Insuring Your Life
Understanding and Choosing the Right Life Insurance
by Deborah Fowles of
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Do You Need Life Insurance?

The choices in life insurance policies are bewildering. Keep one thing in mind: if you don't need it, don't buy it. Life insurance needs vary depending on your personal situation. If you have no dependents, or if you don't generate a significant percentage of your family's income, you probably don't need life insurance, and the money you would have spent on it could best be invested or used elsewhere. If your salary is important to supporting your family, paying the mortgage, or sending your kids to college, life insurance is important to ensure that these financial obligations are covered in the event of your death. It's my personal opinion that life insurance should not be viewed as an investment. Its basic purpose is to ensure financial safety in the event of your death, so you should be sure to choose the right protection and if there IS an investment value, consider it an added benefit, not the primary reason for buying a particular policy.

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How Much Life Insurance Do You Need?

The experts are not in agreement about how much life insurance is enough. It's difficult to apply a rule-of-thumb because the amount of life insurance you need depends on factors such as your other sources of income, how many dependents you have, your debts, and your lifestyle. The general guideline is between 5 and 10 times your annual salary.

What Type of Policy Should You Buy?

Term Life Insurance Policy
Whole Life Insurance Policy
Variable life insurance policy
Universal Life Insurance Policy

Term Life insurance policies

The debate over term versus whole life insurance goes on. Some experts recommend that if you're under 40 years old and don't have a family disposition for a life threatening illness, go for term insurance, which offers a death benefit but no cash value. Whole life offers both a death benefit and cash value, but is much more expensive. The Wall Street Journal has reported that half of all cash value policies are surrendered within the first seven years, making the coverage very expensive because commissions and fees limit the cash value in the early years.

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The basic types of cash value policies include whole life (or straight life), variable life, and universal life.


Whole Life insurance policies

In this more traditional life insurance policy, the premiums stay the same over the life of the policy. The policy stays in effect until your death, even after you've paid all the premiums, which can often be paid up within a certain amount of time. A cash reserve is built up, but you have no control over how it's invested.

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Variable Life insurance policies

Variable life polices build up a cash reserve that you can invest in any of the choices offered by the insurance company. The value of your cash reserve depends on how well those investments are doing.

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Universal Life insurance policies

You can vary the amount of your premium with Universal life insurance policies by using part of your accumulated earnings to cover part of the premium cost. You can also vary the amount of the death benefit. For this flexibility, you'll pay higher administrative fees.

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How Much Will It Cost?

The least expensive life insurance is likely to be from your employer's group life insurance plan. These policies are typically term policies, which means you're covered as long as you work for that employer. Some policies can be converted upon termination.

The cost of other types of life insurance varies greatly, depending on how much you buy, the type of policy you choose, the underwriter's practices, how much commission the company pays your agent, etc. The underlying costs are based on actuarial tables that project your life expectancy. High risk individuals, such as those who smoke, are overweight, or have a dangerous occupation or hobby (for example, flying), pay more.

There are often hidden costs in life insurance policies, such as fees and large commissions, that you may not find out about until after you purchase the policy. There are so many different kinds of life insurance, and so many companies that offer these policies, that I recommend using a fee-only insurance advisor who, for a fixed fee, will research the various policies available to you and recommend the one that best suits your needs. To ensure objectivity, your advisor should not be affiliated with any particular insurance company and should not receive a commission from any policy.

An healthy 30 year-old man could expect to pay approximately $300 a year for $300,000 of term life insurance. To receive the same amount of coverage under a cash value policy would cost over $3,000.

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When choosing life insurance, use the internet's resources to educate yourself about life insurance basics, find a broker you trust, then have the policies he or she recommends evaluated by a fee-only insurance advisor. Don't make the mistake made by many people of buying the wrong kind of life insurance for your personal situation.


(Written mostly for life insurance agents)

by Glenn S. Daily

Life insurance purchases often leave buyers wondering if they did the right thing.  This article provides a framework for making informed decisions. It also discusses some of the tools available for evaluating life insurance products. 

People make dozens of decisions every day without difficulty, but life insurance purchases often leave buyers wondering if they did the right thing. Carelessness is certainly part of the problem; people are amazingly willing to invest money without knowing what they are doing. However, even those buyers who try to be diligent often lack a decision-making framework to be successful.

