Contracts and Investments
To get started, one item to note is the difference between an insurance contract and an investment. A contract contains guarantees – you do this and I’ll do that. For insurance, this means that if you agree to pay the premiums, the insurance company agrees to pay a certain amount of death benefits. This is not an investment.
An investment assumes that you take on a certain amount of risk for which you will hopefully be compensated. For example, you may purchase shares of stock or a mutual fund in hopes that the value will increase, but if the market tanks, you could lose your whole investment. There are no guarantees with an investment.
The reason I point this out here is to remind you that the main purpose of insurance is risk protection. You can’t protect against the risk of death (everyone dies) but you can protect against the financial loss that might be incurred by a death.
No one thinks of their sofa as an investment - you know its value will decline. A sofa is more like a contract. You agree to pay money for a place to sit and relax, and the sofa provides you a place to do that. It is a piece of furniture to be used for comfort, and when it has served its purpose, it is discarded and you purchase a new one. Or you move it to the garage if you can’t bear to let it go.
Think back to college. Did you have a really nice sofa? A futon? Your grandmother’s 3-ton hand-me-down davenport? My roommate and I split the cost of a sofa that we purchased at a thrift store. We re-covered the cushions with sheets and voila! Whatever seating you had when you were starting out was OK because you knew it was temporary.
Term insurance can be thought of as starter insurance. It is pure insurance against death and provides no investment options. This type of insurance is usually purchased for a specific period of time, such as 10, 20, or maybe 30 years. Each year, you pay a set premium for the coverage. The goal of this type of insurance is to replace income that would be lost due to death. Because there are no investment options, this type of policy is relatively inexpensive, particularly if you are young and healthy.
With term insurance if you win, you lose; and if you lose, your family wins. If you live to the end of your policy term, your coverage ends and you do not receive a refund for the premiums you paid. If you should die before your insurance term is up, your family will receive the death benefits. You really don’t lose, although it may feel like it. You purchased an agreement and both you and the insurance company lived up to the agreement. You purchased peace of mind, and that can be well worth the cost of a policy.
Will term insurance work for your entire life? It may. It depends on your need. As your family grows, you may need more. As kids leave for college, you may need less. In any case, term insurance may work just fine even if you need to keep it a long time. You may need to replace your starter sofa, and you may need to replace your term insurance with more term, or other insurance. It’s an inexpensive way to meet your immediate needs.
Whole Life Insurance
Consider the next sofa you purchased. You were probably out of school and wanted (needed!) an upgrade, but still didn’t have tons of money to spend on furniture. You may have purchased a loveseat that was not too expensive and fit in the small space you had available. You figured you would upgrade one day, and it could always be used in another room, so you could keep it.
Whole life insurance, also known as cash-value life insurance, works as insurance that you can keep – you guessed it – for your whole life. Think of it as having two parts. The pure insurance piece and a savings component. The savings component here is usually a guaranteed rate stated by the insurance company, similar to a savings account. These policies have a minimum guaranteed cash value. Because of the cash savings, this policy is treated as an asset so you may be able to borrow against it if needed. This also makes them more expensive than a term insurance policy.
Variable Life Insurance
What if you wanted a sleeper sofa for company? In case you have never had one, this is a sofa that folds out into a bed. They are very convenient, if a little lumpy, but good enough if you put a memory foam topper on it.
Variable life insurance works very much like whole life insurance, but instead of a guaranteed savings component, you have the ability to invest the cash value portion in market securities, usually mutual funds. This allows your money to grow at a rate that could be much greater than traditional whole life; however, you do run the risk of losing value if your investment loses value. There are fewer guarantees on your rate of return with this type of policy.
Universal Life Insurance
Suppose you have a really large room and want a U-shaped sofa with a pull-out bed, recliner and cup holders. Don’t forget the no stain upholstery, reversible cushions, and matching ottoman with pop-up table and wheels. That would be the ultimate sofa set!
Universal life insurance has all the bells and whistles, making it a very flexible policy. The premiums you pay, the cash values, and the level of protection can be adjusted during the contract to meet your needs. There is also a Variable Universal Life policy in which the cash value is invested in securities and fluctuates with the markets. As with whole life and variable life policies, these policies are treated as an asset and you can borrow against the cash value. There are lots of moving parts to this type of policy which can make them appropriate if you need that type of flexibility.
Which policy is the best?
Insurance itself is not good or bad since it is an inanimate object. Policies are all used with different purposes in mind, so the best one is the one that meets your needs.
Pamela J. Horack, CFP® of Pathfinder Planning LLC provides financial planning advice for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.