First published on LinkedIn, then on my ideabins.blog site. The content is relevant for this site as well!
Category: Life insurance
All posts related to Term, universal, index universal (IUL), whole life (WL), variable universal (VUL), final expenses, mortgage protection, long term care, annuities, survivorship go here.
The Takeaways:
- Most insurance agents never care to ask why the CD-type annuities, otherwise known as Multi-Year Guaranteed Annuity (MYGA), can offer higher interest rates than bank CDs (Certificate of Deposit) do. Lucky for them, most annuity buyers have never asked this question.
- This is a totally legitimate question because money does not fall from the sky but must come from somewhere somehow.
- Some say CDs have a shorter life duration than MYGA annuity contracts. However, this may or may not be true because we do have one-year MYGAs in the market and they still have higher interest rates than one-year CDs.
- The first crucial fact: CDs are offered by banks, while annuities are offered by insurers.
- The second crucial fact: Banks and insurers are subject to different regulations. For the most part, banks face tighter regulations than insurers do.
- Therefore, insurers have the liberty to invest premiums in a variety of financial products: Bonds, stocks, mutual funds, real estate and even financial derivatives. On the other hand, banks make money mainly from interest spread, the difference between the interest rate they pay depositors and the one they charge for loans.
A Financial Fact Deserving Explanation
There is a hidden question that most insurance agents never care to find out what the answer is. It concerns the fact that one of the most popular annuity contracts, Multi-Year Guaranteed Annuities or MYGA, almost always offer higher interest rates than bank CDs (i.e., Certificate of Deposit in case you are not familiar with banking terms) do.
Insurance agents love to sell MYGAs because it is a CD-Type annuity, meaning to keep the premium for annuity like keeping the deposit for CD, but with (much) higher rates. Agents will not miss the opportunity to ask their clients the question of how much interest they get from CDs — all because they can brag about how high the rate is for MYGAs in comparison with CDs. They won’t bother to tell clients why they can offer a higher rate.
Most of the time they run into no problem because, guess what, most annuity buyers don’t care about why they get a higher rate of return, either. It’s human nature that people do not bother to ask questions about good news, they will do about bad ones.
But when something most agents won’t do, it helps make you unique if you can answer the question right. Suddenly your image improves a great deal, and you may even receive voluntary referrals by some admiring clients.
The Simple Answer for MYGA Magic
It does not need a rocket scientist to figure out the MYGA Magic: MYGA is offered by insurance companies (insurers), while CDs are offered by banks. Of course, this may or may not make much difference until we know the difference between their business models (i.e., how they make money as an industry) and industrial specific regulations.
Turns out that insurers have more regulatory freedom than banks do. For one thing, insurers can invest the premium in a variety of assets, including bonds, stocks, and real estate, even financial derivatives, to generate returns. Banks on the other hand are required to maintain a certain amount of reserve and are limited in the amount of money they can lend out. They make money primarily by lending out money to borrowers and use the interest rate spread (i.e., difference between the interest rate they pay on CDs and the interest rate they charge on loans) to gain profit.
Some say MYGA has longer time to mature than bank CDs, but this may or may not be true. We have some insurers offering one-year MYGA and still with higher interest rates than bank CDs.
Next time when an insured asks his /her agent how they can afford to pay so much better interest rates than banks, I hope the agent knows the right answer.
The Takeaways:
- Only half (50%) of the US population owned life insurance policies in 2022, down from 63% in 2011.
- The good news is that the “ownership gap” (between people who believe they should have a policy and people who actually own one, sometimes known as “Need-to-Have” gap) for life insurance is smaller (at 18%) than property insurance (up to 54%). The bad news is the gap has been increasing recently.
- There are two fundamental types of life insurance: Permanent vs Term. A term life policy is for temporary coverage over a predetermined length of time, typically no more than 30 years, while a permanent policy covers policyholder’s entire lifetime ending in death.
- All term life policies only cover death benefit with zero cash value regardless of the length of term, while all permanent life policies accumulate cash value to be used for policyholders before death. Term life policies are much cheaper to begin with, but they all have a specific “expiration date,” after which your premium payment is completely gone if you are still alive. Permanent life policies do not expire and the money you saved will be there — for you or your loved ones.
- For policyholders, the most important “must know” concepts are living- versus death-benefits. The former is designed for policyholders’ own welfare before death, while the latter for the named beneficiaries.
- For a long time in the past, life insurance has been largely driven by “altruistic” death benefit in the sense that only proven (or presumed) death of the policyholder triggers benefit distribution. However, annuities for guaranteed post-retirement income, critical care insurance for acute illnesses and long term care for chronic illnesses, these have changed the game profoundly.
Last time the Kingstons talked about inflation and central banks in relation to decentralized finance or DeFi. Today they decided to talk about something more practical and mundane: Life insurance.
Lily: Yesterday we talked about inflation and local reservoirs for holding the flood of money directly from central banks. Kim mentioned household savings as the terminal end of reservoirs, and I talked about life insurance policies as an alternative to household savings. Can we talk more about life insurance today? Part of my job involves marketing life insurance.
Kimberley: That sounds interesting, unless Mom and Dad had something else in mind.
Joy: Insurance is fine with me, especially life insurance, as many people bought auto insurance because the law says they must, but I assume life insurance is not as popular as auto insurance.
Lily: I’m glad you mentioned that. My company invited a knowledgeable speaker from a top life insurance company to educate us last week, and everyone feels they are gaining a lot. The speaker made frequent referral to this website called bestliferates.org during his presentation. Check that site out if you are interested. The only thing is that it covers data up until 2020, not the latest. Anyway, in 2020, only about 54% Americans had life insurance.
Kimberly: So barely over half the people are covered by life insurance in this country.
Lily: Yeah. That 54% is called the rate of “market penetration” for life insurance. Here is the bad news: Over the past decade the penetration rate has been moving downward, meaning fewer and fewer Americans have life insurance coverage today than before. In 2011, for example, 63% Americans had life insurance, but only 54% did in 2020, almost a 10% decrease.
Jason: I wish we knew more recent figures, like from last year.
Lily: We do, actually. This website called Statistica.com tells us that in 2022, based on the LIMRA, which stands for Life Insurance Marketing and Research Association, and Life Happens’ 2022 Insurance Barometer study, the penetration rate was 50%, 4% lower than 2020.
Joy: Hmm. Did the speaker explain why the penetration rate is down?
Lily: He did — at least partially. He talked about insurance “ownership gap” or “need gap,” which is the difference between how many people believe they need life insurance and those who actually own one. Sometimes it’s called the “Need-to-Have” gap. So if 50 out of 100 people believe they need life insurance but only 30 of the 50 actually own a life policy, that gap is 50% – 30% = 20%, meaning life insurance companies have a big job to do to get that 20% to buy life policies.
Jason: Wait, what is a “life policy?” Isn’t a “policy” a rule or regulation like “No gun in school” policy or no racial discrimination policy?
Lily: I don’t know why an insurance contract is called “policy” or “plan.” If I must guess, it may have something to do with the “contract of adhesion,” meaning in an insurance contract only one party, usually the “insurer” or insurance company, fixes the terms of the contract and the other party, usually the “insured” or policyholder, must accept or reject it. So this is like government or authorities make policy and citizens must obey it.
Kimberly: Back to the ownership gap, I just want to make sure I get it. You said if 50 out of 100 people wanted life insurance but only 30 had it, the ownership gap is 20%. Now, let’s say 45, not 30, of the 50 people had a life policy, the ownership gap would be only 5%, right?
Lily: Right. The good news is that compared with property insurance, life insurance has a smaller ownership gap, meaning more people who want a life policy will get one. I remember reading somewhere that says the ownership gap was huge in properties insurance when we look at property losses from natural disasters. We are talking about trillions of dollars there.
Greg: You are right. The most reliable source for that is reinsurance companies, you know, those provide insurance for insurers, or “insurer of the insurers.” I read …
Jason: So why do we need reinsurance companies if we already have insurance firms?
