life. Investing is a different decision altogether, and in general you'll be better off doing it on your own than getting cash value life. In choosing among insurance companies, I would make a decision based on cost (because term life is basically a commodity--it's the same thing regardless of who it comes from) and reputation.

I hope I was able to sufficiently answer your questions. Good luck!

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