How can life insurance possibly work as investment?
Every here and there I hear about the following investment option: There’s an insurance company that is willing to take my money and hold it for some very long time (like 5 years or more) and then repay it together with some rather conservative investment income.
I don’t get one thing. Insuring is done against a specific risk. For example, I can insure my apartment against being destroyed. The apartment maybe gets destroyed, but that’s rather unlikely. The point here is that I see such destruction as negative and am willing to pay for the policy to be protected against the risk. The insurance company will also see that event as negative – if something happens they have to pay. And again, the event is likely to not happen.
Meanwhile the above-mentioned option includes the policy according to which the lump sum is repaid in cases of either
- I survive and live up to the policy term end or
- I die prematurely before the term ends
and points 1 and 2 are both called risks. What puzzles me is that they are mutually exclusive and either will surely happen.
For example, if I buy such investment now for 5 years then in 5 years I’m either dead or alive and the insurance company has to pay. So yes, it can be called risk, but this risk will happen for sure. I can’t see how anyone can be insured against something that will surely happen.
I know that and they know that. Where is insurance here?
First, you need to understand how modern insurance companies operate. On the front end, they write contracts with customers, collecting up front premiums, and promising to pay out to cover future losses. Efficient premiums cover exactly what’s paid out; if you charge too much customers leave for competition, and if you charge too little the company goes under, or at least loses money. Large armies of people are employed to accurately guess future risks, hopefully to the point of certainty you have in human mortality.
So over time, they will pay back those premiums. And there’s a constant stream of new premiums coming in to replace money going out. So there’s this effective pool of money they can use to buffer against large losses with; it’s called float. And when the pool of money remains relatively constant, they can invest it longer term than the people who comprise the underlying risk. Large insurance companies like Berkshire Hathaway function in this manner; it’s where Warren Buffet finds capital to invest while hiding from Wall St in Nebraska.
The way these companies profit is by making sure the equation works:
Payouts could be just payments for insured risk. But they could also be for the whole life insurance you’re running across from time to time. These contracts offer the insured the chance to invest their money with the people who invest the float. And as long as the return on float is greater than the return they’re offering, it’s still profitable for the company. Since this guarantees suboptimal returns for you, it’s usually a good idea to buy term insurance (much cheaper) and invest the difference yourself.
To one extreme, there’s term. Aside from the commission, the premium is buying insurance and that’s it.
But when the tax and math wiz guys started to get together, they were able to use insurance as a wrapper to create products that might have some tax benefits. Whole life created a product that had an investment component which was able to pay the ever increasing premium costs. To the other extreme, there are variable annuities with a fixed $20/mo mortality fee which on a large valued account can be a tiny fraction of a percent of the funds invested. In effect, it’s not an insurance product, but an investment, one that wrapped in a very thin insurance veil to keep it away from certain security regulations. This is likely the product you are being offered, or some variation of it.
This is snarky, but I really consider life insurance only to be an investment for THE INSURANCE COMPANY, if you don’t have dependents who will need the insurance in case you are hurt or die.
Another thing that insurance companies try to do with these types of vehicles is to promote the “cash value” of the policy. The longer you participate in the policy, the more your cash value goes up (assuming the investments perform reasonably well). The selling point is that at any time you can take out part of that cash value without impacting your insurance policy. A lot of people see that benefit as being the same as either putting the money in the bank or investing it, when actually they could do better if they did either of those things themselves.
One true advantage of the whole term policy is that if you should fall on hard times and are not able to work, the premium payments can be taken out of the cash value. That way even if you can’t make the monthly payments, the insurance policy basically pays for itself. I actually experienced this myself many years ago after I lost my job and had some health issues. I was out of work a long time, but my life insurance never lapsed. That in itself made it worthwhile for me.
The catch is in the Premium amount you pay.
In a pure term insurance, there is no survival benefit. You get paid only for the event, i.e. when you die during the policy term, the sum assured is paid to your nominee.
The money back on the other hand, charges a huge premium, typically 5X more than the pure term, part of it is for the risk cover. The balance is then invested in safe instruments and at the end if you survive you would get that money. Typical calculations would show that if you had yourself invested the difference in premium even in CD’s you would get much more money back.
The reason this product is available in the market is more of people cannot part with money when they don’t get anything back. To these vast majority, it looks like insurance company is taking all their money and doesn’t give them back if they survive. Hence to make it seem better to these vast majority, there is money back. Hence people all over the world buy these policy much more than a pure term policy.