Greg: Well, it’s a way to control or rather to transfer risk for each insurance company. Think of why we buy insurance. We buy a policy because in case something happens to our home, our auto, our health, our income, or our capability to live a normal life, what can we do about it?
Jason: Not much. We just hope bad things don’t happen to us.
Greg: This is a common mindset but seriously, there are several common strategies in handling risks. One is avoiding, meaning if driving is risky of traffic accident, we don’t driving at all. Another is risk retention, meaning we simply accept the risk and swallow the consequences.
Jason: These are not insurance, right?
Greg: No, of course not. If everybody is avoiding and accepting risks, there is no business doing insurance. The idea behind insurance is transferring risk, not avoiding, not accepting. Insurance is basically a deal or a contract between insured and insurer, the insured won’t take the risk by themselves because it’s too much for them to take. So they pay the premium money to an insurer and ask them to take the risk for them, in the sense that insurer will pay money to the insured to cover their losses when bad things do happen.
Kimberly: So in that case, insurers need reinsurance just like we ordinary people need insurer?
Greg: Exactly. That’s why reinsurance is called “insurance for insurance companies,” or a contract between a reinsurer and an insurer. Just like we pay premiums to insurers, an insurer also pay premiums to the reinsurer. Anyway, back to the ownership gap in the property insurance world as I was saying, there is a study by Swiss Re, one of the largest reinsurance firms, that says only 45% of global economic losses from natural disaster were covered by insurance in 2022. That means 55% were not insured, which is a shockingly large number.
Kimberly: 55% is for the world, perhaps the US is lower?
Lily: Not necessarily. I remember reading an interesting article on AP news that says our country is Earth’s “punching bag” for nasty weather because of the unique geography. We are hit “by stronger, costlier, more varied and frequent extreme weather than anywhere on the planet.” We also have the two oceans of Atlantic and Pacific, plus “the Gulf of Mexico, the Rocky Mountains, jutting peninsulas like Florida, clashing storm fronts and the jet stream combine to naturally brew the nastiest of weather.”
Kimberly: Interesting! Now, if we take 55% as the ownership gap for property insurance, what is the ownership gap for life insurance?
Lily: Much better actually. The highest life insurance ownership gap came in 2020 at 16% if I remember it correctly. Jason, could you go to the website “bestliferates.org” please? I want to cite numbers there.
Jason: I just found it. Which numbers are you looking for?
Lily: Search for the words “ownership gap” please.
Jason: Sure. It says in 2011 the ownership gap was 7%. The lowest gap was only 3% in 2013, while the highest, like you said, came in 2020 at 16%. But wait, here is another website called Moneygeek.com that has newer figures. In 2022, 50% of Americans had life insurance like you mentioned earlier, but 68% believed they needed life insurance coverage, so the ownership gap is 18%, 2% higher than in 2020.
Joy: Hmm, I was gonna say that the pandemic finally woke people up for life insurance, but I guess that hasn’t been translated into real ownership figure. Instead of reducing the ownership gap, it increases it.
Lily: That seems to be the case. Life insurers really need to do a better job for reducing that ownership gap to a single digit.
Jason: The same website, I mean “Moneygeek.com,” also tells us that of the 50% owning a life policy, 59% bought on their own, while 23% received a policy from employers. The remaining 18% had life coverage from both sources.
Kimberly: Maybe it makes sense to add that 59% and 18% together: These are the people who actively bought life policies on their own, which is 77% or nearly 80%. The other 23% perhaps don’t count as much because they were given a policy by employers or someone else. After they retire or leave the job, they may or may not have life insurance.
Lily: You are right. Employer provided life policies are a part of employment benefit and are almost always group life policies. Many group life policies automatically terminate once the employee leaves the job. Some companies may offer “portable” policies that continue to cover you after retirement but that’s rare and there is no guarantee. Therefore, if a life policy was given by the employer, the person may not continue after retirement.
Jason: Wait, what is group life insurance?
Joy: It’s a type of insurance offered by employers or organizations to employees or members. There is a single “master” contract between the employer and the insurer, but covers everyone or at least full time members for the employer. Each employee or member receives a certificate of coverage. Because of its coverage to many people, its price is usually lower. This is just like buying stuff from Costco, when many shoppers buy in bulk from the same place the price goes down.
Greg: I wonder whether we should completely ignore group life policyholders. The way I understand it, employer-sponsored group life insurance comes in two types: Basic and Supplemental. Basic group life insurance is a policy offered as an employee’s benefit, typically free or highly affordable. In addition, they are often guaranteed issues, meaning you will qualify regardless of your age or medical history.
Kimberly: That makes sense: If someone is still working, they can’t be too old nor too sick. But why would anyone buy supplemental policy if they have the basic policy?
Joy: Because a basic life policy is what its name says: Basic, in the sense that it only provide basic or barebone coverage. I remember reading an article on Forbes Advisor that says the basic policy typically pays the amount that’s equal to one year’s salary, or a lump sum that is, depending on the employers, typically only around $25,000 according to a survey of compensation. That’s not enough for many if not most people.
Kimberly: So people buy additional supplemental policy to get more coverage for themselves or for someone else?
Joy: Both. They can choose to add additional coverage for themselves, or they can buy additional coverage for spouses and children. It is also called voluntary life insurance and typically bought from the workplace. You obviously need to have basic insurance before you buy supplemental. According to the article by nerdwallet.com, “Maximums typically hover around $500,000 but can reach into the millions of dollars. In some cases, managers or high-level executives have access to higher amounts than rank-and-file employees.”
Kimberly: Basic policies are guaranteed issue, how about the supplemental policy?
Joy: Generally no. At the minimum, health questions or even a life insurance medical exam may be needed. Employees usually will have to buy it with their own money, although for spouse or child the prices are generally cheap.
Kimberly: You talked about having a master contract for the entire group of employees. How does the employer sponsored group life insurance work?
Lily: Most group life are term life policies, sometimes you need to renew it every year, called Yearly Renewable Term or YRT. Other times term life policies last longer, ranging from 5 to 30 years. The most popular term is 20 years, followed by 10 year and then 30 years, according to an insurance survey report. Regardless of the length of the term, it’s still term, meaning there is an “expiration” day when the term is over. In general, all term life policies are cheaper than permanent life, meaning you pay lower premium. A group term life policy covers many people, so it’s even cheaper than individual life policy.
Jason: Other than being cheaper, is there any other difference between term- and permanent-life insurance?
Lily: The most obvious difference is that term life provides temporary or limited time protection while permanent life is “permanent,” meaning the coverage is there for the entire life of the policyholder.
Kimberly: Do they really mean that? What if someone lives to the age of 100? Will her permanent life insurance policy still cover her?
Joy: I’m glad you asked. I was reading this article of Forbes Advisor. It says, “many forms of permanent life insurance issued prior to 2004 have maturing dates of 100,” meaning even a permanent life insurance will expire before death. What is bad is that “the policyholder (and their heirs) get nothing, despite decades of paying into the policy.”
Kimberly: That IS terrible. Are they still doing that?
Joy: Not according to the Forbes article, which tells us that in 2018, there were 94,000 “Centenarians” according to the Census Bureau, meaning people who lives past 100. I won’t be surprised if we now have 100,000 centenarians in this country.
Jason: So how do they fix the expiration problem?
Joy: Interestingly they did it in a scientifical way in 2004 using the so called “mortality table.” If you don’t know, mortality table, which is also called life table or actuarial table, is a statistical table that lists the rate of deaths by ages, or more accurately the probability of death over ages. This table is used not just by insurance but also governmental agencies like the Social Security Admin. For example, when you are before your first birthday in the US, your death probability is 0.005837. But when you are 119 year old, you have a death probability of 0.972793, which is close to certainty. Previously the maximum was 100, but after 2004 it is 121 year old.
