"You should never mix life insurance and investing." You've probably heard that before, right? Here's the problem with that thinking: you can't do it. You can't separate life insurance from investing. Not really. Life insurance policies require an investment component to function. The only choice you can make is whether you want to participate in the insurer's profits or not. Sometimes, it's worth the hassle of getting a blood and urine test. Here is what you need to know about life insurance investment policies:
Whole life is the most basic form of "investment" life insurance. Premiums are collected and invested in the insurer's general investment account. While not all of the investments in the general account are bonds, many of them are. Insurers attempt to diversify investment holdings so that you can be guaranteed a minimum interest rate on policy cash values. This also ensures that the insurer meets its contractual obligation to provide for a cash value that equals the death benefit amount at your age 100.
Two of the most popular types of whole life used for investment purposes are "participating whole life" and "current assumption whole life."
- Participating Whole Life: Whole life policies may credit dividends based on the policy's death benefit. Dividends may be used to increase the amount of death benefit, they may be paid out as cash, they may be invested with the insurer, or they may be used to pay premiums due on the policy. They are a benefit to you when you use them to purchase additional paid up life insurance. This "supercharges" the cash value growth and forces the policy to function similar to a bond fund. As interest rates climb, you get progressively higher interest crediting to your cash value account. When interest rates fall, you never lose money and you never drop below the contractually guaranteed minimum interest rate specified in the policy. Nice huh?
- Current Assumption Whole Life: Another method to credit excess interest to a whole life policy is to tie the cash value performance, in part, to current market interest rates. As these rates fluctuate, the whole life policy's cash value may be credited with more or less interest. Like participating whole life, you can never make less than the guaranteed minimum.
Universal life is arguably the most complex insurance option on the market, but it was born out of a brokerage firm with a keen eye on elaborate investment strategies. In the 1980s, it was all about maximizing gains using money market funds and other fixed-rate investments while minimizing the costs paid out for the death benefit.
Universal life insurance (also called "UL insurance" or simply "UL") consists of a one-year annual renewable term life policy and an investment account attached to it. The insurer collects deposits and allocates them to a cash value account. The company then subtracts all costs associated with the policy. Finally, it credits interest based on one of several methods that you select at policy issue.
Your investment choices for a universal life policy vary. In general, you may choose between an interest rate tied to current interest rates, investment returns derived from the insurer's separate account (i.e. mutual funds), or an equity-indexed investment strategy managed by the company. The insurer also pays a guaranteed minimum interest rate regardless of what interest-crediting option you choose. If or when the policy's cash value account reaches $0, due to poor policy performance, excessive policy loans, or high policy costs, your policy terminates, and you lose your life insurance.
Here is a visual illustration of how the whole thing works:
Universal life insurance policy
This is the classic "bucket analogy" taught to just about every life insurance agent. My drawing is a bit crude, but I hope you get the gist of it.
In my experience, that minimum rate is almost always 2 percent, but some policies are now coming equipped with a 3 percent minimum guarantee. The insurer also promises you a guaranteed maximum insurance charge (i.e. a maximum amount it will charge you for insurance coverage). However, these policies are designed to function optimally at interest rates above the minimum guaranteed interest rate and below the maximum insurance charges.
How do you make a universal life policy a covert investment? Simple, tell the insurer to "minimize death benefit/maximize cash value" when you first purchase the policy. Use that exact wording: "minimize death benefit, maximize cash value." Most all insurers know what this means, and any insurance agent worth his salt will understand your intentions.
When you schedule your policy like this, you dramatically accelerate the cash value growth in the policy. It's not unheard of to receive returns in excess of 7 percent which makes this kind of strategy similar to investing in a good index fund or even a dividend stock. However, unless you choose mutual funds as your policy investment, you're never investing money into the market. The insurer manages the risk and gives you the lion's share of the returns.
Picture whole life without any of the guarantees and you've essentially got a variable life policy. Variable life insurance works by allowing you invest some or all of your premiums into the insurance company's separate account. Premium payments are fixed, but there are no explicit guarantees on the performance of your policy. Your policy's death benefit and cash value is driven entirely by the underlying mutual fund investments. If your policy's cash value reaches $0, your policy terminates and you lose your life insurance.
When To Use Life Insurance
A lot of folks tend to take an "all or nothing" approach to insurance. You don't have to put all of your money into a life insurance policy, but I think it's a mistake to overlook this strategy altogether too. It's an excellent way to built a financial foundation. The policy's cash account is extremely liquid, in most cases it's guaranteed against loss, and it earns a very competitive rate of return. It's exactly what most conservative investors would be looking for: stability in an unstable world.
David Lewis is the owner and founder ofTwin Tier Financial. He is a member of the International Association of Registered Financial Consultants and author of over 1,500 articles on business and personal finance. Want to learn more about life insurance investment policies? Visit: http://www.twintierfinancial.com/whole-life-insurance-rate-of-return/