We would like to point out that the following article discusses the concept of self-insuring. A self-insurance strategy should only be pursued by individuals with a robust understanding of financial instruments and concepts, and the risks associated with them. While a self-insurance strategy may be perfectly suitable for financially sophisticated individuals, most people who are looking to purchase insurance are hoping to pay the insurance provider to assume their risk. A self-insurance strategy means that the individual retains the risks. While no insurance strategy can eliminate risk, paying insurance professionals to manage that risk should be given serious consideration before deciding to initiate a self-insurance strategy. While the strategy discussed below is not necessarily inherently more risky than purchasing a permanent insurance policy from a regulated insurance company, it can be if not executed correctly. Our goal is to inform you of this strategy, we neither advocate its use nor do we assume responsibility for the results of our readers employing it.
Many people like the simplicity and low cost of a term life insurance policy (otherwise known as a temporary policy), but aren’t satisfied with the fact that temporary policies usually don’t result in a benefit payment (in fact, payments are relatively rare, which is what makes the temporary policies so much cheaper than the permanent policies). Policyholders want the guaranteed benefit payment associated with a permanent life insurance policy, though they may not be willing to pay for it.
While there are many “flavors” of permanent life insurance policies, and we encourage you to assess each of them to make sure that you haven’t overlooked a relatively standard permanent policy that fits your needs, there is an alternative strategy that provides you a lower cost solution and guarantees that there is a valuable asset available upon an individual’s passing.
The strategy is relatively straightforward (and quite frankly, is a replication of how insurance companies operate). Purchase a temporary insurance policy and invest the difference between the premium on the temporary policy and the permanent policy in a self-directed investment account. At the expiration of the temporary life insurance policy, the policyholder should have built up a sizable investment account balance that will serve as the “death benefit” from a traditional permanent insurance policy. You will need to calculate the variables necessary to execute your specific plan, which will include pricing both term and permanent life insurance policies, defining an investment strategy, estimating a rate of return on those investments and determining the period required to achieve a self-insured investment balance.
There are many benefits to this strategy:
1) Policyholders (or investors as it may be) may be able to generate a greater return on investment, increasing the amount of the death benefit, from the death benefit amount under a permanent life insurance policy. By eliminating the profit margin charged by insurance providers, a self-insurance policy effectively adds that amount to the benefit payment.
2) Investors have maximum flexibility over their investments. They can change investment strategies, increase or decrease the rate of growth of the investment and withdraw balances at will. Self-directed investment accounts generally provide a greater range of investment options than are offered by third-party operated permanent life insurance plans.
3) Tax advantage benefits with permanent life insurance plans can be replicated with a self-directed plan.
4) Flexibility to alter the life insurance plan to account for life changing events. For instance, if you were insuring so that the death benefit would be able to pay for a dependent’s education, but they earn a scholarship, you can reduce the target benefit to reflect this.
5) There are no contractual limitations to worry about (such as penalties for late premiums, disqualifying events or actions, etc.).
Certainly there are risks associated with executing a self-insurance strategy:
1) Financial discipline is required to make this strategy work. Investors must have the discipline to invest the difference between the premiums. This strategy is certainly not for individuals who struggle with financial discipline since failure to invest the delta between premiums or “skimming” from that delta will surely result in an underfunded death benefit. Even financially disciplined individuals may make choices, which are financially sound (such as paying off high-interest debt), may result in an underfunded self-insurance account.
2) The estimated rate of return on investments may not be realized. While self-directing investments gives flexibility, it also offers the investor the option of investing poorly. Poor investment choices will result in lower returns and an underfunded investment account.
3) Generally, death benefit payments are exempt from Federal income taxes (check your policy and with a qualified CPA to be sure!). However they are subject to estate taxes. Not all investment vehicles under a self-insured plan will provide the same tax-exempt benefit. While the investor can use tax deferred investment vehicles (such as an IRA, “529 plan” and certain annuities), each of these vehicles have their own specific advantages and disadvantages, should be well understood by the investor and may not exactly match those of a permanent life insurance policy
4) Some permanent life insurance policies offer additional guarantees for payments that may not be easily replicable using the simple strategy of a term policy and a personal investment vehicle. While these additional guarantees or features command a higher premium, the cost of replicating them with a self-insured strategy may not be cost-beneficial.
This relatively simple strategy can be a very viable alternative to traditional permanent insurance policies. Again, people who choose to pursue a self-insurance strategy should be sophisticated investors who understand the risks of self-insuring, the investment vehicles available to them and the investment securities those vehicles will hold. They should have the financial discipline to direct the difference between temporary and permanent premiums to the investment vehicle to ensure that they meet their death benefit goals. These individuals should have the financial knowledge and intelligence to be able to react to a changing financial and economic environment and to take steps to “alter course” where necessary.
This is a do-it-yourself strategy, and as with all do-it-yourself projects, some people have the knowledge and internal fortitude to execute, while others do not. After all, there are highly skilled individuals who do this work for a living. In order to make a do-it-yourself project cost-effective, you have to be able to execute as well (or nearly as well) as the professionals in order to achieve a similar result. However, if you are able to execute a self-insurance strategy you can save significant costs.
Be sure to do your research though before heading down this path. This is after all, a benefit intended for your beneficiaries after you pass away. The peace of mind of employing a professional may be well worth the cost.