Kimberly: The new mortality table would offer extended coverage but what about those who bought the policy much early, before 2004?
Joy: Good question. The answer is provided in the same Forbes article: “Many insurers, in addition to updating their mortality tables beyond age 100, have added a Maturity Extension Rider (MER) to existing policies issued long ago to extend their coverage.” In other words, even though the old mortality table did not have anything above 100, the old policyholders will still be covered by a rider or extension.
Lily: We’ve been talking about permanent life policies and now I want to go back to comparing term and permanent policies. The difference is not absolute because once the term expires when the policyholder is still alive, she can (1) renew or extend it for another term; (2) convert to a permanent policy, or (3) stop the contract altogether. In that case the person loses life insurance, which is not recommended.
Joy: The key difference I believe is that a term life policy gives no value to a policyholder, because it is all about death benefits, meaning the insurance firms pay the beneficiaries money when the policyholder is dead before the term is over. That death benefit is guaranteed. Let’s say you bought a 20-year term life policy and 20 years later if you are still alive, you get nothing back from the policy — unless you switch to a permanent life policy or extend it to another 10 years.
Greg: This is why they say term life is a “using it or losing it” policy. The insurance company that sells 30 year term policy is betting that you won’t die within 30 years, so they get to keep your premium money without paying you anything. This is also why they charge so low a premium, especially for young people, who are unlikely to die in 30 years.
Jason: Sounds like insurance company has good deal: It can collect premium from term life policyholder but not paying death benefit to anyone — unless the policyholder died before the term is over. They should go around finding more people who they believe will still be alive after 30 years and then sell term policy to those people, right?
Greg: It’s tricky to say that insurance companies make money by term life premium. It’s true that term life premium becomes a source of income for an insurer, and if a term life policy paid no death benefit, the insurer would make money from the premiums paid by the policyholder. The same goes to some insurance policies that go unclaimed. Any expired term life policies or unclaimed policies are good news for insurance firms because it means they have collected decades of premiums without paying out any claims.
Joy: I have a feeling that you have more to say on how insurance firms make money. It’s getting late and let’s stop here as we’ve had a long meal today.
The Takeaways
- Life Insurance is better called “death insurance” for most cases because it covers the death of a policyholder and pay the coverage to the beneficiaries.
- Life insurance is the most altruistic insurance of all — to the extent that insurers will pay the beneficiaries rather than policyholders.
- Not everyone is altruistic, which is why not everyone will buy life insurance, especially if they do not a close family relationships.
- The need for long term cares changes everything. Unlike other needs for life insurance, buying long term care insurance is entirely for the policyholders themselves. Given the prevalence of health care needs at senior ages, nobody is safe without the coverage. Another even bigger driver is the cost of long term cares.
- You can buy a standalone long term care insurance or add a long term care rider to a life insurance policy. For most people, the latter is a better choice because a standalone policy is “use it or lose it” without accumulated cash value, while a life policy with a LTC rider allows death benefits to beneficiaries even if it turns out that you have no need for long term care.
Why Do We Want to Buy Life Insurance?
Why would anyone buy a life insurance policy? This is the question I have asked myself lately.
Do not take the question for granted, nor think it’s a no-brainer. After all, life insurance is not what the name may sound like: to insure one’s life. Life is full of risks and nobody can guarantee your life for even a short period of time like one year, let alone your whole life.
This is why many celebrities insure their body parts like voice, legs, hands, or feet? Even for those parts insurers will not guarantee the integrity and functioning of the parts, only compensate their losses.
Sometimes I tell myself that “life insurance” is a misnomer, and for the majority of life insurance policies, a more accurate name should be “death insurance,” because they cover your death event more than anything else, and the main beneficiaries are not you but your loved ones. In that sense, life insurance is the most altruistic or benevolent policy of all types. You really need to have a big heart to buy it.
Life Insurance for Final Expenses
I used to be with a life insurance marketing company that sells nothing but final expenses, meaning the only reason someone buying the policy and pay premium for it is that at the end of their lives their “final expenses” in life, such as the funeral, the cemetery site, and the cost related to cremation, will all be taken care of by the insurance company.
The fact that a firm is selling nothing else but final expenses shows a solid market demand for this type of policy. Apparently for some people, that’s the only reason for them to buy life insurance.
But there are several things to be noticed on final expenses. First of all, strictly speaking, final expense is not exactly nor entirely altruistic because the policyholders are mainly concerned about their dead bodies more than others.
Secondly, not everyone is willing to pay money today for something remotely in the future. For one thing, this is not one of the “hard needs” or “must haves” to consider, unlike foods, water and air. For high net worth individuals, final expenses are too small a portion of the money they leave behind, and are automatically included in their estate. But for those “have nots” it is too little for the beneficiaries. For example, would anyone buy a final expense policy when they still have mortgage outstanding?
Finally, we often hear stories that parents or grandparents decided to leave properties to the youth but then quietly used some of the money that is supposed to be passed down in its entirety to next generation. The truth is that gifts and inheritances are promises but as humans we may or may not be good at keeping the promises.
How Long Term Care Changes Everything
Buying life insurance to cover the need for long term cares makes perfect sense for two reasons: the need for cares and the cost of cares.
Let’s look at the need first. According to the Centers for Disease Control and Prevention (CDC), 70% of people who turn 65 years old will need some form of long-term care services and supports in their remaining years. That is almost 3 out of every 4 seniors, although the length and level of long-term care vary from person to person and often change over time. For example, women tend to need care longer than men, with women staying in long-term care facilities for an average of 3.7 years and men for 2.2 years.
CDC also gives the following percentages for people aged 65 or above:
- Percent of adult day services center participants: 63.3% in 2020.
- Percent of hospice patients: 94.8% in 2017.
- Percent of nursing home residents: 83.1% in 2018.
- Percent of inpatient rehabilitation facility patients: 87.9% in 2017.
- Percent of long-term care hospital patients: 74.3% in 2017.
- Percent of residential care community residents: 94.2% in 2020.
Now consider the cost of long term cares. According to the Administration for Community Living, the average cost for long-term care in a nursing home is $225 a day, which amounts to $6,824 per month for a semi-private room and $7,698 per month for a private room.
Guess what, for an average American, she or he will spend more money during their final stage of lives than they made. According to the Bureau of Labor Statistics, the average salary across the entire country in the first quarter of 2020 was $49,764 per year, which breaks down to $957 per week and $191.4 per working day.
Savings and Retirement Money May Not Cut It
Relying on your savings and retirement money is not a smart idea because it may not cut it for long term care costs. Notice Medicaid, a government program for low income individuals and families, requires meeting a low income threshold. Another government program, Medicare that covers people who are 65 or older, as well as some people under 65 with certain disabilities or conditions, only cover short term, not long term care needs.
This leaves two viable options for most if not all Americans: Buying long term care related insurance and buying life insurance with a long term care (LTC) rider.
Standalone LTC Insurance
When we talk about long term care insurance, this is what they have in mind: A special type of insurance policy that is designed specifically for LTC.
Long-term care insurance is an optional (unlike auto) insurance product that reimburses the policy owner for costs associated with long-term care. It is purchased before it is needed, with the knowledge that many older adults eventually need long-term care. Long-term care is expensive and isn’t covered by traditional health insurance or Medicare.
Long-term care insurance typically has an elimination period lasting 30 to 90 days at the beginning of the care period. This means if you buy a policy today, you will have to wait for at least 30 days, maybe even 90 days, before the insurance begins to cover your need of LTC. The covered person pays for the care during this period, and the insurance company evaluates medical records to determine if the person qualifies for reimbursement for long-term care. If the person qualifies, they can file a claim with the insurance company.
There are two types of long-term care insurance policies: traditional long-term care insurance and hybrid long-term care insurance. Traditional long-term care insurance is becoming less common due to high costs. Hybrid long-term care insurance combines long-term care insurance with life insurance or an annuity. Hybrid policies are more expensive than traditional policies but offer more flexibility.
