Most insurance products stink.
When you buy a term life insurance policy to protect your young family, there’s a very good chance that you’ll collect absolutely nothing in exchange for your premiums.
And when you buy homeowners insurance, there’s a good chance you’ll get back far less than what you spend on the policy.
And when you buy a fixed lifetime annuity, there’s a decent chance you’ll die well before reaching your life expectancy, thereby resulting in an atrocious return on investment for the money you spent on the premium.
And this stinkiness — the ability to “lose” each of these bets — is precisely what makes these products helpful.
Can’t-Lose Life Insurance
Imagine 1,000 thirty-year-old people buying 15-year term life insurance policies on the same day. Because most of these people will not die before age 45, most of these policies will pay out nothing at all. And this is what allows the insurance company to provide such a large benefit to the beneficiaries of the policyholders who do end up dying.
This concept is known as “risk pooling.” And it is what makes insurance worthwhile.
By way of comparison, imagine if our hypothetical 15-year term policy was instead rewritten so that the benefit amount was paid out to each policy holder a) upon death, or b) at the end of the 15-year term. In such a situation, there would be no risk pooling, because every policy is going to have to pay out. As a result, the benefit amount would obviously have to be dramatically reduced — so dramatically, in fact, that there would typically be no point in buying such a policy.
In other words, if an insurance product doesn’t offer the possibility of a very poor outcome, there’s going to be little or no risk pooling going on, and it will typically not be able to offer much bang for your buck in terms of protection against whatever it is the policy insures against.
When An Insurance Product Promises Everything…
Whenever you encounter an insurance product that promises to pay you money regardless of the situation, it’s time to be skeptical.
For example, equity indexed annuities (sometimes called fixed indexed annuities or hybrid annuities) are often sold on the premise that they:
- Guarantee your capital, thereby protecting you against market declines, while
- Allowing you to participate in market gains.
It sounds like a win/win. But if the insurance company is insuring you against loss, how can they afford to give you the positive returns that result when the market goes up? Where does the money come from?
As it turns out, the answer is that they don’t give you all of the returns from good years in the market. Typically, they leave out dividends, and they limit the return in other ways such as imposing an annual maximum. (In addition, they typically hit you with large surrender charges if you try to get out of the annuity within the first several years.)
Another insurance product that appears to offer a no-lose proposition is the variable annuity with a “guaranteed withdrawal benefit” rider. These products:
- Guarantee a certain (non-inflation-adjusted) level of income for the rest of your life (regardless of how poorly the markets perform), and
- Give you the chance to have that level of income increase if the underlying mutual funds in the annuity perform sufficiently well.
Again, it sounds great. But the reality might not be as good as the sales pitch. The problem is that:
- The guaranteed level of income is significantly lower than what you can get from a simple fixed lifetime annuity, and
- The annual costs charged on the investment are quite high — usually well over 2%, sometimes more than 3%.
As a result, it’s difficult for such products to outperform a simple “buy a fixed annuity and invest the difference” strategy. (Note: Vanguard’s GLWB product does have significantly lower costs than most such products, which makes it a much better deal.)
What’s the Catch?
If you can’t figure out the way in which an insurance product stinks — that is, you cannot figure out a single way in which purchasing the product could result in a bad outcome — that is not actually a good sign. In fact, it should be a red flag. More likely than not, it means your evaluation of the product is off-target in some way.