Longtime readers will remember my love/hate relationship with life insurance. From my perspective, life insurance is a bit too much like a Vegas game, reminiscent of the roulette wheel and the craps table, and the insurance company is always the house.

Life insurance often seems complicated and daunting, leaving many people unsure of its true value. While it certainly serves a crucial role in managing unacceptable risks—such as providing financial security for a family’s primary breadwinner or protecting against estate taxes—it’s essential to approach these products with a discerning eye.

Many consumers have likely found themselves in situations similar to my recent experience with my mother’s estate. When she passed, she held a $50,000 life insurance policy, for which she had paid more than $60,000 in premiums over 30 years. She lost hundreds of thousands in potential alternate value due to living a long life and paying exorbitant premiums to keep the policy alive when the odds of death got very high. At age 93, who can afford to drop a policy to avoid a $6,000 annual premium when payout is seemingly imminent? With the benefit of hindsight, it made sense to drop the policy as late as age 87. This realization highlights a common issue: the costs of life insurance can often far exceed the eventual benefits, but surely the insurance company was taking risks that simply did not materialize. Had she lived a short life, it would have been a clear winner for the family. But even a normal life expectancy would have made the math iffy at best, which translates into “don’t buy insurance for risks you can otherwise absorb yourself.”

We played our cards differently with her life insurance trust, however. Back in the old days, when the lifetime estate tax exemption was $600,000, we set up a $1million death benefit policy to pay estate taxes, primarily to protect the family farm. As the estate tax issue waned with successive hikes in the exempted amount (now $15 million), we opted to forego the premium payments and let the policy lapse. Good thing, because premium hikes over the ensuing twenty years would have wiped out the trust and resulted in nothing since the policy would have lapsed anyway. Instead, we purchased stock with the cash earmarked for premiums. That $150,000 residual unpaid premium account was worth $500,000 at her death.  

Mom also insisted on a prepaid burial contract, which is nearly always an iteration of a whole life policy. In her case, 25 years passed on her $7,200 paid-up policy premium, funding an $8,600 death benefit: a whopping 0.61% internal rate of return. But in her case, this also locked in costs from 2000, essentially providing a hedge against a doubling of costs over time. Again, in retrospect, she would have been 4x better off in stocks.

She’s not alone in getting turned around in insurance products. We also see very wealthy people, who have very little motivation for windfalls from a death benefit, seemingly get romanced by the so-called “tax-free” nature of policy loans. Those who dig into policy details will find the illustrations and disclosures reveal a labyrinth of potential gotchas that will shatter most illusions. We compare outcomes to low-turnover stock portfolios, like those at my firm, which tend to generate similar tax-free results by focusing on maximizing the benefits of the step-up in basis rule. Someone could obtain very similar benefits of the much-touted tax-free policy loans through margin loans on gain-laden stocks, until the decedent passes and gains on stocks step up tax free. That sexy feature of life insurance is easily replicated elsewhere and cheaper.

But let’s give credit where credit is due. Many growing young families need protection from the devastation of the loss of a primary breadwinner. The good news is that policies are cheap when you’re young, especially if you buy agent kryptonite: term policies. Another appropriate use of life insurance is to provide ready cash to pay estate taxes on a unique or illiquid asset. Think of a large family farm or ranch, maybe with limited liquidity otherwise, and a married couple at the helm of more than $30 million in assets. It could also be a family business with disproportionately aligned heirs, in which insurance could square the math of a buyout. There are plenty of other appropriate examples for excellent utility in life insurance. My cautionary words are intended to ensure you understand why you may have these policies and whether needs or exemption amounts may call into question whether to continue and not let inertia decide. Do the features and risks and costs align with your understanding of them and are they consistent with the changes in your life over time? Momentum is often not a justifying factor to keep a policy that has outlived its usefulness, and conflicts abound in advice on these topics.  

For forty years, I have heard client lamentations about disappointing insurance results compared to other paths. Surely some of this comes from the sour grapes of retrospect; the knowledge today of what did not happen before, like an untimely death that would have made the math of insurance very compelling.

Ultimately, while insurance has its place in risk management, it is vital for clients to weigh the complexities and potential shortcomings against alternative strategies for asset accumulation and avoid getting romanced into especially creative strategies like those involving financed premium and other crazy concepts. It should be a goal, or at least a consideration, to become less reliant on insurance as a mitigator of unacceptable risks and move toward self-insurance by building sufficient assets so that the risks are no longer material.

With odds in my favor, I can say that owning an insurance company stock is likely to be a profoundly better investment than one of their policies, unless you croak sooner than expected.

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