Long-term care insurance is not cheap, and not everyone can buy a policy. Long-term care insurance companies won’t sell coverage to people already in long-term care or having trouble with activities of daily living. Private savings, Medicaid, annuities, and other insurance can also help pay for long-term care.
One of the most important features of standalone LTC policy is that it accumulate no cash value, so you must use it or lose it.
Life Insurance with LTC Rider
This is the option I would personally recommend. A long-term care rider is just a normal life insurance policy. You will receive death benefit when you die, but before that, you can receive a portion of the death benefit while you’re still alive, if the policyholder is unable to perform at least two of the six Activities of Daily Living (ADLs), they can access the long-term care benefit via the LTC rider. The monthly allowed amounts vary but could range from 1% to 4% of the policy’s death benefit.
The LTC life insurance rider allows you to combine your life insurance benefit and long-term care needs.
It is important to note the followings. First of all, while standalone long-term care insurance policies were more prevalent in the market, they’re now rare and can be expensive. More people opt for the rider option.
Secondly, you want to buy a permanent life insurance, not term life policy. The latter does not have cash value accumulated over time, it works exactly like standalone LTC insurance in the sense that if you don’t use it, you lose it. For example, if you buy a 15 year term life at the age of 30, and by the end of the 15 years when you are 45, you are still healthy and alive, you get nothing back from the policy.
On the other hand, if you buy a permanent or whole life, you pay premium over time and the money will be divided into death benefit and cash value. A permanent life policy will not be “using it or losing it” because the death benefit and cash value are stored like in a bank’s checking /savings account. They stay under your name — unless you prematurely used them up.
Finally, when you buy a permanent life insurance policy with a long-term care rider. You pay a bit extra above and beyond the life insurance premium. Long-term care riders pay either by reimbursement or cash indemnity.
A reimbursement policy means you collect the receipts from everything you’ve spent on long-term care, home health aides, occupational therapists, nursing homes, etc. You submit them to the insurance company, and you get reimbursed.
A cash indemnity policy means you get a set amount of money each month, regardless of how much you spend on long-term care. Some insurers are better than others. For example, Equitable life insurance, which has a partnership with Farmers, allows the insured to hire anyone you like to take care of you, whether your family members, your neighbors, friends or colleagues.
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Why Do I Need Life Insurance?
The Takeaways:
- You don’t have to buy life insurance, but the first reason to consider it is when you have a big and long term financial responsibilities for you or your loved ones, it is to your great advantage to own life insurance.
- Everyone talks about “death benefits” from life insurance because that is often the largest payment from your life insurer, who paid $100 billion to the beneficiaries of policyholders who died in 2021, the highest amount in a single year.
- You don’t have to have a child to buy a life insurance. Living benefits of a life policy give anyone reasons to have a life policy for unpredictable future events for oneself, like accelerated death benefits & secured mortgage payments when one lost job.
- Life insurance involves very personal choices, where a long term oriented mindset matters more than demographics and liabilities. Cultures play a big role especially between American parents and Chinese parents.
- Next to the long term mindset is the long term financial responsibilities one faces, like raising children, saving money for college education of the youth, leaving a legacy in personal cause, mortgage payments, owning a business, and senior long term cares.
Do I must Have Life insurance?
I have heard that question many times in my life. I myself also wondered about that. But the short answer is “No” because, let’s face it, life insurance is not for everyone, or in a flip side, not everyone needs a life policy.
To avoid sounding negative, the safe and sound answer should be “It depends.”
Unlike auto liability insurance that is required by the law, no one will force you to buy life insurance. The urge to own life insurance may come from inside more than outside.
That said, let’s change the question to this: “Why would anyone want to buy a life insurance policy?”
Reasons for Owning a Life Insurance
With the new question we will have a more constructive, more positive answer. We are not talking about why anyone must have life insurance. Instead, we ask for reasons why someone would choose to have it.
Let’s begin from ChatGPT and see what the chatbot would have to say (with my edit).
Here are some reasons why you might need a life insurance policy:
- Demographic Reasons to Protect Your Loved Ones: If you have anyone financially depending on you (spouse, children, or aging parents), life insurance can ensure that they are financially protected in the future when your pass away, allowing your loved ones to maintain their standard of living.
- Business Continuity Reasons to Protect Your Brand or Endeavor: If you are a business owner, life insurance can ensure that your business continues and that your family is protected in case of an untimely passing. Both whole life and term life insurance options should be considered for the reason of protecting your business.
- Funding for Future Expenses: Life insurance can be seen as an investment for future expenses, such as college tuition for your children.
- Peace of Mind: Having life insurance can give you peace of mind, knowing that your loved ones will be financially protected in the event of your passing. It can also provide a sense of security and stability during uncertain times.
The above is just a start, and I’d say it missed at least two things: It does not cover the particulars or specifics of why you should have life insurance and it essentially skips the “living benefits” for policyholders. Let’s get into details below.
Life Insurance Is Very Personal
The first thing ChatGPT missed is your personal choice for life insurance. To be sure, all insurance decisions are based on personal choices, even for auto insurance. The law says every driver must have a liability auto insurance to protect other drivers involved in an accident that is your fault. At the minimum, all California drivers must have:
- $15,000 for injury/death to one person.
- $30,000 for injury/death to more than one person.
- $5,000 for damage to property.
However, you don’t have to have a comprehensive and/or collision coverages that are designed to protect yourself and your autos. Whether you choose to buy those coverages is totally up to you or is your personal choice.
Personal choice matters especially for life insurance because no law says one must buy life insurance. Just because you have a demographic need (a wife, children and/or grandchildren) does not necessarily mean you will buy life insurance. Let me illustrate with real life examples.
Americans Do Not Always Pass Wealth to Heirs
According to an article published in New York Times, “Two-thirds of Americans who have at least $3 million in investable assets have not talked to their children about their wealth or never will.”
Another article by the Atlantic discusses how many grandparents offer some sort of financial support to their grandchildren. Some may choose to keep their wealth private from their own children. This could be due to a variety of reasons, such as not wanting to create conflicts among siblings or not wanting their children to become complacent with the idea of inheriting wealth.
Let me use a hypothetical example. Sam owns a small business with a net worth of $6 million. Sam was divorced with one son, Simon, and three daughters, Ashley, Dawn and Kelley. Sam has decided to pass his wealth not to the offspring but to an estate, which starts from a will, an executor who is in charge of the estate after Sam dies, a guardian for Kelley who is currently only 14 year old, an inventory or an account for distribution of heirs, among other things.
ChatGPT offers several reasons why a life insurance policyholder, like Sam, might name their estate as the beneficiary of their policy (with my edit):
- Simplicity: If you name your estate as the beneficiary, the distribution of the death benefit is determined by the terms of your will. This can simplify the process of distributing the funds to your heirs, as it’s all managed through the probate process, which is the legal process of administering a deceased person’s estate, including identifying, valuing, and distributing the assets, settling debts and taxes, and transferring the remaining assets to the beneficiaries.
- Flexibility: By naming your estate as the beneficiary, you retain control over how the death benefit is distributed. If your circumstances change, you (or the court in California) can update your will to reflect your wishes.
- Protection: If you have debts or liabilities that may not be covered by your assets, naming your estate as the beneficiary of your life insurance policy can provide additional protection for your loved ones. One way is to establish a trust, a legal arrangement where you transfer ownership of your assets to a trustee who manages them for the benefit of your beneficiaries. When you establish a trust, your assets are no longer considered your property, so they cannot be seized by your creditors or debtors.
However, naming your estate as the beneficiary may also delay the distribution of funds to your heirs. Additionally, if you have a large estate, naming your estate as the beneficiary could increase the overall size of your estate, potentially triggering estate taxes.
That said, Sam and his heirs do not need to worry about that because the IRS will charge estate tax only for estates with a value above certain tax exemption threshold. For individuals passed away in 2021, the exemption amount is $11.7 million, meaning any estates valued at or below $11.7 million are not subject to estate tax. Sam’s net worth was only $6 million, way below the tax threshold.
