Evaluating Investment Life Insurance

The bear market in traditional assets has investors in search of different ways to invest their savings. One strategy investors are trying, if sales figures are an indication, is to invest through life insurance policies.

Investment life insurance is nothing new. It was widely-used from after World War II through the 1980s. As the stock bull market accelerated through the 1990s, investment life insurance began losing favor to higher return alternatives. Returns from investment life insurance could not keep up.

Now, investment life insurance is attracting new investors. Returns of 4% and higher are attractive compared to losses of 40% and more.

Investment life insurance comes in many varieties. The oldest version is whole life insurance. There also is variable life, universal life, and variable universal life. The names and details change, but the basic concepts are the same.

Investment life insurance is permanent life insurance. Unlike term life insurance, there is no date when the policy expires. Part of each premium payment is for the life insurance coverage and part goes into a cash value account. The cash value account is invested or earns interest. In variable life, the policy owner chooses how the cash value account is invested from among mutual funds selected by the insurer. Most policy owners selected stock-based funds and saw their cash value accounts decline. That is why variable life is not as popular as other forms of investment life insurance now.

More popular now are whole life policies in which the cash value account is guaranteed by the insurer. The account earns a stated interest rate, currently 4% to 5.5% in most cases. The rate changes periodically, usually annually.

The returns in the cash value account are tax deferred. No taxes are due on the income and gains until they are withdrawn. In addition, the policy holder might be able to borrow from the cash value account, which is a tax-free transaction.

The package can seem very attractive, especially when accompanied by projections showing how the cash value account grows over time. Projections often show that after a period of years the cash value account is large enough that it can begin paying the premiums without additional payments for the policy owner, known as the vanishing premium. Or the policy holder can continue paying premiums to build the cash value account. Then, when money is needed it can be borrowed tax free from the account. The cash value account might grow enough to be able to both pay premiums and make loans for a period of years.

There are, of course, potential downsides to permanent life insurance.

The first disadvantage is the cost of the life insurance is very expensive. Term life is much cheaper. If you do not need the life insurance, this is an inefficient way to obtain the investment benefits. In fact, first-year whole life premiums increased in the last year while overall life insurance premiums declined.

The traditional need for permanent life insurance is to pay estate taxes. Other reasons to own it are to pay debts or fund a business or asset buyout. Permanent life insurance can be an efficient way to make a postmortem charitable gift or to increase the value of estate for heirs. If none of those reasons apply to you, there are better ways to invest your money.

Another disadvantage is the interest rate on the account is not guaranteed, though some policies have a nominal minimum interest rate guarantee. The insurer adjusts the rate based on the investment returns in its portfolio. If the insurer has a bad year in its portfolio, it will offer a lower rate than competitors for the next year. Many insurers offer a “teaser” initial rate that declines significantly after the teaser period ends.

Often, it is not clear what the rate of return earned by the account is. Insurers will state a rate, but it is reduced by various fees and charges before being credited to the account. Determining the credited amount might not be easy. In addition, some insurers overcharge for the life insurance premiums, and then refund part of the premium back to the cash value account at the end of the year.

Inflexibility is another downside of permanent life insurance.

Because of the fees and surrender charges on a policy, the projected benefits of a cash value policy are realized only if the policy is held for 20 years or more. Relinquish the policy sooner, and the realized benefits are much lower or even negative. Despite this, over 40% of whole life policies lapse within 10 years. Purchasing an investment life policy obligates the insured to stay with the insurer and that policy for at least 20 years to realize the expected returns. If the insurer’s interest rate or financial security decline, the insured incurs penalties to change insurers.

Particularly important today is that purchasing an investment life insurance policy means your results depend on the performance of the insurance company. If the insurer’s investments perform poorly or it underwrites risky policies while charging insufficient premiums, your returns could suffer. It is possible for the insurer to go out of business, leaving you to rely only on a state guaranty fund to recover something from the policy.

Investment life insurance was very popular in the 1980s and early 1990s. Interest rates were high, and tax rates were high enough to sway the choice of investment vehicle. But many investors who bought those policies were disappointed. As market interest rates fell, the returns on the cash values of the policies fell below projections. In many cases, premiums reappeared after they vanished because the investment income fell so far below the projections.

Investment life insurance is recommended for a relatively few people. Those who have the permanent life insurance needs listed earlier are the prime candidates. Others are buying the policies now because they want to provide more for their heirs in case it takes many years to recover the bear market losses.

Before purchasing investment life insurance, compare the projected results with the results of purchasing a 20-year term life policy and investing the difference in bonds or other conservative investments. You should not purchase investment life insurance unless you plan to hold it at least 20 years. Of course, be sure to check the financial status of the insurer. Right now it appears mutual insurance companies are more secure than publicly-traded insurance corporations.

The Consumer Federation of America has a web site where you can purchase an evaluation of insurance policies you are considering at www.EvaluateLifeIn-surance.org. (Ignore the hyphen.)

Investment life insurance is very complex. It is difficult to compute your investment returns and what the results would be under different scenarios. Also, the numbers in the projections are not guaranteed. They are based on a series of assumptions that might or might not be realistic.

Even those for whom it is appropriate, investment life insurance is not a magic solution to financial problems and requires a fair amount of work to compare the alternatives and make a good decision.

RW June 2009.