Insurance is a contract between you and an insurance company to protect you from potentially costly events. You pay a premium to the company, and it insures you against various unpredictable occurrences:
- Insurance can provide you or your family with replacement income if you die or become disabled.
- You can protect valuable assets, such as your car or home, as well as liability for accidents you're responsible for.
- You can reduce the impact of unexpected expenses with health or long-term care costs.
I'm a big believer in insurance because you want to protect yourself against losses that would dramatically alter your lifestyle, as long as you can afford the premium. However, the insurance industry makes additional money by combining investing and insurance. That's where we part ways.
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This insurance/investment combination sold to consumers is generally found in so-called permanent insurance offerings, which provide both insurance protection and a cash value. These include policies known as whole life, universal life, variable annuities and equity indexed annuities, now rebranded as fixed-indexed annuities. Whether or not they are pitched as "investments," they are shown as a way to grow your nest egg.
I've studied these types of policies for many years and can tell you that most make rocket science look simple. So, rather than tackle each one in a 5,000-page post, let me explain how this works, using travel agents as an example.
Travel agents were intermediaries practically all of us once used because they were the only ones with access to real-time information on flights and hotels. They profited by providing consumers this information and took a commission as compensation for these services. When the Internet gained traction, suddenly we all had access to the same information, and most of us no longer needed agents' services, saving money by booking directly.
Investing through an insurance company is no different. You can either do your investing directly using low-cost products, such as index funds or bank CDs, or you can do it via an insurance company. If you use an insurance company, you pick up two intermediaries - the insurance company and the agent. The insurance company takes the portion of your money that didn't go to commissions and premiums and invests in bonds and stocks, which you could have bought directly. Each of the two intermediaries profits from your money. You also pay more in fees than if you invested directly. The only difference is, you don't necessarily need the Internet to bypass the agent and insurance company.
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Many insurance products mask this fact in very complex designs that are hard to decipher. I often ask my clients if they think the attorneys and actuaries who wrote the thick disclosure document did it to protect them or the insurance company.
A response I often hear from insurance agents is that buying permanent insurance can provide some savings discipline, as few consumers will buy pure insurance and invest the rest. While it may be true that a bad investment is better than no investment, I suspect that those who don't have the discipline to save are also likely not to have the discipline to make premium payments on permanent insurance, which could cause the policy to lapse.
So my advice is: Never forget the different roles of investing and insurance. The role of investing is to grow wealth, while the role of insurance is to protect it. Mixing the two may lead to disappointment.
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