Chinese Want to Pass Every Penny to Heirs Top of Form
On the other end of the spectrum and unlike many American parents, many (mainlander) Chinese parents will treat their children as the most important people in the world, literally more so than their spouse. They will do everything in their power to make sure the children get all the wealth they created, which has been their life goal to begin with. For these parents, one of the favorite way to pass wealth to the next generation is to open an irrevocable life insurance trust (ILIT) account.
This is obviously the topic for another day but briefly, an irrevocable life insurance trust (ILIT) is a type of trust that is commonly used to manage life insurance proceeds. It is called “irrevocable” because, once the trust is established, the grantor (the person who creates the trust) cannot change or revoke it without the consent of the beneficiaries.
In other words, an ILIT is permanent and not meant to be changeable. You really must have made up your mind to pass the wealth down to the trust, otherwise you may get into a lengthy process to reverse it — if possible at all. Some states allow for modifications if all of the beneficiaries consent to the changes. In other cases, the court may have the authority to modify or terminate the trust based on certain circumstances, such as a change in circumstances that makes the trust’s purposes impractical or impossible to achieve.
But Chinese parents are unlikely to change their mind on their children, so this is not really a risk factor for them at all.
There are several benefits to using an ILIT, including:
- Estate tax savings: Since the life insurance policy is owned by the trust, it is not considered part of the grantor’s estate for tax purposes, which can reduce the amount of estate tax that must be paid. Say a Chinese businessman named Mr. Lin owns a net worth of $50 million. He can put $11 million into an ILIT for his 15 year old son, Ben, which is just below the lifetime gift tax exemption that allows individuals to make gifts up to $12.06 million as of 2023 over their lifetime without incurring a gift tax for Ben to pay.
- Asset protection: Because the ILIT is irrevocable, the assets in the trust are protected from the grantor’s (e.g., Mr. Lin) creditors and from any legal claims against the grantor. In other words, even if Mr. Lin owed $2 million debt to the bank, bankers cannot take money from the $11 million in ILIT, which is off limit to all creditors.
- Control: The grantor like Mr. Lin can specify how the life insurance proceeds will be distributed, which can provide greater control over how their assets are used after their passing.
The American example of naming an estate as the beneficiary versus the Chinese example of using an ILIT to pass the wealth down help illustrate how different people choose to work with life insurance differently, which in turn is affected by different cultures and preferences.
Why Death Benefits Matter
Like I pointed out earlier, the ChatGPT answer listed above also missed the living benefits of a life insurance policy. This is understandable as when it comes to life insurance, the thing called “death benefits” quickly come to our mind. This makes total sense as they are typically the biggest chunk of money from the insurer, and will only be sent out after the policyholder is no longer alive.
Not only are death benefits the primary payment from a life insurer but they are not generally taxable income for the beneficiaries.
For example, you have a daughter named Chloe who is the beneficiary of your life insurance policy and when you passed away, leaving a death benefit of $100,000, Chloe gets to keep that lump sum without paying income tax. In fact, Chloe does not even need to report that $100,000 on her income tax form for the year she received the money.
Only under unusual circumstances would Chloe have to pay taxes. One scenario is when she decides to let the life insurance company keep the money to generate interest, Chloe then needs to pay tax on the interest part. For example, say Chloe keeps the $100,000 on the account with the insurer and one year later it generates $500 interest, Chloe would have to report that $500 as income and pay tax on that.
Another scenario is when Chloe’s father bought the life insurance policy through a group life plan, which is typically paid by pre-tax dollars, then Chloe would have to pay taxes and her death benefits will not be $100,000 after paying taxes. Another (unusual) scenario is when Chloe decided to sell the policy (with $100,000 death benefits) to someone else.
Why Living Benefits Also Matter
When prompted, ChatGPT offers the following answer:
Life insurance provides financial protection through death benefits for your loved ones, but it can also offer living benefits while you’re still alive. Here are some listed by ChatGPT (with my edit):
- Cash value accumulation: Many whole life insurance and universal life insurance build cash value over time, which policyholders can use the money anyway they see fit, with the following uses or advantages:
- Tax-deferred growth: The cash value of certain life insurance policies grows tax-deferred, meaning you don’t have to pay taxes on the growth until you withdraw the money. Being able to pay taxes later rather than now saves you money because money has more value today than tomorrow.
- Supplemental retirement income: You can use the cash value of certain life insurance policies to supplement your retirement income. This can be especially useful if you’ve maxed out other retirement savings options, such as 401(k)s or IRAs. This means in addition to the money saved though 401(k) and IRA, plus social security, you have an extra source of income when you retire.
- Collateral for loans: The cash value of a life insurance policy can be used as collateral for loans, such as a home equity loan or business loan. When you need money today, banks can look at your cash value from the life insurance policy and say “Okay, we see you have $100,000 cash value from your life policy and we can loan you $150,000 using that $100,000 as the backup.” Banks won’t say that to someone with no life policy, or with a term life policy that carries no cash value.
- Estate planning: Life insurance can be used as part of an estate planning strategy to transfer wealth to your heirs. Life insurance proceeds are generally tax-free to your beneficiaries. We say “generally” but more specifically the death benefits will be tax free, while the beneficiaries do pay taxes on the cash value that is more than the paid premium. Say Sam has paid a total of $250,000 in premium and the cash value comes out at $400,000 at Sam’s death, due to insurance company investing the $250,000 in the financial market, that extra $150,000 (=$400,000 – $250,000) will be taxable income for any beneficiaries of Sam’s life policy.
- Long-term care benefits: Some life insurance policies offer long-term care benefits, which can help cover the costs of long-term care if you become unable to care for yourself due to an illness or disability.
The above list misses one thing: accelerated death benefits, which allow policyholders to receive a portion of their life insurance payout in advance if they are diagnosed with a terminal illness or critical condition.
Say John has a life policy with a death benefit of $250,000. At the age of 55 John was diagnosed with Lewkemia and will be treated by chemotherapy, radiation therapy, and/or bone marrow transplantation. John is never married and has no kid, but he can talk to his life insurer about getting a portion of the $250,000 death benefits out for his terminal illness.
Accelerated death benefits are typically included as a standard feature in many (whole) life insurance policies so you don’t need any special rider or add-on terms. That said, you do need to meet a few requirements, such as medical documentation of your condition, and other requirements such as minimum age and time since the policy was issued.
Only whole or permanent life but not term life insurance, which covers typically from 10 to 30 years, will offer accelerated death benefit. That said, some term life insurance policies may offer other riders, such as accidental death and dismemberment riders or waiver of premium riders.
Life Policies Are for People with a Long Term Orientation
In my view, life insurance is ultimately for people with a long time orientation. It is one of those things where mindset matters more than demography, liabilities or specific life circumstances.
What do I mean by long time orientation? It means one must think in longer terms like decades rather than years, months or days. The longest term we can think of is cross- or inter-generations like many if not most Chinese parents do.
Sometimes long time orientation comes to us or forces itself upon us. Mortgage protection insurance is a perfect example. It is a type of insurance that pays off your mortgage in the event of your death, disability, or job loss. The most typical term of mortgage is 30 years, which means even if you don’t want to think long term, mortgage payment will force you to act in a long term manner.
Here are some reasons why someone might consider getting mortgage protection insurance:
- Peace of mind: Knowing that your mortgage will be paid off in the event of your death or disability can provide peace of mind for you and your loved ones.
- Protection for your family: If you pass away, mortgage protection insurance can help ensure that your family is not left with the burden of paying off the mortgage on their own.
- Job loss protection: Some mortgage protection policies also include coverage for job loss, which can help cover mortgage payments if you lose your job.
- Simplified underwriting: Compared to traditional life insurance policies, mortgage protection insurance typically has a simplified underwriting process, which means you may be able to get coverage without undergoing a medical exam or providing extensive medical information.
