Thursday, May 13, 2010

Back to Basics: Life Insurance Edition

At a consumer-driven bulletin board to which Bob and I frequently contribute (Bob more than I, since he has more knowledge and experience), I recently became entangled in a kerfluffle involving the misuse of life insurance. The subject at hand (deconstructed here) stands on its own, but I'd like to revisit some fundamentals regarding how permanent (in this case, Whole Life) insurance policies work, and don't work.

The first concern is need: that is, how much life insurance is appropriate for a given individual (or couple, or family). This is paramount: without an assessment of the risk (i.e. the net financial cost of one's demise on one's family or business), it doesn't matter what kind of policy one buys. Simply buying a policy without regard to that underlying metric is a waste of one's time and money.

The second concern, then, is time-frame: that is, for how long will one need the insurance in force. Ideally, the appropriate amount is that which is in force on the day of one's demise. Often, this includes a mix of "term and perm" (permanent), and will be adjusted as one travels life's highway.

Finally, one arrives at the decision that at least some of the insurance will be permanent; to keep things simple, we'll assume it's Whole Life (WL). There are two basic kinds of WL, participating and Non-Participating, Par and Non-Par. Participating policies have a unique and useful feature called "dividends," and it is on these often misunderstood proceeds that we'll focus in this post.

In the life insurance world, "dividends" represent, essentially, a rebate: the insurance company, in determining the cost of insurance for a particular year, miscalculates and is obliged to rebate (or refund) any overage to its policyholders. The key point here is that these are miscalculations, and as such, are not guaranteed from one year to the next. Some companies point proudly to many years of miscalculating insurance costs, and thereby a long history of having to refund these overcharges. But they are equally quick to point out (as required by law), that these refunds are not guaranteed; that is, there is no certainty that next year will yield such a windfall, nor how much it might be.

In addition, these refunds are never to be expressed as "rates of return:" it would be inappropriate to classify a given refund as a percentage, or to imply that this is a valid ROI (return on investment). That's because participating whole life policies are not in fact, "investments," but "protection." The "percentage" is the carrier's rate of return, not the insured's. Anyone categorically stating that a dividend is guaranteed is, at best, misstating their nature and, at worst, lying about it. Which is not to say that dividends are a "bad thing," but simply one of many factors that go into the insurance buying process.

Why all this "inside baseball" about dividends and life insurance? Glad you asked:

If someone offers to you a life insurance plan with a "guaranteed" dividend, run - don't walk - away, because there is no such beast.
blog comments powered by Disqus