Life insurance contracts and annuities both use a similar strategy for managing risk. Each product combines the money of large groups of investors to share a type of risk and protect each individual from a financial disaster. Even though the two products use a similar strategy, they are actually complete opposites in risk-sharing goals.
When you buy a life insurance contract, you agree to make monthly premium payments to your insurance company. When you die, the insurance company pays your heirs the promised death benefit from your contract. To buy an annuity, you deposit money with your annuity company, often a one-time lump payment. In exchange, the annuity company agrees to give you monthly payments for a certain amount of time, either a fixed period of years or for the rest of your life. Both these products help you sleep better at night by protecting you from a type of financial risk.
In life we face two major financial problems: we can die too early or we can live too long. Life insurance and annuities each address one of these risks. Life insurance protects your heirs from the cost of your death. You can design your policy so it both covers your final expenses plus gives extra money to your heirs to replace your lost wages. An annuity guarantees your monthly income. By buying an annuity that lasts for your entire life, you make sure that you never outlive your monthly income. Basically, you create a paycheck for life.
When you buy life insurance or an annuity, companies look at your riskiness as an applicant. If they don't get this calculation down pat, they could go bankrupt as a company. One way they measure your riskiness is by your age. This has an opposite effect on the two products. Older applicants are riskier for life insurance. Since they are more likely to die sooner than younger applicants, they will make fewer payments on average to the insurance company. As a result, older applicants pay more for life insurance. With annuities, the applicant is the one that gets monthly payments. As a result, older applicants are less risky than younger ones, because they'll take fewer payments in total. To make things fair, an older applicant gets more money per month than a younger applicant making the same annuity investment.
Insurance and annuity companies also look at your health to measure your riskiness. Sicker applicants must pay more for life insurance than healthier applicants because of their greater chance of dying young. While they get punished for life insurance, sicker applicants get a better deal on annuities. If an annuity company decides an applicant has below-average health, he gets a higher monthly payment than regular applicants. When you consider these two risk-sharing factors, you can see the ideal strategy is to buy life insurance when you are young and healthy while delaying your annuity purchase as long as you can hold out.
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