- Affordable premiums: Mortgage protection insurance premiums are often more affordable than traditional life insurance policies, which can make it a good option for people who want protection but may not be able to afford higher premiums.
Final expense insurance is another long-term consideration, where life insurance payment can provide funds to cover your own funeral and burial expenses, which can be quite costly.
Leaving a legacy is another long term concern, where you can leave a charitable donation or other legacy to a cause or organization that is important to you.
Locking in insurability and low insurance cost, this requires a long term mindset to look into the future. If you are young and healthy, purchasing life insurance now can help you lock in a lower premium rate while you are still insurable.
The final scenario that a long term mindset provides motive for life insurance is a business owner, who can pass the business to their heir or heirs through a variety of methods, such as a will or a trust. This is known as succession planning and is an important consideration for any business owner, especially those who want to ensure that their business continues to thrive after their death.
The question is if business owners can pass the businesses to heirs, why would they have life insurance? ChatGPT offers the following answers (with my edit):
- To cover estate taxes: When a business owner passes away, their estate may be subject to federal or state estate taxes, which can be significant, up to 40%. Life insurance can help cover these taxes, so that the heirs don’t have to sell the business or other assets to pay them.
- To provide liquidity: Even if the business owner plans to pass the business to their heirs, there may still be expenses that need to be paid upon their death, such as funeral expenses or outstanding debts. Life insurance can provide the necessary cash flow to cover these expenses without requiring the heirs to liquidate assets.
- To equalize inheritances: If a business owner has multiple children who will inherit the business, life insurance can be used to provide an equal inheritance to children who are not involved in the business. For example, if one child is going to take over the business, the business owner may choose to purchase life insurance to provide an inheritance of equal value to their other children.
- To provide a buy-sell agreement: If a business has multiple owners, life insurance can be used to fund a buy-sell agreement. This agreement ensures that if one owner passes away, their share of the business will be sold to the remaining owners at a predetermined price. The life insurance provides the necessary funds for the remaining owners to buy out the deceased owner’s share.
The Takeaways:
- Property insurance and life insurance are two major categories with different purposes, for different people, and covering different things.
- A trend of late is to see property insurance rate moving up, while real life insurance rate going down.
- One important but little known way of predicting insurance cost is to look at reinsurance cost insurance firms pay to reinsurance company.
- More competition, advanced technology for underwriting, increased life expectancy, better risk management and more informed consumers, these all contribute to a lower cost of life policies.
Property Insurance vs. Life Insurance: An Overview
Did you know one way to divide insurance business is to separate them into property insurance and life insurance? Yes that’s true and property and life insurances make up the biggest categories, in addition to a few other “biggies” like commercial insurance, liability insurance and health insurance.
Property insurance is about protecting physical assets (e.g., personal homes and personal belongings, businesses building and business properties, vehicles) against financial losses from covered perils (i.e., direct causes of loss that your insurer will pay you for) like fire, theft, weather damage and natural disasters. They differ from life insurance in two ways: What they cover and for whom. Simply put, (1) property insurance is always protecting properties while life insurance is always protecting loss of human lives; and (2) property insurance is always designed for property owners, while life insurance is mostly designed for the loved ones of the policyholder, occasionally for the policyholder themselves.
Note property and property insurance are not always the same. It is easy to think of property insurance as for autos and homes. After all, for most families the biggest asset is the house. But insurance terminology does not always work that way. Strictly speaking property insurance does not cover everything related to your house or autos. Remember property insurance only protects property owners? That means whenever your insurance pays money to someone else, that part of coverage belongs to liability insurance, not property insurance.
Consider an easy example: Say you were driving under influence, and you hit Joe’s car, your auto insurance will pay Joe for his bodily injury and his car damage. That money received by Joe is not strictly from your property insurance but rather your liability insurance, even though the same (comprehensive) auto policy of yours will cover both.
Life insurance, on the other hand, protects financial loss caused by the loss of human lives, not physical properties. While property insurance protects property owner(s), life insurance mostly protects others — your loved ones — although it can protect oneself (i.e., the policyholder, see more details below).
Because life insurance mostly protect your loved ones, “death benefits” is a big term that appears in all life insurance policies. This is for a good reason: Death benefits often are the biggest chunk of insurance payment. It is called death benefits because they must be paid after the policyholder is dead, only to beneficiaries (i.e., recipients of insurance payment).
But death benefits are not the only benefits in a life insurance policy. Sometimes we can receive “living benefits” that are unique in two ways: They are paid to policyholders themselves rather than to their loved ones, and they are paid when policyholders are still alive.
This is a topic for another day, and I will not get into details in this post. What I will say is a quick fact that term life insurance can have living benefit as well, contrary to a misconception some may have. For example, a terminal illness rider is typically included automatically on term life policies, providing a lump sum payment if the policyholder is diagnosed with a terminal illness and has a life expectancy of 12 months or less.
Insurance vs Reinsurance
One of the reliable ways for predicting how much premium you and I will pay for our insurance policies is to look at reinsurance cost for the insurance companies like in this report of January 2023.
Many if not most of us have never heard the word “reinsurance” before, or have but did not bother to dig deeper into it. It sounds more complicated than insurance and yet seems to be one of those things that we can afford to ignore in our lives.
In truth, reinsurance has lot to do with how much you and I will pay for our insurance premium. Let me explain. Reinsurance is simply insurance of the insurances, and only insurers or insurance companies can and will buy it, not individuals. That said, the way it works is the same: We pay premiums to the insurers for the right to receive insurance payment in case we have financial loss due to the agreed perils or direct causes of loss. Insurers also pay premium to a reinsurance company so that if during catastrophic events there are more claims than the insurers can pay, they will ask reinsurer to pay it.
Reinsurance is especially important for catastrophes like earthquakes, hurricanes, floods, wildfires, and volcanic eruptions. Human-caused catastrophes can include industrial accidents, terrorist attacks, wars, and pandemics.
Catastrophes could be disasters for any particular individuals, businesses and governments alike. But they are especially bad news for insurance companies as they bring significant financial losses for insurance companies that are unable to cover the costs of claims made by policyholders.
Insurance industry has a quantitative threshold for an event to be designated a catastrophe “when claims are expected to reach a certain dollar threshold, currently set at $25 million, and more than a certain number of policyholders and insurance companies are affected.” According to this article by Triple-I.
You probably think insurance companies all have a deep pocket that can survive any catastrophes with no problem paying insurance claims. In truth, some insurance companies are pretty vulnerable to disasters, which is why you often hear the news that some insurers got themselves into insolvency, meaning they run out of money to pay the claims from their policyholders or clients.
By buying reinsurance, insurance companies transfer some of the risk they have taken on by insuring their customers to another insurer.
From Reinsurance Cost to Insurance Cost
Here is what ChatGPT has to say about how reinsurance premium is related to our own insurance premium to be paid to our insurer.
“Yes, generally higher reinsurance costs can lead to higher insurance premiums for customers… When reinsurance costs are higher, it means that the insurance company is paying more to transfer its risk to another company. To make up for this added cost, the insurance company may pass on the cost to customers in the form of higher insurance premiums.”
Of course, there are many factors that can affect insurance premiums, like the level of risk being insured, the insurer’s expenses, and competition in the insurance market. But reinsurance cost is one of the major factors because it is the cost for the insurers to do business, which is always significant just like in any other business.
But how does reinsurance firm determine how much it will charge insurers? It is not much different from how an insurer determines our premium. The key factors are risks involved, past frequency and severity of claims made, plus industry trends and the overall cost of risk across insurers, allowing reinsurers to set more accurate prices for their coverage.
ChatGPT tells us the following: “If reinsurance rates are high, it may indicate that reinsurers are pricing their coverage more cautiously, which suggests that the overall cost of risk in the insurance market is high. This can lead insurance companies to increase the premiums they charge customers to compensate for the increased cost of risk.”