A Three-step Process
After you have verified that life insurance is an appropriate tool for a financial-planning goal, 1 which product should be chosen? This three-step process is useful for many decisions, including life insurance purchases:

Identify and explain the relevant considerations. You can start with your own knowledge, and you will discover other items by asking people why they
did what they did. Some reasons may seem frivolous, but what is frivolous to one person may be important to another. A good framework can accommodate anything.

Identify the trade-offs involved for each of the alternatives. No product is better than all others in all respects, so trade-offs are always necessary. It may take considerable effort to uncover the strengths and weaknesses of each option, and some uncertainties will always remain.

Weigh the trade-offs and choose the best alternative. Sophisticated quantitative techniques are available, but a casual approach may be sufficient. Initial preferences often change as more information comes into play. As with a good mystery, a product may be a prime candidate and then recede, and you must simply follow the process through to the end.

Exhibit 1 is a starting point for constructing your own list of considerations for three decisions: choosing between term and cash-value life insurance, choosing a term policy, and choosing a cash-value policy.

Choosing Between Term and Cash Value

For most people, the intended holding period will be a decisive factor. Short-term needs require term insurance be cause the high selling expenses of most cash-value products make them uneconomical for short holding periods. Needs lasting into retirement require cash-value products because term insurance is usually a poor value at older ages. If the holding period is uncertain, term is a safer choice.  Term requires a lower initial outlay and may be the only affordable option for the desired amount of coverage; the long-term outlay may be higher, however. From an asset-allocation perspective, cash-value products may belong in an optimal portfolio because a lower long-term outlay translates into a higher after-tax rate of return.

Term is more flexible because it can be dropped at any time with little penalty. It also is easier to understand and does not suffer from the misleading sales practices, inadequate disclosure, and frustrating complexity of cash-value products. The performance of term insurance is much easier to monitor; just compare the premium notice each year with what you expected to pay, or obtain a new quote for competing products.

Choosing a Term Policy
Shopping for term insurance is relatively simple, though not quite as simple as it might appear at first glance.  Cost is likely to be an important factor.  If the goal is to get good value for the money, the solution is simple: buy low-load products and get on with life. It is helpful to compute the present value of premiums for each holding period from I to 20 years. If you put five competitive products side by side, each of them will probably have the lowest cost for at least one period. Level-premium products are often cheaper than annual renewable term if your holding period happens to match the level-premium period, but they may be unattractive beyond that point if you are no longer in good health and cannot "re-enter" at continued low rates.

In evaluating cost, you are therefore faced with two uncertainties: how long are you going to keep the policy, and how long will you remain healthy?  For products with a re-entry feature, the scheduled rates with and without re-entry must be considered. The guarantee period may be important for peace of mind, but insurers in the past have rarely increased term rates on existing policies for fear of driving away the healthy policyholders. Renewability is useful if the client might hold the policy longer than expected. Convertibility may be valuable as well. Obviously, it is more valuable if the company's cash-value products are attractive.

The insurer's financial strength is less important for term than for cash value products because you do not have an investment at stake. Death claims are usually paid promptly even when a company is taken over by regulators. However, financial strength affects peace of mind, and it becomes more important if deteriorating health locks the client into the insurer's cash-value product through the conversion option.

For large amounts of coverage, a portfolio of different types of products may make sense, at the cost of multiple policy fees. A needs projection beyond the first year will provide some clues about how to structure the coverage.


Choosing a Cash-Value Product
Shopping for cash-value life insurance can be as difficult as you want to make it. If the goal is to get good value for the money, the solution is simple: buy low-load products and get on with life. If you want to give every product in the marketplace a fair hearing or match wits with the life insurance industry, you will have to do more work.

The choice of advisor may limit product selection. No commissioned agent represents every company, and agents generally avoid low-load products. Fee-only advisors can recommend any product, but they tend to prefer low-load products. Service after purchase may also be a factor. You must decide if you want to deal with a commissioned agent, a planner or consultant, or directly with the insurer.  For cash-value products, flexibility has several dimensions. Can you adjust the premiums, death benefits, cash values, and investment strategy, both before and after issue? Can you structure the policy so it offers a reasonable rate of return to the beneficiaries at all ages of death and not just before life expectancy? Flexibility varies by product within each type; for example, universal life is generally more flexible than whole life, but not always. A universal life policy with a bonus contingent on target-premium payments could feel less flexible than some whole-life products.

