In general, life insurance is something you do for others. You won't be around to benefit from it -- that's kind of the point -- but your foresight prevents your loved ones from experiencing hardship after you're gone. That said, many life insurance products offer a significant degree of flexibility to increase or decrease premiums, and invest the policy's funds in nontraditional ways. When used correctly, these policies can provide a number of benefits while you're still alive to appreciate them.
How It Works
Traditional cash-value insurance, or whole-life insurance, gives each policyholder a share in the success of the insurance company's investments. Premiums are set for the life of the policy, and so is the death benefit. Universal life insurance and its derivatives unlocks those rigid policy provisions, giving the policyholder more control over how much to pay in premiums, and how those premiums may be used. With these policies, clients may raise and lower their premiums or death benefits as needed, or overpay for their insurance and use the extra as a tax-sheltered investment.
The Investment Side
The investment portion of your insurance policy is permitted to grow tax-free unless and until you withdraw it. The rise of IRAs and 401(k)s has made that less important than it used to be, but it's still handy if you have money to invest and have already hit your IRA limit. Insurance companies offer the option of a guaranteed minimum return, with the potential for more. Alternatively, you can invest your cash in mutual funds or other investments to be held within the policy. This provides potentially higher returns, but it carries a risk of losses as well.
A variation on that approach invests your insurance premiums in a major equity index, such as the Dow Jones or the Standard & Poor's 500. Investing in an index is generally considered to be safer than investing in individual stocks or even mutual funds, because it tracks the movements of the market as a whole. That means no single underperforming stock or fund manager can sink your investments. Indexed policies often provide a guaranteed minimum return to insulate policyholders from ill-timed market downturns. Unfortunately, they compensate for that by capping your gains when the markets are up.
Other Indexed Features
Aside from index investing, your specific policy might contain other references to indexing. Most often, it's a reference to the rate of inflation in the economy as a whole. You can structure your policy so that its death benefit is indexed to the consumer price index, increasing in lockstep with inflation. That way, its purchasing power remains unchanged over time. If you start drawing an income from the policy's cash values, that can also be indexed to inflation.
Although flexible life insurance policies have many virtues, it's important to remember that they've also got limitations. Viewed as an investment, their costs can be higher and returns can be lower than those of many competitive products, even when the benefit of tax sheltering is factored in. A major downturn in the markets could wipe out much of the value in your policy, making it necessary to increase your premium or reduce your death benefit to keep the plan in force. It could also reduce your policy's value to the point that it won't provide for your loved ones. As with any other financial decision, consider it carefully before you buy.
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.