“Overall, while reinsurance rates are not the only factor that insurance companies consider when setting premiums, they can be a useful indicator of the overall cost of risk in the insurance market and may play a role in determining the prices that customers ultimately pay for insurance coverage.”
Property Insurance Rate Goes Up, Real Life Insurance Rate Down
ChatGPT tells us the following that “it appears that property insurance rates are indeed on the rise in the US. A report by Gallagher Re shows that property catastrophe reinsurance rates for loss-hit US accounts increased by between 45% and 100% at Jan. 1 renewals, indicating a significant increase in rates for property insurance policies in some areas. This trend of increasing property insurance rates is also supported by a recent analysis by Bankrate.com, which found that the average homeowner spends about 1.91% of their household income on home insurance, a figure that has been rising over time.”
This report in Business Insurance cites a report from Amwins Group Inc as saying: “Property markets will remain hard with no softening in the foreseeable future.” “Due to the challenges in the property market, however, reinsurers are being ‘extremely cautious’ with all their capacity.” The reason for property insurance market getting tough is “the combined effects of a major hurricane making U.S. landfall in five out of the last six years, wildfires engulfing thousands of acres, unprecedented winter storms and Midwest flooding. All ‘have played a major role in hardening the insurance marketplace.’”
What about life insurance premium? ChatGPT tells us that the trend of premiums for life insurance policies has remained relatively stable in recent years. This may not sound exciting but wait for taking inflation into account: Life insurance prices remained relatively the same throughout 2021 despite inflation and an increase in death claims. The average monthly cost of a $250,000 policy only increased by a small amount from January 2021 to December 2021.
Combining the above I’d say the “real” (i.e., inflation adjusted) life insurance premium has gone down.
While there is no specific data provided for California, it is likely that the trend of stable premiums applies to the state as well.
It should be noted that while the cost of premiums may remain relatively stable, they can still vary depending on factors such as age, gender, and health status.
Explaining the Decreasing Real Life Insurance Cost
ChatGPT offers several reasons why life insurance rate may go down (with my edit):
- Improved Health: One of the primary factors that influence life insurance premiums is the health of the policyholder. If you have made positive lifestyle changes that have led to improved health, such as quitting smoking or losing weight, then you may be eligible for lower premiums. Note this is an individual specific reason, although modern medical technologies can certainly benefit anyone.
- Increased Competition: As more insurance companies enter the market, there is greater competition to offer more affordable policies. This can lead to lower prices for consumers as companies try to attract more business.
- Lower Risk: Insurance companies base their premiums on risk factors such as age, health, and lifestyle. If these risk factors decrease over time, then insurance companies may lower their premiums accordingly.
- Advances in Technology: With advancements in medical technology, it has become easier to diagnose and treat various illnesses. As a result, life insurance companies may be more confident in their ability to predict the life expectancy of policyholders, and this can lead to lower premiums. The other reason is the use of technology in underwriting, such as using Google Maps for homeowner policies and wearable devices for monitoring personal fitness.
- Economic Conditions: Finally, economic conditions can also impact life insurance costs. If interest rates are low, for example, insurance companies may need to lower their premiums in order to remain competitive and attract new policyholders.
The Takeaways:
- Investing in a time of inflation is essentially buying the best physical and financial products to preserve the value or the purchasing power of your money. The goal is to invest so that your rate of return on investment will beat the inflation rate.
- An annuity is mostly a retirement product offered by insurance companies to provide protected, reliable income for life after retirement. It can help bridge the income gap between the savings you’ve accumulated over time, traditional sources of retirement income, like Social Security and the goal of living a comfortable retirement life.
- The chain of reactions: Inflation entices fed to raise interest rates, which in turn push bond yield high, and potentially lead to higher annuity income. Bond yield is the rate of return earned by an investor who buys a bond and holds it until maturity (i.e., Annual Interest Payment / Face Value x 100.).
- The higher the interest rate, the more money you earn on your annuity. When you’re ready to retire, you’ll have more wealth in your account as a result of earning higher interest, also with regular payment that is inflation adjusted to keep the same purchasing power for your retirement money.
A Common Question People Ask
I’m not sure about you but in my experience one of the most common questions people have asked is what the best investment is today. We can be curious for different reasons — sometimes just for the sake of striking a conversation, other times deadly serious about investing and making money.
Of course, you do not need me to tell you that one of the biggest concerns for today is inflation. Thus, the above question becomes what investment tool we should choose that can beat inflation.
Let’s find out first what ChatGPT has to say. Below is the heavily edited answer, as the original version was too “plain vanilla” for lacking a better word. My hope is to make the explanation easier and livelier.
Inflation means price hikes for goods (e.g., gas, eggs, meat) and/or services (e.g., ridesharing price), which lowers down how much goods you can buy with the same amount of money (e.g., $10).
Sometimes people ignored the fact that inflation must be sustainable for a period of time rather than a short-term phenomenon. You may also hear people saying inflation is “general” price hike, although inflation can be “sectorized,” meaning different sectors of an economy can receive different impacts rather than all sectors move together.
In a farming economy, food price can be a major driver of inflation, but in an energy or natural resource centered economy like Russia, oil price change plays a big role.
A simple, hypothetic example is $1 buys 3 eggs now, compared with 4 eggs before inflation. The value of your $1 decreased and it took one egg away from you (or 25% of its original value was “eaten” by inflation.)
Formally, we say the value of your money decreases, even though a $10 bill will always be $10 on the face value, no matter how long it sits in your wallet. Another way to say the same thing is consumer’s “purchasing power” goes down when inflation goes up. Note value of money comes from its purchasing power, in addition to other factors like its intrinsic value (e.g., gold or silver), acceptance, scarcity, stability, government backing.
General Principle of Investment During Inflation
Regarding what investment is the best for inflation, the idea is this: During inflation most if not all goods are getting more expensive or priced higher. This is the time to ask yourself what specific goods you should buy so that not only your initial investment will not be washed away or severely reduced by inflation, but you make money beyond the invested money — despite inflation.
Let me use an example to illustrate the point. If you believe the price of pork will be significantly higher one year from today, it will be a good idea for you to buy piglets and raise them so that one year later you can not only get your investment money back but with a large profit margin.
The pig example involves physical property. Another example of physical property is real estate. For those not know yet, real estate is known for its value in fighting inflation because housing price and rental income both tend to go up during inflation.
They are like boats: When the water level is up, boats go up with that.
As you can see from the above example, the key to fight inflation is to compare two rates. The first is inflation rate, typically measured by Consumer Price Index (CPI). The CPI is a measure of the average change in the prices paid by urban consumers for a basket of goods and services over time.
The second is your rate of return on investment. Say one year later the inflation rate hits 5%, but selling pigs gets you 10% of return, you win because your return is twice the inflation rate. On the other hand, with the same 5% inflation rate but your pig sales only offered you 4% of return, you know your real return is actually 4% – 5% = -1% or negative 1%, because real return must be adjusted against inflation.
Note sometimes you hear people mixing up “rate of return on investment” and “profit margin.” They are related but not the same. Briefly, profit margin focuses on measuring the efficiency of a company’s operations, while the rate of return on investment is on evaluating the performance of a particular investment, although both are percentage figures.
Investing in Financial Products
Investing in physical properties (pigs, real estate) sometimes is not the most convenient thing to do to earn a high return. To raise pigs you will need the piglets, the feed, the pig farm, the labor and the veterinary, to name just a few. To invest in rental income you must do a good job in maintaining the properties and also in dealing with dishonest renters.
Is there anything else that allows profit but is easy and fast to operate?
You bet. They have a special name “financial products” to differentiate from physical property. The former possess ideal features and should be among your first consideration for investing.
Speaking of investable financial products, in the old days gold came first but not anymore, as there are financial products that do better nowadays. I won’t get into the list of all the investment portfolio options for inflation purpose here. Let’s just consider one financial product that will benefit from inflation: annuity.
