Insurance policies are increasingly becoming popular as investment tools. But, one type of insurance often gets a bad rap when it comes to being viewed as an investment tool. Because there is no cash value in term life insurance plans, it’s often viewed as more of a vehicle of protection than a vehicle of investment. That view is a little skewed, though, since term life insurance policies can be a part of an overall investment strategy, by protecting assets.
Whole life insurance can legally be sold as an investment because it has a positive expected rate of return for anyone who keeps their policy for life. Term life insurance has a negative expected return on investment so as a standalone product it is not an investment. This does not mean that it is not a useful part of an overall investment portfolio.
What is Term Insurance?
Term life insurance covers the policyholder for a set amount of time or a “term.” This is where the policy gets its name from. Unlike a whole life policy or permanent life insurance, term insurance only pays out a death benefit if the person being covered by the policy passes away during the term that’s covered.
Most term insurance policies last 20 or 30 years. If the person covered under the policy passes away in that defined timeframe, then the policy would pay out the death benefit to the beneficiaries. If the person covered outlives the defined term — even by one day — then the policy simply expires. Term life insurance is much less expensive than a permanent policy because most people outlive their policy and the insurance company never actually pays out.
Most term life insurance policies are level, meaning that they have a level death benefit and a level premium for a specified length of time.
The Lack of Guaranteed Payout
Because term insurance plans don’t provide a guaranteed payout since most people outlive their policy, they are often seen as a poor investment vehicle. Whole life policies, by contrast, will always pay a death benefit because, as the saying goes, nothing in life is certain except death and taxes.
Whole life policies have what’s known as a cash value because, no matter when the covered person dies, the beneficiaries will be paid a death benefit. The guaranteed payout is often seen, then, as a valuable investment, since there is no chance it doesn’t happen at some point in the future. In fact, this guarantee also creates the opportunity for beneficiaries to borrow against the death benefit in certain circumstances.
Advantages of Whole Life Policies
Whole life insurance policies are often seen as the preferred investment vehicle. One reason is that they provide growth on a tax-deferred basis. Beneficiaries don’t pay any taxes on the capital gains, dividends, or interest the policy provides until they withdraw the proceeds from it. In many ways, this makes a whole life policy similar to a 401(k) or Traditional IRA.
In addition, as mentioned above, you can borrow against the whole life policy’s cash value. If you need money to purchase a home, pay for your kids’ college or finance other investments, you can borrow against its cash value.
This is different than a 401(k) plan, which might impose stiff penalties and fees for withdrawing money early. In addition, not all retirement plans that have tax advantages even provide for the option of borrowing against their value.
Advantages of Term Life Policies
One of the biggest advantages of term life policies is the fact that they have much lower premiums than whole life policies. Because the insurance company is guaranteed to have to pay out, they are taking on less risk by issuing the policy. As such, the monthly premiums you pay to offset that risk are lower. In addition, premiums will be lower based on your age and general health.
Term life policies also provide a lot of flexibility. You can purchase them for as little as 10 years or as many as 30 years in most cases. This gives you a cost certainty when it comes to how much you’ll pay in premiums over the life of the policy. Many insurance companies will also provide you with the option of converting your term life policy into a whole life policy, should you need to do so. While your premiums will increase if you do this, you’ll also create a cash value in the process.
Term Insurance as an Investment
Because term insurance doesn’t have a cash value, most people don’t consider it a good investment vehicle. While by itself, term life insurance is not an investment, it is an important supplement to an overall investment strategy because it provides downside protection. In a worst-case scenario (death of an income-earning insured person) term insurance can fund an investment portfolio and protect against the drawdown of current assets to fund a potential income shortage the beneficiaries may face after the death of the insured person.
Term life insurance has a negative expected return, by itself. This is because people are expected to outlive their policies, so the life insurance company rarely pays out a claim.
Because term life insurance is so inexpensive though, many financial pundits promote a strategy known as “buy term and invest the difference“. This means that someone could purchase a term policy, but set aside the difference in premium between term and a whole life policy, in an investment portfolio. Over time, this has a higher expected return than purchasing a whole life policy alone. This is another way that term life supports an investment strategy, even if it is not by itself an investment.
One of the main reasons is that when you purchase term insurance, you’ll be investing in the security of your beneficiaries. When family members rely on your finances, a term life insurance policy can provide them with the security and safety they need. In this regard, a term insurance policy gives you peace of mind in knowing that, if you were to pass away unexpectedly, your beneficiaries would still be provided for.
The return on investment for term policies is quite significant as well. That’s because of the low monthly premiums compared to the high payout of the death benefit. If there is no benefit paid because you outlive the policy, you won’t suffer a huge loss because of the low premiums. The difference in premiums between term insurance and whole life insurance is why many people will opt for a term insurance plan and then invest the leftover money they would’ve paid toward the premiums of a whole life plan.
An Investment in Financial Security
It’s almost impossible to define the value of security, and that’s one reason why term insurance isn’t often seen as a prime investment vehicle. Term insurance’s value can’t be defined in simple numbers, especially since if beneficiaries do “profit” from the policy, it means they have lost a loved one earlier in life than would normally be expected. The future is unpredictable, though, and term insurance plans provide some stability to beneficiaries in what can often be an unstable world. While other investment vehicles could be used as financial security if a loved one passes away, not many come with unrestricted rules as term insurance policies do.
In fact, beneficiaries are not restricted in any way from how they use the death benefits of a term life policy. It could be used for end-of-life expenses, to pay for children’s education, to pay off a house, to fund everyday expenses, or for whatever else is needed. Not many other security investment options provide that same unfettered access and usage of funds, making term insurance plans a valuable investment vehicle.