Financial Strength is Important
Financial strength matters for two reasons: peace of mind and product performance. A useful evaluation should try to anticipate what could go wrong. The available tools for this task are ratings and reports prepared by the major agencies, statistical models based on accounting data, and actuarial reviews.  As with most things, you get what you pay for. An actuarial review could easily cost over $50,000 a company. It would include cash-flow testing under multiple scenarios and extensive discussions with company management to determine if they really know what they are doing. This process is not foolproof, but it is the most direct way to answer the relevant questions. Of course, the insurer must be willing to cooperate with the independent analysts. 

Publicly available ratings cost much less, and their analyses are less thorough. You may have to read between the lines of the full reports to see where future problems might lie. Although the overall track record of the major agencies has been very good, you should not be surprised when a well-publicized slip-up occurs.  Statistical models using statutory accounting data dominate the academic literature on insolvency prediction, and they provide the basis for some financial-strength ratings as well. Success is measured by advance warning of at most three years, and even then the misclassification-error rate is generally 5 to 20 percent. Available techniques include multiple discriminate analysis, logit and probit models, event-history analysis, and neural networks. 

Regulators and actuaries are taking more responsibility for monitoring the financial condition of insurers in order to prevent costly insolvencies, and that is certainly good news for insurance buyers and their advisors.  it is more useful in concept than in practice. Variations have received support in the academic literature on cost disclosure. Again, few agent-sold products can compete with the low-loads on this measure because of the impact of early lapses.

Cash value at some duration say, 20 years for the same premiums and death benefits. This is practical for flexible-premium products, such as universal life, but difficult to implement for fixed-premium products. It may be dangerous to focus on illustrated and actual values for one year because insurers sometimes design bonuses and other features to make their products look better in standardized comparisons.

Value added to policyholder wealth, assuming optimal use of contract provisions. This is appealing in concept because it recognizes that product rankings may well depend on individual circumstances, such as the timing of premium payments, which in turn may depend on specific product features such as premium loads.  This circularity creates extra work for a diligent advisor.

Whichever performance measure you use, you will probably never know if you chose the best product because you will have no way of determining how you would have fared if you had chosen differently. This lack of accountability spares agents from having to answer more questions than they already do.

Predicting Future Performance
Predicting future performance is another challenge, starting with the definition. Here are some possible measures:

Immediate cash value. It is probably unwise to use this measure by itself, but insurance buyers would be far better off if they paid more attention to early cash values. Few agent-sold products can compete with low-load products on this measure because commissions and other distribution costs often exceed the first-year premium.

Ratio of expected present value of all benefits to all premiums. The calculation of this benefit/cost ratio requires discount, mortality, and lapse rates, and predicting Long-term Performance Can you predict the relative long-term performance of cash-value products? All other things being equal, it is reasonable to expect a low-load product to cost 15 to 25 percent less for the same death benefits than a full-commission prod-If you cannot talk about a product for at least five minutes without reference to a sales illustration, you do not know much about it, and no stack of illustrations will change that. on A.M. Best's latest 20-year dividend comparisons, along with readily-available information that you could have used in 1973 to make a 20-year prediction. It is not an encouraging picture.

Life is full of uncertainties, and that applies to life insurance products as well. Keeping that warning in mind, what are the available tools that might be useful in predicting relative long-term performance?

Actuarial pricing techniques. Since insurance companies have some control over product performance, it makes sense to look at products from the insurer's point of view.  The policy values the buyer sees are the result of premium deposits, interest credits, and mortality and expense charges, similar to the activity in an interest-bearing checking account. This activity may be explicitly shown, as with universal and variable life, or hidden, as with traditional whole life and adjustable life.

The load structure follows from the complete set of pricing assumptions, which are based on the company's view of its experience. Before a product is introduced to the marketplace, actuaries usually perform a series of "profit tests" to verify that the pricing is reasonable in relation to the company's own goals. These calculations are similar to the discounted cash-flow analyses that planners use in evaluating investments.