A Sideline Story of Eggs
Before proceeding, let me tell you a side story to lighten up the reading a little bit.
Assuming my previous hypothetic example of egg price in inflation is real, does it mean we should all stop buying eggs because their prices are so high and $1 now only gets you 3 eggs instead of 4?
I actually asked ChatGPT this egg question just for fun. Interestingly, although the database of ChatGPT does not cover the latest news, WebChatGPT, a free Google Chrome extension, does that. Every time you ask a question, the app will search three pieces of latest news related to the inquiry and then ask ChatGPT to present a conversational answer drawing from these reference.
Perhaps you already know the answer but formally, no, we don’t want to stop buying eggs if they are important to us. WebChatGPT also correctly points out that “the increase in egg prices is not directly caused by inflation, but rather as a result of various market factors.”
We need to separate consumption from investment, as well as separating segments of consumers. For some people eating eggs is a daily necessity and eggs are their staple food that nothing else can substitute. Others however will be happy to explore alternative sources of protein that are more affordable, such as beans, lentils, and canned fish.
Now let’s switch to the topic of “Annuity and Inflation.”
Nature of Annuity
Let’s begin from ChatGPT again. The following is an edited version of the answer.
An annuity is a financial product that provides regular payments to the owner over a certain period, often for the rest of their life. This means you won’t be too far off if you link annuities to retirement, as they are frequently retirement related investments products.
I say “not far off” because some annuity like immediate annuity provides regular income payments right away for a set period of time or for life, and you don’t have to wait until retirement. Instead, you can begin receiving payments immediately after purchasing the annuity with deposited fund.
Similarly with deferred annuity you may or may not have to wait until retirement — as long as you wait long enough to enter annuity’s “annuitization” phase (i.e., time to receive annuity payment).
You may hear some people calling annuity “annuity insurance” but that is not exactly right — even though annuity is a type of insurance contracts between insurance company and the person receiving annuity payment, or “annuitant” as they are called.
For one thing, insurance, especially life insurance, is designed to benefit one’s loved ones (i.e., spouse or children or any designated party), while annuities are mostly for oneself.
Secondly, annuities usually do not need a particular “trigger event” to start the payout, as long as enough money has been accumulated to pay. Life insurance however always requires that (most likely death but also terminal or chronical illness) to start the payout. In other words, you can’t start receiving insurance payment just because you feel like it. You must convince the insurance company that it’s time for them to pay you according to terms of the insurance policy. Annuity does not need you to do anything in particular, as everything is in the contract and is predetermined.
Finally, most annuity features regular payouts over a fixed interval, while life insurance can have a lump-sum payment to the beneficiaries.
Parties in the Annuity Contract
The typical parties listed on an annuity contract are:
- Annuity owner: The person who buy the annuity either in a lump sum payment or more typically through a series of regular contributions in order to receive regular payments either immediately or wait for a period of accumulation.
- Annuity issuer: The company or institution that issues the annuity and is responsible for making the payments to the annuity owner. This is generally an insurance carrier but can also include other financial service firms.
- Annuitant: The person whose life expectancy is used to calculate the annuity payments. The annuitant can be the same person as the annuity owner or a different person. This is why I say annuity is mostly designed to protect oneself.
- Beneficiary: The person or persons who will receive any remaining funds in the annuity upon the death of the annuity owner or annuitant. However, unlike a life insurance policy there is no guarantee for annuity beneficiary to receive money. It all depends on whether there is fund left in the annuity account when the annuitant died.
Let’s use a hypothetic example to show how annuity works on the high end. I made the human characters up, but the rest of story is reasonably realistic.
Owning a Luxurious Shipboard Condo
Beth is in her 50s and has never married with no child. As a company executive, her personal assets are in the millions. One day she received a phone call from her friend Gloria who is also in her 50s and a female executive in another firm. Gloria suggested Beth to check out the sales materials she received and invited Beth to own one of the “private residential yacht” apartment rooms next to her, in the world’s largest residential ship called MS The World with 12 decks, 165 luxurious shipboard condos built 13 years ago and equipped with every possible modern convenience in each apartment, costing from $825,000 to $7.3 million. Beth and Gloria each must prove a net worth of at least $5 million, then add another 10 to 15 percent for annual maintenance and other fees based on your apartment size.
Beth and Gloria have no problem with provable net worth, the concern is with the regular annual payment for maintenance and other fees. They both want to set up a way to take care of the money. Beth has a Farmers insurance agent friend named Tiffany who heard the issue and offered to help. Tiffany told Beth, and through her to Gloria, that since they both will own the shipboard condos after retirement, annuity would make sense for them.
How Annuity Works
The steps are listed below:
- You make either a lump sum payment or a series of payments into an annuity account. For Beth and Gloria, a one-time only, lump-sum investment makes sense.
- The annuity provider (or issuers, in this case, Farmers insurance) invests money from Beth and Gloria in a portfolio of assets such as stocks, bonds, and other securities.
- The investments generate interest, dividends, or capital gains, which accumulate in the annuity account and are tax-deferred until you withdraw them. Here “tax deferred” means taxpayers owe IRS taxes on investments, revenues, or profits but they don’t have to pay now and can be “delayed” or “postponed” to the future. (If you know the concept of “time value of money,” you know $1 today carries more value than $1 next year, so delayed tax payment is a good thing.)
- Depending on the type of annuity, you may receive payments immediately — if you made a lump sum investment into the annuity like Gloria and Beth will do, or at a future date, either for a fixed period or for the rest of your life. Most people will choose not to receive a lump sum payment. The whole reason they invest in annuity is to get a stream of regular payments month to month, quarter to quarter and year to year. In that case, the annuity issuer (i.e., Farmers in Beth and Gloria case) will write you a check on a regular basis and it’s worry free.
- The amount of the payments depends on several factors, such as the size of the initial payment, the duration of the annuity, and the interest rate or returns generated by the investments.
An important thing to know is that sometimes an annuity can pay you (the annuitant, like Beth and Gloria) more money than you initially invested because the earnings from stock and/or interest rate from bonds are higher than expected.
Beth and Gloria each will invest $500,000, but Beth picks a “Single Premium Immediate Annuity (SPIA)” that provides a guaranteed income stream for life (or a specified period). This annuity is ideal for those who want to convert a lump sum into a guaranteed income stream. It is possible that Beth’s $500,000 may turn out to be $550,000 in the end, due to good marketing performance of the investment by the annuity issuer.
Gloria on the other hand decides to invest in a variable annuity, which is for annuitant with a higher risk tolerance and wants to invest in a range of mutual funds or other investment options within the annuity. Variable annuities can offer potentially higher returns but come with more risk and fees.
Why Is Annuity More Attractive During Inflation?
When price increases during inflation, annuities become a more attractive investment option because it provides a fixed income stream that is immune to inflation. For others without owning annuity, inflation lowers their purchasing power of money. An annuity, however, can provide a guaranteed income stream that is typically linked to inflation, meaning that the income increases along with inflation. This can help protect annuity owners from the negative effects of inflation on their purchasing power.
For example, say an investor (not Beth nor Gloria) purchases an annuity that promises to pay her $1,000 per month and inflation is 3%, the annuity may increase the payout to $1,030 per month to keep up with inflation. This has a special name for it: cost-of-living adjustments (COLAs), which helps her payments keep pace with inflation and keep her purchasing power over time, even if the general cost of living goes up.
Of course, money does not fall from the sky. The reason annuities can afford to pay COLA is because the insurer (or annuity issuer) will invest the annuity premiums in assets that will provide a higher return to offset the impact of inflation. According to this report, “In general, insurance companies earn more in bond yields when the Federal Reserve raises interest rates. As a result, they can offer their customers higher rates.”
Remember the “boat” metaphor I used earlier for real estate? When price level goes up, rental income and housing price goes up as well. This applies to annuity which is guaranteed income to annuitant.