By STEVEN LEWIS
Insurance is like buying new tires or underwear. The only person that appreciates it is the one who purchased it…or the one who sees you in the dark or in the grave.
Funk & Wagnalls (1962)* defines insurance as an act, business, or system by which financial security is guaranteed by one party in certain contingencies, as in death, accident, damage, disaster, injury, loss, old age, risk, sickness, unemployment, etc., upon specified terms. I guess I could define it as how I feel wearing underwear…. assurance. As with underwear, brands matter.
I like the term assurance. As Funk & Wagnalls adds, “The sum that the insurer has agreed to pay in case of the occurrence of the specified contingency (i.e., guaranty or pledge). I think a more simplistic way of defining insurance is “the means to mitigate risk.”
Within the financial service business, there are primarily two types of insurance that can be utilized when creating a financial plan. Life insurance and annuities. (The explanation I provide is just a summary at best.)
Life insurance has been around for a very long time. The first life insurance company was established in Great Britain in 1706 and was named “Amicable.” America was not too far behind when, in 1759, England introduced the Presbyterian Ministers’ Fund, established in Philadelphia. That’s a very long time ago, and life insurance was considered “one dimensional,” meaning that it would only cover deceased individuals. Today, many life insurance plans now provide what would be defined as “living benefits.” This allows an insured individual, or their beneficiaries, access to a portion of the benefits before the insured’s death if they meet certain health requirements.
Life insurance comes in two forms: Permanent (in the form of whole life and or [variable] fixed universal life) and term life insurance. The main difference between permanent and term life insurance is that a permanent life insurance policy will last past the death of the owner. Whereas a term life policy is limited in its contractual duration. The most popular term policies are 10, 20, and 30 years.
Other distinctions are as follows:
Coverage Duration
Term life provides coverage for a specific period, such as 10, 20, or 30 years. Note: some term life policies can be converted to a whole life policy at or near the end of the term.
Permanent life offers coverage for the entire life of the insured provided the premiums are paid.
Purpose
Term life is a terrific tool to replace income such as mortgage payments, children’s education in the event of the insured death and is free from income taxes.
Permanent life, other than providing an income tax free benefit, often serves as a long-term financial tool for estate planning and other financial goals. It qualifies as a tax-advantaged savings vehicle since all growth (like annuities) is tax deferred.
Additional Benefits
Term life and permanent, if offered, may provide additional benefits (i.e., living benefits) to the insured. These benefits have been categorized as home health benefits, chronic care benefits, etc.
Premiums
Term life does not accumulate cash value.
Permanent life builds cash value over time, which can be accessed through policy loans or withdrawals. Variable universal life’s cash value works in a similar fashion to variable annuities, in that the cash is invested in sub-accounts and are therefore subject to additional fees and expenses.
The first annuity came out of Rome**. The word annuity comes from a Latin word annus or annua, meaning annual stipends or “year.” Funk and Wagnalls defines an annuity as, “an annual allowance or income, the return from an investment or capital, in a series of payments; an agreed amount paid by an insurance company.”
The funny thing about this early annuity is that qualified individuals must attain a specific age to receive their annual payment (just like today). However, the problem back in their day was that the expected lifetime expectancy was lower than the required minimum age to access the annuity.
Annuities come in three types: Immediate annuity, fixed annuity, and variable annuity.
Immediate annuities, sometimes called SPIAs, pay out a contractual annual payout immediately upon premium received as there is no duration requirement. Most pension plans fund these types of annuities and carry zero expenses.
Fixed annuities come in two types. Standard fixed annuities and fixed index annuities (FIAs). These annuities are regulated by the department of insurance and considered no-risk investments. Once interest is credited to the account, it is locked in. It is this very feature that attracts investors. These annuities (in most cases) carry no annual fees or expenses, unless the owner chooses to purchase what is called a “rider” or added benefit.
Variable annuities, on the other hand, do not provide risk-free investment options and are considered a securities investment. Consequently, they are regulated by FINRA and the Securities and Exchange Commission (SEC).
Returns
Fixed annuities offer a declared fixed rate for the duration of the annuity contract period.
FIA’s rates of return will be based on a stock index return selected by the owner each year. Because these annuities are considered a “fixed” annuity, there are limitations on how much one can obtain.
Variable annuities are direct investments into the stock market (called sub-accounts) like mutual funds. The returns are not fixed and are strictly dependent on the performance of the underlying investments.
Investment Options
Fixed annuities do not offer investment options. The insurance company provides the fixed return. That return is guaranteed for the life of the contract term.
FIAs may offer one or several index options with which to track. One of the most popular is the Standard & Poor 500. Note that one only tracks an index and does not literally invest in a specific index and can allocate their premiums among different indices if available. If one does not desire to allocate premiums into any of the offered indices, they can allocate to a one-year fixed rate option.
Variable annuities provide a range of investment options (sub-accounts). Policyholders can allocate their premiums among different sub-accounts. If one does not want to invest in the sub-accounts, a declared one-year fixed rate is available.
Risk
Fixed annuities carry minimal risk while in deferral and, if elected, provide a steady income stream up to a lifetime.
FIAs also carry minimal risk because they are fixed annuities.
Variable annuities carry higher risk due to market exposure. Though they offer the potential of higher returns, there’s also a risk of loss within the sub-accounts.
Guarantees
Fixed annuities and FIAs typically offer guarantees of principal and provide a minimum rate of return.
Variable annuities do not provide guarantees on returns.
Fees and Expenses
Fixed annuities and FIAs by and large do not charge additional fees and or expenses. However, one can purchase added benefits (if provided) to enhance additional benefits that may be offered by the issuing insurance company.
Variable annuities often come with higher fees, including management fees for the sub-accounts, administration fees, and mortality and expense charges.
Taxation
Fixed annuities and FIAs grow tax-deferred, meaning taxes on earnings are deferred until withdrawals are made.
Variable annuities also grow tax-deferred, meaning taxes on earnings are deferred until withdrawals are made.
Note: Any gains upon withdrawal are taxed as ordinary income unless the accounts are Individual Retirement Accounts (IRA) of which all withdrawals are subject to taxation. Additionally, withdrawals made before 59½ may incur a 10% IRS tax penalty.
Duration
Fixed annuity contracts are typically between five to seven years, whereas FIAs are between seven and 12 years.
Variable annuities predominantly carry a duration of seven years as these are brokered securities products. Investment advisory variable annuities carry no duration periods and are far less expensive and flexible than their brokered counterparts.
Utilizing these types of insurances can certainly complement both an estate plane and a family investment portfolio. However, when considering any insurance product, it is important that one greatly consider how much risk they choose to carry or avoid. This is the sole purpose of insurance. Remember, insurance is the means, and most effective way, to mitigate risk. We all tend to insure things of value, right? Our home, our automobiles, etc. How about insuring our lives (and or the lives of others)? How about insuring our income in retirement? These are a few things one should think through carefully and thoroughly.
Annuities are a contractual agreement between you and an insurance company. When choosing between a term life insurance and permanent life insurance and or a fixed annuity and a variable annuity, the choice depends on your financial goals, risk tolerance, and investment preferences. It is essential to carefully evaluate your options and consider consulting with at least two to three financial consultants (preferably those consultants who represent all these financial instruments) before deciding.
* Funk & Wagnalls Standard Dictionary, 1962
** Webster’s Unified Dictionary and Encyclopedia, 1959
Investment Advisory Services are offered through Lewis and Associates Capital a Registered Investment Advisor.
