Life Insurance

In the middle of the Superbowl my old buddy Joe Felser said to me, “Here’s a bet for you, Hank. A guy offers to pay $1 million to your estate when you die. To get the million, you have two options. Pay him $20,000 a year for the rest of your life. Or pay him $50,000 a year for eight years and the deal is made. But there’s a wrinkle. If you take the $50,000 alternative, after the eighth year you can borrow back the entire amount of your contributions. You would have to pay interest on the loan, but it will be there if you need it. You want to make the deal because you want your estate to have the money when you’re gone. But which option do you take?”

“I don’t know,” I said.

“Think about it, and get back to me.”

Joe was describing two life insurance proposals that he had received that week. Joe is 60 years old and in good health. According to the charts, he should live until he’s 80 — which means he has a 50-50 chance of dying before 80 or living past it.

There are two big issues in making a life insurance decision: the cost and the value of the benefit. The added wrinkle Joe told me about is called the cash value build-up of a whole life policy. It’s a borrowing limit available to the owner of the policy. It makes it more difficult to compare the values of term and whole life policies. But for many people it doesn’t add a lot of value, as I explain below.

In the old days, life insurance companies said that they sold two different products: whole life and term. Whole life was called permanent insurance because it covered you for your whole life. Term on the other hand was temporary. A term usually lasted for five years, although you were often guaranteed the ability to renew it when it expired — at a higher price since you were older.

But what Joe described to me was “Term to 100.” That’s permanent insurance just like whole life. It has a set premium for as long as you live, which is safer than renewable term. So really it makes sense to think of Term to 100 and whole life as nearly identical products with different payment plans.

Which brings us back to the price. When we think of money paid over a period of time, we must consider the present values of dollars spent. The reason that Joe can pay $20,000 per year in premiums and be guaranteed a payout of $1 million (which is kind of a miracle if you think about it), reflects the truth that a dollar received in the future is worth less than a dollar received today. That’s because cash can be invested to yield a return. If the company promises to pay you $1.00 in a year’s time, it needs to invest about 93 cents today to earn that dollar. So a dollar in a year’s time is really worth 93 cents today. Assuming the insurance company earns 7% on its money, it would need to invest just $277,000 to have a million dollars in 20 years. If the company did better with its money, say it earned 10%, it would need to invest only $138,000. That’s important, because the higher the rate of return, the less money the insurance company needs to invest to achieve its $1 million goal. Investments are tricky things at best, but insurance companies are among the investment champs. They have to be since their investments will be used to fund the payouts they’ve guaranteed.

To figure out the present value — “PV” — of the cost of the two policies, I discounted each payment using an interest rate of 7% — which is what Joe expects to earn on money he invests. Once you look at it this way, it’s clear that the term policy is cheaper if Joe dies young. For example, if he died in one year, the term policy would have cost $20,000. The whole life policy would have cost $50,000 (see chart). Joe’s agent assured him that if he lived a long time, the whole life policy was a better deal — and that would be true if we were concerned with nominal dollars instead of present values. But to get a real understanding of the situation, we have to use discounted dollars. Discounting helps us understand the relationship between the premiums paid and the money received.

If Joe lived 30 years he would pay term premiums of $600,000 (30 years x $20,000). That’s more than the whole life cost of $400,000 (8 years x $50,000). But when we look at the present values of those premiums, a different picture emerges (see chart). The present value of term premiums to age 90 is $295,000. That’s lower than the $329,000 present value of whole life. The difference lies in the timing. Since the term premiums are paid later, they’re worth less. In fact, even if Joe lived to 100, the present value of the term policy doesn’t exceed the present value of the whole life.

Discounting reminds us that the value of the death benefit declines over time just as do the premiums we pay. When we buy term, the value of the dollars we spend on coverage erodes in lock step with the dollars we will receive. There’s an equivalency of dollars-in and dollars-out that doesn’t exist with whole life.

But whole life does have a special wrinkle — the cash value account. In the sales process, a lot of time is spent talking about the cash value, the investments you can make with it, added insurance you can buy with it, and how much you can borrow from it. That’s confusing since the cash value isn’t an asset the way most of us think of assets. It’s simply the amount the company will lend you against the future proceeds of the insurance you’ve already paid for. In most cases, paying more for this option doesn’t make economic sense. The company is extremely careful to structure the cash values and attendant loans in a way to benefit itself.

So my advice to Joe — buy term to reduce your family’s risk. Don’t use insurance as an investment substitute. It’s too expensive for that. And before you buy, do the present values. The agent won’t do it for you, and it’s the only way to figure out what you’re really getting and really paying.

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. E-mail hbulmash@bulmashcullemore.com

present value (PV) of Life Insurance Premiums Compared to PV of $1 million payout