Life Insurance: What Type?

Recently I had lunch with a friend who is about to get married. Over the meal, the issue of financial planning was brought up. Being a responsible husband-to-be, he thought about taking up an insurance policy to protect his wife-to-be in case he is not around to provide for her. But what kind of insurance is adequate? And how much to buy? I shall first give my opinion to the first question.

There are basically 2 types of life insurance available: whole life policies and term life policies. Whole life policies provide protection for the whole life of the insured. There is cash value in the policy such that at any point of time the insured wishes to stop the policy, he or she may cash in the cash value.

Term life policies protect the insured for a limited period of time. One can, for example, take up a 10-year term insurance for protection over a 10 year period. There is no cash value in the policy, so if the insured decides to stop the policy, he or she cannot get any refund from the premium paid.

Most Singaporeans are sold the whole life policies because insurance agents in Singapore pushing these products in preference over term policies. The reason is simple: they earn more commission selling whole life policies over term life policies.

While insurance agents earn about 5% of the premium paid for term insurance, they pocket about 50% of the premium paid in the first year for whole life policies. Add to that the fact that premium for whole life policies are about ten times that of 20-year term life policies, you don’t need a PhD to figure which products are more popular among insurance salespeople.

Insurance agents will often point to the cash value of the whole life policy to illustrate the advantage of whole policies over term life policies. But one has to remember that the premium for a whole life policy is about ten times that of a 20-year term life policy. It is this extra premium that is creating the cash value.

When you pay the premium for a whole life policy, a small part of it (after paying for expenses of the insurance company like commissions etc.) is used to purchase term insurance for your protection. Whatever is left is being invested to give you the cash value of the policy. If the expenses that the insurance company charged are high, you get a bad deal.

Note that you can achieve the same results by buying a term life policy, save the difference in premiums and invest it yourself. You will still incur expenses when you invest your savings, but you will be in control of it and you can minimize it by investing n low-cost funds (more of that another day). More importantly, your insurance is not tied to you savings and investments so that you may cash in on your investments or withdraw your savings without terminating your insurance and deprive yourself of the protection.

This strategy is known in the industry as “buy term and invest the rest”. Advocates of this strategy include former CEO of NTUC income, Mr. Tan Kin Lian, and New Paper columnist, Larry Haverkamp.