The main difference is that it takes more work to figure out the relevant cash flows for an insurance product.  Distribution costs are a primary determinant of performance. For a typical block of agent-sold policies, the expected present value of all distribution costs is 15 to 30 percent of the expected product. Of course, all other things are never equal, so it is logical to ask how unequal they would have to be to offset the difference in distribution costs. Profit testing can provide some answers, and it is curious that it is so infrequently used for this purpose.

For typical pricing assumptions, you will generally find that a full-commission product needs a combination of competitive advantages to match the 20-year performance of a low-load product; one advantage alone is not likely to be sufficient, even when consulting fees are taken into account. For other performance measures, such as the benefit/cost ratio, there is probably no plausible combination of competitive advantages that can offset commissions.

One obvious obstacle to the use of profit testing in due diligence is that insurers regard most of their pricing assumptions as proprietary. You cannot solve this problem by using financial-statement ratios as a proxy for product-specific pricing assumptions because these aggregate ratios are affected by product mix, age distribution of insureds, and other factors.

Past performance. In a statistical sense, the correlation between past and future performance is probably stronger for cash-value life insurance than for most other asset classes. However, there is still a significant risk of disappointment; about one third of the companies in the top quartile of whole-life performance for 1970-80 were not in the top quartile for 1980-90. In addition, dividend histories may not be relevant for new types of products, such as second-to-die, and long-term track records are not yet available for universal and variable life.

The limited data that is available can be misleading. For example, in A.M. Best's latest 20-year dividend comparison, USAA is ranked 17th. However, it is well known that during periods of high interest rates, cost indexes computed at five percent penalize companies with low premiums. USAA had the lowest premium of the products surveyed; if a reasonable adjustment is made to correct the penalty, 8 it would be ranked 4th.

Illustrated values. Sales illustrations can be useful if you know what you are doing and dangerous if you do not.  They can help explain how a product or sales concept works. The problems arise when they are used to predict relative performance. Without an understanding of the underlying assumptions, and a test for reasonableness, it is easy to be misled. If you cannot talk about a product for at least five minutes without reference to a sales illustration, you do not know much about it, and no stack of illustrations will change that.

As with past performance, there is a statistical correlation between illustrated and actual performance, but there is also a considerable risk of disappointment. 1 Illustrations are better at screening out inferior products than guiding you toward superior ones. Illustration games have probably increased in recent years, so any conclusions drawn from the past should be adjusted accordingly.

In today's marketplace, lapse-supported pricing is the most powerful technique used to improve illustrated values. The idea is to take money from policyholders who drop out early and invest it to provide higher long-term values for those who remain. Three things have to happen to make this work:

1. The client has to keep the policy in force.

2. Many other people have to drop their policies.

3. The insurer has to play fair and use the proceeds from early lapses to boost later values.

Consumers embraced lapse-supported pricing 100 years ago with disastrous consequences, 11 and you should not be surprised if this new experiment produces another cycle of lawsuits in the early 21st century.

Two Promising Strategies
Where does all of this leave insurance buyers and their advisors? Two strategies seem promising:

Focus on distribution costs. If you know that a company has low distribution costs and no serious shortcomings in other important areas, such as investment yield, mortality experience, and target market, you can place a bet on future performance with more confidence than other information permits.

In today's marketplace, you can make a rough estimate of distribution costs by looking at the first-year cash value in relation to the premium, a high value usually indicates that commissions are low. Of course, this simple technique will not work if the insurer pays levelized commissions.

Diversify. You can construct attractive portfolios of products with diversification across several dimensions, including product type, investment strategy, flexibility, and distribution method.

Unfortunately, this may be feasible only for large purchases, due to policy size minimums, policy fees, and banding.  Many people who buy life insurance are not sure if they made the right choice. By approaching the decision with a framework that respects individual preferences and encourages information-gathering, you can feel that at least you did the best you could,

GLENN S. DAILY, CFP, is a fee-only insurance advisor in New York City. He is the author of Life Insurance Sense and Nonsense and The Individual Investor's Guide to Low-Load Insurance Products.  He is often quoted by the financial press and is an editorial consultant to Medical Economics. His current research interests include probablistic estate planning and variable immediate annuities. He is a graduate of Princeton University.


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