Life Insurance is NOT an Investment
Updated: Jan 23
An insurance policy is not an efficient investment vehicle for the majority of families. Anyone who tells you otherwise is ill informed or likely an insurance agent trying to sell you a policy. There are many life insurance companies out whose brokers that pitch themselves as "financial advisors” or "financial planners” when, in reality, they are just insurance salesmen. They will find a way to recommend a whole life insurance policy, or any number of other expensive insurance products, to just about anyone. This is because agents are highly incentivized to sell policies- they are paid on commission. You do not need an insurance agent to purchase life insurance and you almost certainly do not need a permanent life insurance policy.
There are a couple of main types of life insurance; permanent life insurance and temporary, or term, life insurance. One of the most common types of permanent insurance is whole life insurance. For simplicity's sake, I am going to focus on whole and term life insurance, but keep in mind there are a few other variations of permanent life insurance such as variable and universal.
Whole Life Insurance
There are two parts to a whole life insurance policy. Part one is the insurance that pays a death benefit, and the part two is the cash value portion that grows over time. If you die, the life insurance company takes the cash value portion, and your beneficiaries receive the death benefit.
The cash value portion of the policy can be accessed throughout the life of the policy and is typically used as a selling point. This cash value grows tax deferred and you are able to take out a loan against it and do some things that insurance companies love to talk about to sell you. Sounds convenient right? This type of insurance is commonly pitched by insurance salesmen as a "defensive investment" or a "rich man’s Roth." These are thinly veiled lies to get you to buy a whole life insurance policy. At best, these are essentially high yield savings accounts with insurance bundled in, and lots of fees. These policies are riddled with complex fees and regulations, and most families do not have the need for one. It is nearly impossible to get a straightforward answer about how the cash value portion of these policies builds over time, but for the purposes of this analysis, Investopedia provides a realistic analysis:
Term Life Insurance
In a term insurance policy, you pay a premium every year to be insured in the event of death for a fixed period of time. This insurance is usually very cheap and can be obtained for a few hundred dollars per year for a $1 million benefit for young, healthy individuals. This is the type of insurance that I would typically recommend to most families to protect against the death of a family member who earns income. This is the both the most streamlined, and efficient type of life insurance. As opposed to whole life insurance, there are very few fees associated with term policies. There is also no investment portion of this policy, thus they are typically much less expensive than whole life insurance policies. The great thing about these policies is that you can stop paying the premium at any time and discontinue the policy when term insurance is no longer required. A term life insurance policy is no longer needed when, in the event that an income earning family member dies, their family/spouse/children etc. could support themselves without an issues. In other words, the family left in the wake of the income earner's death does not need lump sum payout in order to stay financially afloat without them.
Whole Life Insurance is NOT an Investment
Now I am going to show you why whole life insurance should not be used as an investment and probably not touched by most. Let’s look at a simple term insurance policy versus a whole life insurance policy. For example, imagine a 40 year old male who needs a $1 million insurance policy to cover the loss of their income in the event of death. According to the Value Penguin, the average 20 year term policy for a 40 year old male has a premium of $93 per month. This means that the family will pay $93 per month for 20 years for $1 million of death benefit. According to Policygenius, a $1 Million whole life insurance policy for a 40 year old will cost $1,372 per month. This is over 14 times more expensive than the term policy- for the same benefit!
We are going to assume that in both instances, a death benefit will pay out $1 million, so we will simply focus on the difference between the cash value portion of the whole life insurance policy over 20 years vs. buying term life insurance with that premium and investing the difference.
Here are the policy assumptions that I used for the whole life insurance policy after extrapolating the data from Investopedia on a policy:
After running the numbers, here are the results in both table and graph format. I compared cost, cash value, death benefit, and cost per dollar of death benefit at the end of 20 years:
Looking at the above, can see that in both comparisons of the death benefit and cash value, term insurance is a much better deal. In the first graph, we compare 20 year cost of the policies vs. the cash value portion. For a term insurance policy, I assume that the cash value portion is the difference between the premiums ($1,279) invested monthly at a rate of return of 7%. This means that at the end of 20 years, you would have $338,380 in your whole life insurance policy if you wanted to withdraw it or surrender the policy (not accounting for fees associated with surrender), while you would have $666,229 in an investment account if you just bought the same amount of term insurance and invested the rest- rather than dumping all of into a whole life insurance policy. That’s a difference of $327,849, and its going straight into the pockets of the company and the agent that sold you the whole life policy. These fat commissions are what make whole life insurance such a bad deal for most.
Now, let’s look at the second chart. This illustrates the 20 year cost of both policies, as well as the death benefit if you were to die at exactly 20 years. You will note that this particular type of whole life insurance policy pays a slightly higher death benefit, but that comes at a very steep cost. The last row in the second graphic shows that you pay $0.02 of premium for each dollar of death benefit in a term insurance policy, but you pay $0.29 of premium for each dollar of death benefit in a whole life insurance policy. That means that the whole life policy is over 14 times more expensive than the term insurance policy! If you need or desire additional death benefit, you should simply purchase more term insurance.
I hope that this analysis helped demonstrate why term life insurance is the most effective and efficient form of life insurance for more than 99% of families. There are many insurance agents out there who are paid very handsomely every time they wrongly encourage people to purchase whole life insurance policies, and other types of insurance, that is simply unsuitable and overpriced for families. In summary, when it comes to life insurance, families should be assessing the need to replace income in the event of the death of one of the breadwinners and cover other liabilities like the mortgage or a children's college, and then purchasing enough term life insurance to cover that potential loss.