Should I buy a life insurance policy?

Should I buy a life insurance policy? (Several clients have asked recently about life insurance as well as annuities.)

First, you have to decide if you even need life insurance. Are you the sole provider for young dependents? Are there other people who are dependent on your income? Are your assets too limited to take care of these people if something happened to you? Also, life insurance can be used in some sophisticated estate planning techniques. If none of these apply, you may not need insurance.

If you decide that you do, our usual recommendation is to buy term life insurance rather than a policy that includes an investment component like whole life. In general, investments that are bundled with insurance tend to be low performers with high costs. Since they aren’t clearly broken out as an investment, they can also be hard to understand and track.

With a term policy, you simply pay for the insurance you need, which is far cheaper. As a number of consumer advocates have pointed out over the years, you can buy term insurance and invest the difference. In particular, you want to avoid paying an insurance salesperson’s large commission on a new policy – often as much as 4 to 7% (we recently saw a policy with an 8% commission and 5% annual fees).

For our clients, it would likely be a huge mistake to liquidate holdings to buy anything other than a simple term life insurance policy. Not only would you incur capital gains tax and sell undervalued holdings – but you would lose 5% of the money raised in commissions and then reinvest in much lower-quality holdings with high annual expenses.

Worst of all, however, is that today many large financial firms – especially life insurers – are in much worse shape than they appear. So there is a risk that you could pay your premiums but never get the expected payout. In a deflationary environment like the global economy today, life insurers are particularly at risk, since their investments can go down at the same time that people decide that they want or need to cash in their policies.

The 2008-09 financial crisis put a focus on weakness at major banks, but few people have given much thought to major life insurers. Although people who follow the industry have long been aware of the risky investments in many life insurers’ portfolios, recently the New York superintendent of financial services, Benjamin Lawsky, has raised some additional concerns about serious weaknesses in their finances. A June 2013 New York Times DealBook article describes this issue in more detail:

New York State regulators are calling for a nationwide moratorium on transactions that life insurers are using to alter their books by billions of dollars. ... Insurers’ use of the secretive transactions has become widespread, nearly doubling over the last five years. The deals now affect life insurance policies worth trillions of dollars. ... These complex private deals allow the companies to describe themselves as richer and stronger than they otherwise could ... life insurers based in New York had alone burnished their books by $48 billion, using what he called “shadow insurance.” ... The transactions are so opaque that Mr. Lawsky said it took his team of investigators nearly a year to follow the paper trail, even though they had the power to subpoena documents.

Moreover, life insurance isn’t the only product at risk. Annuities have become increasingly popular after the market declines in 2000-02 and 2008-09, since they offer the promise of a “guaranteed” payout rather than the uncertain returns of the stock market. Of course, annuities actually have the same weaknesses that are inherent in insurance policies that have an investment component – high commissions, high annual expenses, lower return, and lower-quality securities backing the policies, etc. But ironically, though annuities are sold for their safety and reliability, the biggest risk is that the issuer of the annuity will fail and not make the payments at all.