“Someday financial markets will decline...rising stock/bond markets will no longer be government policy. QE will end and money won’t be free. Corporate failure will be permitted. The economy will turn. Someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be commensurate with risk.” Seth Klarman
Wednesday, October 28, 2015
Buy Term, Whole Life Insurance, or Both? Part 2: Does the Pricing of Term Insurance Actually Dictate Value, a True Cost Advantage?
This is the second in a series of articles summarizing a preeminent, recent study examining the intersection of insurance and personal savings.
In “Buy Term and Invest the Difference Revisited,” finance professors David F. Babbel from The Wharton School of the University of Pennsylvania and Oliver D. Hahl from Tepper School of Business, Carnegie Mellon University examine in detail term vs. whole life insurance in a paper published in May of this year in theJournal of Financial Service Professionals.
There may be no other form of insurance available that matches the predictability of life insurance. Do we protect anything more dearly than our own life? Because of this fact, term or temporary life insurance which typically ends by the age of 85 (or earlier) can be priced quite reasonably, particularly at younger ages. Term life insurance is pure insurance, it provides no cash value and typically terminates without paying benefits, other than peace of mind, during its term.
The price of term insurance per $1000 of coverage is usually constant for its particular term, (e.g., 5, 10, 15, 20, or 30 years), then jumps precipitously in the event of renewal. This jump in premiums due at the end of the term period to renew the policy is often so abrupt that policy owners lapse their policies. These lapses are referred to as “shock lapses” and often induce more than 50 percent of policy holders to abandon their term life insurance according to an extensive study jointly sponsored by The Society of Actuaries and LIMRA.
In Babbel and Hahl’s analysis (above), contrary to common thought:
“People often think that term insurance is the least expensive way to purchase coverage, but this is not necessarily true. The misunderstanding can be analogized to purchasing apples at a market. One vendor may offer to sell a dozen apples for $6. Another vendor nearby may offer to sell apples for only $4. But if paying the lower prices delivers only a half dozen apples, the price per apple is actually higher. In the first case, the price is 50¢ per apple, but in the second, it is 67¢ per apple. Alternatively, the second vendor may offer a dozen apples for only $4, but they may differ in quality from those offered by the first vendor. Accordingly, when considering cost, one must also consider the benefit received. Financial economists call this the cost-benefit ratio… .”
Further, Dan M. McGill, in the classic textbook, Life Insurance, points out:
“…term insurance has a long history of being controversial. He noted as early as 1967 that “there are certain…‘consultants’ who, when they find permanent plans in an insurance program, will advise their surrender for cash and replacement with term insurance.”
Superficially, the appeal is lower premiums, but does this necessarily translate into a lower cost of insurance? McGill stated:
“…at the time of renewal…resistance to increasing premiums will cause many of those who remain in good health to fail to renew each time a premium increase takes effect, while those in poor health will tend to take advantage of the right of renewal. [This is called adverse selection.] As time goes on, the mortality experience among the surviving policy owners will become increasingly unfavorable… . As a result, each dollar of protection on the term basis tends to cost middle-aged or older policy owners more than under any other type of contract.”
“This observation regarding the high cost of term life insurance was confirmed by David F. Babbel and Kim B. Staking (“A Capital Budgeting Analysis of Life Insurance in the United States: 1950-1979,” Journal of Finance 38:1 : 149-170). Over the 30-year period examined, and assuming 15-year holding periods, individual renewable 5-year term life had average net cost-benefit ratios, or markups per dollar of insurance coverage provided, as measured in expected present value terms, much larger than whole life contracts—on the order of three to four times higher. …the additional values derived from many elements and options associated with the whole life policies were ignored… . Since that time, however, term insurance has become much more competitively priced and the authors expect that the cost advantage that whole life has vs. term over periods of 20 years or longer has diminished... . (Interestingly…over that same time period the study also found that the true cost of participating whole life over 20-year periods was only about half as much as [term insurance], owing to its dividends.)” [Emphasis added.]
McGill did discuss circumstances under which term insurance may be the best option, including when:
“…the need for protection is purely temporary, or the need for protection is permanent, but the insured temporarily cannot afford the premiums for permanent insurance.”
In the former case, the term insurance should be renewable in case the temporary need is extended. In most cases, the term insurance should be both renewable and convertible to whole life insurance as financial circumstances improve:
"For example, term insurance may be particularly important to young people who are making substantial investments in education and training that are likely to translate into an improved financial situation over time, and to growing families. In both cases, having sufficient protection over the early years is crucial.”
As a young graduate student, for example, finishes his Ph.D. program his salary may increase from an 18,000 a year teaching or research assistantship stipend to 3 or more times that amount as an entry-level assistant professor.
Next, PART 3: Whole Life Insurance and Economic Modeling—Enter "Buy Term and Invest the Difference"
 David F. Babbel and Oliver D. Hahl, “Buy Term and Invest the Difference Revisited.” Journal of Financial Service Professionals 69, No. 3 (2015), 92-103. (LINK)
 “U.S. Life Insurance Persistency.” The Society of Actuaries and LIMRA, 2012.
 Dan M. McGill, Life Insurance, Richard D. Irwin, Inc., Revised Edition 1967. Updated in McGill’s Life Insurance, Edward E. Graves, Editor, The American College, Bryn Mawr, PA, 1994 through the 9th edition, 2013.