Buy Term and Invest the Difference Revisited by David F. Babbel, PhD Oliver D. Hahl, PhD Introduction: Traditional Roles of Term and Whole Life Insurance ABSTRACT ife insurance has been available in the Unit- The decision whether to buy term or perma- L ed States since shortly before it became a nent life insurance, or some combination nation. Whole life and term insurance have of both, is among the most challenging el- been and continue to be important, basic products.1 ements of the purchasing process for many Naturally, these two insurance products have been people. This study demonstrates that finan- compared and purchased as complements to each cial analyses which purport to show that the other, and sometimes substitutes, depending upon Buy Term and Invest the Difference (BTID) the stage of life or differing needs. concept dominates the combination of per- The venerated Professor Dan McGill examined manent life insurance supplemented with in depth these two types of policies and identified their traditional uses.2 To provide some background term life are deficient in many ways and inca- to this analysis, the authoritative analysis he provided pable of establishing this dominance. It also is outlined briefly here. shows that the assumed financial discipline necessary to successfully implement the Term Insurance BTID approach is an unrealistic expectation Term insurance provides coverage only for a lim- for many consumers. Accordingly, it should ited term. That period can be for a single commercial not be claimed that one approach necessari- airplane flight (flight insurance), a single year, or a ly dominates the other for all consumers. period of years, such as 5 years, 10 years, 20 years, or term-to-age-65. In fact, in recent years several com- panies have offered term coverage up to 85 years of age, and there were even a couple of companies that offered it, with limitations, to age 95 or 99.3 Vol. 69, No. 3 | pp. 92-103 Some term insurance is available with a renew- This issue of the Journal went to press in April 2015. al option. For instance, annual renewable term has Copyright © 2015, Society of Financial Service Professionals. been popular in the past. Another policy design ex- All rights reserved. ists whereby at the end of a multiyear period (e.g., 5 JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | MAY 2015 92 Buy Term and Invest the Difference Revisited David F. Babbel and Oliver D. Hahl or 10 years), the policyowner may renew the policy The premium for term insurance is initially rel- for another multiyear period of equal length. If the atively low [when compared to the premium for policy provisions allow it, the policy can be renewed a whole life policy with an equivalent amount of without providing new evidence of insurability. Such insurance in force], despite the fact that it con- renewal options typically expire after a stipulated tains a relatively high expense loading and an maximum number of renewals, or until reaching allowance for adverse selection… . Whether the some prespecified age. The insurance premium per policy is on the yearly renewable term plan or a $1,000 of coverage is typically constant throughout longer-term basis, there is likely to be strong se- each term, but at the beginning of each renewal peri- lection against the company at time of renewal, od, jumps to a higher level. The jump in premiums at and this adverse selection will become greater as the onset of each renewal period is often so high that the age of the insured—and hence, the renewal policyowners lapse their policies.4 premium—increases. Resistance to increasing People often think that term insurance is the premiums will cause many of those who remain least expensive way to purchase coverage, but this is in good health to fail to renew each time a pre- not necessarily true. The misunderstanding can be mium increase takes effect, while those in poor analogized to purchasing apples at a market. One health will tend to take advantage of the right vendor may offer to sell a dozen apples for $6. An- of renewal. As time goes on, the mortality ex- other vendor nearby may offer to sell apples for only perience among the surviving policyowners will $4. But if paying the lower price delivers only a half become increasingly unfavorable… . As a result, dozen apples, the price per apple is actually high- each dollar of protection on the term basis tends er. In the first case, the price is 50¢ per apple, but to cost middle-aged or older policyowners more in the second, it is 67¢ per apple. Alternatively, the than under any other type of contract.5 second vendor may offer a dozen apples for only $4, but they may differ in quality from those offered by Of course, insurers are very aware of this adverse the first vendor. Accordingly, when considering cost, selection and set their schedule of term insurance rates one must also consider the benefit received. Financial anticipating the effects of age-related increases in mor- economists call this the cost-benefit ratio, and mea- tality as well as likely adverse selection. Certainly ad- sure the numerator and denominator of this ratio in verse selection would be expected on insurance issued expected present values. A cost-benefit ratio in excess with little or no underwriting, which is more com- of 1.0 means that there is a markup or profit margin, monly ignored with smaller policies. Also, an insurer which is common—indeed, necessary—in viable may periodically offer reduced rates to persons who commerce. This concept will be revisited shortly. are willing to provide new evidence of insurability. McGill points out that term insurance has a long McGill discusses circumstances under which the history of being controversial. He noted as early as choice of a term policy may be the best option. These 1967 that “there are certain insurance ‘consultants’ include situations where “the need for protection is who, when they find permanent plans in an insur- purely temporary, or the need for protection is per- ance program, will advise their surrender for cash and manent, but the insured temporarily cannot afford replacement with term insurance.” Its appeal, at least the premiums for permanent insurance.” In the for- in earlier years, was the lower premium outlay asso- mer case, the term policy ideally should be renew- ciated with a given amount of coverage, but this does able in the event that the need for protection extends not necessarily translate into a lower cost. Indeed, somewhat beyond the period originally expected, and McGill has stated: McGill provides several examples where the needs are JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | MAY 2015 93 Buy Term and Invest the Difference Revisited David F. Babbel and Oliver D. Hahl clearly temporary. In the latter case, the term insur- 1960s and continuing well into the 1990s, it be- ance purchased ideally should be both renewable and came fashionable to break down investments into convertible. For example, term insurance may be par- their component parts. For example, for investors in ticularly important to young people who are making a portfolio of mortgages, it became possible to pur- substantial investments in education and training chase a share of mortgage payment proceeds, such as that are likely to translate into an improved financial the “interest only” portion, “principal only” portion, situation over time, and to growing families. In both or various tranches like the payments due between cases, having sufficient protection over the early years years two and five. Similarly, with government bonds, is crucial.6 Given the relatively higher premiums, it the stripping of coupons became popular and inves- can be much more difficult to purchase the appropri- tors could purchase rights to the particular coupon or ate/correct amount of life insurance coverage when coupons that suited their desires, such as the coupon using cash value policies. interest payment due in 25 years and 6 months. McGill continues with a discussion of what he In the spirit of that time, and to gain the advantag- terms “fallacious arguments in favor of term insur- es of mathematical tractability when modeling whole ance,” including often-repeated claims that level pre- life insurance without the “clutter” of contractual de- mium insurance overcharges the policyowner, that tails, economists abstracted from many of its elements the accumulation and protection elements should be and began to posit the whole life policy as a series of separated, and that whole life policies are illiquid.7 single-period or instantaneous term contracts, renew- While we do not rehearse each of those arguments able throughout life without providing new medical here, they are worth considering. evidence of insurability.8 Notwithstanding the fact that such contracts did not exist at the time (nor even Whole Life Insurance to this day), this modeling simplification provided The insurance contract known as whole life dif- some valuable economic insights into the investment fers in several respects from term life. In its classic and savings strategies facing consumers with uncer- textbook form, whole life has level premiums that are tain lifetimes. Some early studies considered whole paid throughout life and a death benefit paid regard- life insurance to be “a linear combination of one pe- less of the age of the insured at death—hence the name riod (year) term life insurance and a savings plan of “whole life.” Unlike term insurance, the whole life con- some sort. (emphasis added)”9 The last part of this tract never expires, so it never has to be renewed nor be statement is emphasized for a good reason.