How to replace a whole-life policy?

Question

If I understand a whole-life insurance policy correctly, it can be viewed as a series of predefined term insurance policies combined with a savings account with a guaranteed minimum return. You "over-pay" for the term insurance in early years and the excess goes in to the savings account as your "cash value". As you get older and the cost of insurance goes up, eventually you are supplementing your payment with your "cash value" to avoid an increase in your costs.

If you die before you take out your "cash value" and terminate the policy, your heirs get the greater of the insurance amount or the amount in the "savings account". If you cash out early, you get the value in the "savings account" and the policy ends.

Do I have a right understanding of a whole-life insurance policy?

If so, can the same thing be done by purchasing term life insurance and putting the excess in your own investment vehicle (likely getting a greater return if your risk tolerance allows)? Are there drawbacks (e.g. from a protection against lawsuit/bankruptcy perspective) or alternative tax implications that should be considered?

As a young man, term life insurance is cheap and can easily protect my family if they lost my income. As an old man, I expect to have investments far beyond the life insurance policy that would pay any death expenses. However, I would want something to be protected from medical bills or other issues to guarantee my heirs aren't burdened by funeral expenses.

Answer 1

You seem to have a solid understanding of whole life policies, and their drawbacks vs term life, vis a vis cost.

From a tax perspective, if you are at a level of wealth that you aren't planning for your own retirement, but rather maximization of your heirs' post-tax inheritance, then whole life policies may offer tax benefits. In basically all other circumstances, whole life insurance policies typically represent one of the worst-priced possible investment structures. You can see the bare truth in this from the ultra-high commission structure of whole-life insurance sales vs term life insurance sales [see here, no affiliation: https://www.investopedia.com/articles/personal-finance/080514/what-your-life-insurance-agent-makes-you.asp].

As you've pointed out, you can mimic the creation of a whole life policy yourself, by buying term-life insurance, and investing the difference in premium amounts. To the extent that you haven't yet maximized your country's possible tax-advantaged accounts [ie: 401k/IRA in the US, RRSP/TFSA in Canada, etc.], this has the added benefit of reducing your immediate tax burden in a way that may allow you to further increase the amount you can save in this way.

Answer 2

Whole life is generally a terrible idea, and I say this as someone with actuarial training and who in the past has had a life insurance license. The main problem with it is inflation. You pay the premiums for many years at a fixed nominal value but when you (or your heirs) collect the payout, its real value is a fraction of the nominal value. If dollars had a relatively fixed value over time, then the value proposition would be there, but that is not the case. Buy term and invest the difference.

Answer 3

If so, can the same thing be done by purchasing term life insurance and putting the excess in your own investment vehicle (likely getting a greater return if your risk tolerance allows)?

Not quite. There are differences in risk. With whole-life, you are given a guaranteed fixed sum of money no matter what happens, provided that you keep paying the monthly fees.

With term + investment, you are making an assumption that you will continue to be able to take out term insurance for as long as required until your investments catch up. This means that you are exposed to risks that aren't present with whole-of-life. For example, let's say you take out term insurance to cover you aged 30 to 40. Aged 39, you develop a serious health condition (e.g. terminal cancer) which means that no insurance company is willing to offer you further term insurance, or that whatever they are willing to offer is unaffordable. You die aged 41. All your family are left with is whatever investments you made up until that point. With whole-life they would have received the same amount regardless.

Effectively with whole-life you are covered based on a "snapshot" of your health at the moment you took out the policy, and whatever happens after that doesn't matter. With term insurance your health will be continually re-assessed every time you need a new term.