As we saw in permanent life insurance explained, the benefit of investing in these policies are their living benefits in form of a cash value that can produce tax free investment returns and serve as a security for flexible loans.
Once a cash value has been funded, it can be invested in three different ways.
The main difference between these ways lies in risk and return potential.
The three main classes of permanent life insurance policies are whole life insurance, universal life insurance, and variable life insurance.
Whole life insurance
The first type of permanent life insurance is whole life insurance, which is the most secure form of life insurance, and features a minimum guaranteed return. This means that the cash value is by design guaranteed to never return less than 4-5 % per year.
While it can and regularly does generate higher returns than this minimum, this is not guaranteed, and is dependent on the financial performance of the life insurance company during that year.
Whole life insurances are often sold by mutual life insurance companies, which just like credit unions or mutual funds are owned by their customers, not stockholders. Because of this, the profits that remain in the end of the year are given back as dividends to the customers, instead of being given to external shareholders.
Having returns that are dependent on the business of life insurance has proven to be a stable choice over the past centuries.
Unlike all non-life insurance, life insurance is generally not affected by market cycles. During the great depression in 1930, almost all life insurance companies stayed in business while the majority of banks went bankrupt.
The profits of the insurance companies are coming from selling life insurance policies and collecting more premium than they pay out in death benefits, as well as investing the money they get in conservative investments like bonds.
Universal life insurance
The second type of permanent life insurance is universal life insurance, which provides downside protection for the cash value and allows the owner to have returns correlated with the markets.
This means that there will never be negative returns, but that the cash value might get a 0 % return one year if the markets drop.
When it comes to returns on universal life insurances, they are usually tied to the returns of a certain index, such as the Dow Jones. Usually, the policy is credited the growth of the index minus adjustments, which might be done in a few different ways:
- Participation rate, where a certain percentage of index growth is credited. For example, if the index makes a return of 15 %, and you have a participation rate of 70 %, you would get credited 10.5 %.
- A cap that limits the max return for a certain year. For example, if the index makes a return of 15 %, and you have a cap of 11 %, you would get credited 11 %.
- A yield spread that deducts a few percent from the index growth. For example, if the index makes a return of 15 %, and you have a yield spread of 3 %, you would get credited 12 %.
The advantages of universal life insurance policies are the ability to take part of the returns of the stock markets without taking on the risk of losing money in downturns.
The way that profits are generated for universal life insurance is built upon financial structuring done by the insurance company.
When they invest the money in the policy, they place the majority of it in bonds that earns interests, and uses the rest to buy call options on the index.
This gives the portfolio the ability to participate in the gains of the index while avoiding losses, as the dividends on the bonds are used to lower costs on an call option that can limit downside risk while still having a leveraged participation in the upside potential.
Variable life insurance
The third type of permanent life insurance is variable life insurance, which does not provide any downside protection and could result in losses, just like a normal mutual fund or 401K account could.
It does, however, provide the greatest degree of freedom in how the money can be invested, and presents the ability to invest directly into investments with higher return potential.
There is no downside protection in a variable life insurance, which makes it the riskiest type of life insurance.
Instead of downside protection, a variable life insurance policy offers the owner the choice of placing their investment between a number of sub-accounts, which follows specific investment themes.
This gives options like investing in domestic and foreign stock markets, government and corporate bonds, or options strategies.
While variable life insurance presents the possibility of the largest returns over the long term, they also contain more risk than whole life and universal life, which might make them harder to use for risk management purposes.
Because all types of policies presents their own opportunities and risks, some people might want to own different types of policies, which they can do through creating a portfolio of life insurance policies.
There are three different types of permanent life insurance policies, with three different levels of risk and potential return associated with the investments of the policy.
Whole life insurance has a minimum guaranteed return and the lowest potential for return.
Universal life insurance has a no-loss guarantee and offers a higher potential for return than whole life insurance.
Variable life insurance can lose money, and offers the highest potential for return of the three policies.