How does life insurance work?
As a business model, life insurance is very simple. You pay an annual premium which the insurer invests. In the event of your death the insurer pays out the agreed amount. Except this is unhelpful. With term life insurance, the amount to be paid out will usually be fixed so the calculation of the premium rate is quite straightforward. However, the life insurance industry only pays out on about 10% of all term policies. The vast majority of people either stop paying or live beyond the end of the term. For investors, this is good news because the premium revenue is almost pure profit when you add in the investment income the term life fund generates. Whole life and universal life policies usually have a guaranteed minimum payout but calculate the actual payout when death occurs. This gives the insurers the chance to manipulate the calculation to ensure they always make a profit. This flexibility makes the for-profit insurance companies a good investment with healthy dividend yields.
Following the collapse of the stock market in 2008, many investors looked for a safe haven in life insurance products. The insurance industry was offering guaranteed dividends far higher than the bond market. They ignored the high agent commissions on sale and the less than transparent accounting practices. Sales of whole life rose by 10%. Sales of universal life were even stronger. At present, insurers are actually paying up to 6% in annual dividends. There's just one problem. One-fifth of all policies are cancelled within the first three years. That rises to two-fifth at the end of ten years. To break even, you need to keep paying into a whole life policy for at least twenty years. So the market loves whole life insurance. The companies collect their set-up costs and management fees, pocket all the investment revenue, and return a small percentage of the premiums when you surrender. The profitability is very high.
Before you start talking to anyone about whole life insurance, recognize a simple fact. Your cash value can fall through charges and fees, the dividends can fall to their guaranteed minimums, and the insurer still has the right to increase its fees and charges for the next year. This leads to two pieces of advice.
- You must shop around. Get as many life insurance quotes as possible from as many companies as you can find. At this stage, do not talk to any agents or brokers who may contact you. This is simply the first step in exploring what premium rates are on offer.
- Talk to a fee-only life insurance advisor or use the service offered by the Consumer Federation of America. What you need is unbiased advice and not advice based on the amount of commission to be earned if you buy a recommended product.
The best advice is usually to buy from a mutual insurer, i.e. a life insurance company owned by its policyholders. If possible, do not buy from a for-profit corporation.