Personal Finance Essentials

The 2 Basic Types of Life Insurance

Life Insurance > The 2 Basic Types of Life Insurance

Despite the array of names and marketing terms – mortgage insurance, credit life, key person coverage, second-to-die coverage and more – virtually all life insurance falls into one of two categories: temporary (term) or permanent.

Everything else is simply a different use of one of these two underlying policy types.

Term Life Insurance

Term insurance is exactly what its name suggests: coverage for a specific term, or period of time. It’s the simplest form of life insurance. You pay for the policy, and when you die, the insurance company pays the death benefit to your beneficiaries. If you don’t die during the coverage period, the policy expires and you receive nothing back. This is what makes term insurance the least expensive type of life insurance – the insurer is betting that you won’t die during the term, and the statistics favor them. In fact, fewer than 5% of all term policies ever pay a claim.

Think of it this way: when you buy term insurance, you’re betting you’ll die within the coverage period. The insurer is betting you won’t. If you don’t die, you must renew the coverage – and you do this until you win the bet.

There are three kinds of term insurance:

1

Annual Renewable Term (ART)

The cost rises each year because, as you get older, you become more likely to die. ART is inexpensive when you’re young but can become very expensive later. A 30-year-old non-smoking woman in excellent health might pay as little as $180 per year for $500,000 in coverage; a 70-year-old woman might pay thousands for the same amount.
2

Level Term

The cost is locked in for a period of 5 to 30 years. It’s more expensive than ART initially but cheaper overall – which is why it’s the type most advisors recommend. At the end of the term, the cost increases dramatically if renewed.
3

Decreasing Term

The cost stays the same but the death benefit shrinks over time. Since most people want their beneficiaries to receive the same amount no matter when they die, this type is rarely recommended.

Mortgage Life Insurance: A Policy to Avoid

The most common form of decreasing term sold today is so-called mortgage life insurance – and it’s one of the biggest rip-offs in the industry. The pitch is designed to appeal to new homeowners: a young couple, stretched to buy their home, worries that if one of them dies, the other won’t be able to make the mortgage payments. A policy with a death benefit equal to the outstanding mortgage balance sounds like a solution.

It isn’t. Here’s why. With each monthly payment, the mortgage balance declines – and so does the death benefit. Meanwhile, the premium stays the same and the cost of living rises. Worse, if one of them dies, the insurance company writes the check directly to the mortgage lender. The surviving spouse never sees the money, even if they need it for other pressing expenses like groceries, childcare or education. Companies also charge substantially more for these policies than for equivalent term coverage by giving them the friendlier name of mortgage insurance.

If you’re worried about your family losing the home if you die, the better solution is plain level term insurance. The policy will be less expensive, and because the death benefit is paid directly to your beneficiary – not to the lender – your family can decide for themselves how to best use the money.

Permanent Life Insurance

Permanent insurance covers you for your entire life rather than a specific period. It’s more expensive than term in the early years, but it’s designed to be economically viable over your full lifetime. A permanent policy also accumulates a cash value over time – an internal savings component that can be borrowed against or withdrawn. This third feature – the accumulation account – is what drives most of the complexity in permanent insurance.

To understand why permanent insurance works the way it does, consider Steve. He can buy a term policy for about $300 per year. As he ages, the cost rises. By the time he’s 70, the same policy might cost $5,000 or more per year. A permanent policy solves this problem by charging a fixed premium – say, $3,000 per year – that never rises. In the early years, Steve overpays relative to the actual cost of coverage. The insurer sets that excess aside and credits it with interest. In later years, when the true cost of coverage exceeds $3,000, the insurer draws from that accumulated reserve to make up the difference.

There are three types of permanent life insurance:

1

Whole Life

Everything is guaranteed – the cost, the death benefit, the interest rate the policy earns and the future value of the accumulation account. Because the insurer is making firm promises it must be able to keep, the guarantees are conservative. That means high premiums and modest growth in the accumulation account. But you know exactly what you’re getting.
2

Universal Life

Like whole life, but with the potential to earn a higher return. If the insurer earns more than the guaranteed minimum – say, 4% – it credits you with the higher amount. This allows the insurer to charge lower premiums, since it’s assuming better future performance. The risk: if performance falls short, your premiums can increase. This happened to thousands of policyholders who bought universal life in the late 1970s and early 1980s, when policies were written assuming 15% returns. When rates fell, premiums rose sharply. If you buy universal life, do so with clear eyes: the premium you pay today may not be the premium you pay in 20 years.
3

Variable Life

This type allows you to invest your excess premiums into mutual funds. The upside potential is greater, but so is the risk – if the market drops significantly, your accumulation account can be wiped out and your policy could lapse at the worst possible time. There are no guarantees. For most people, variable life introduces an investment risk that isn’t appropriate inside a life insurance contract whose primary job is to protect against financial loss.

The Truth About Cash Value

The accumulation account – or cash value – is the source of much confusion and many misleading sales presentations. The key fact to understand is this: when you die, your heirs receive either the death benefit or the cash value, but not both.

Say you own a $500,000 policy with $50,000 in accumulated cash value. If you die, your heirs receive $500,000, not $550,000. If you borrow that $50,000 during your lifetime – which the policy allows – your death benefit is reduced to $450,000. You’re not borrowing money from the insurer; you’re effectively taking it from your own beneficiaries. And if you carry that loan, the annual interest cost can exceed $7,000 on top of your regular premium.

The lesson: when you buy a permanent policy, pay only enough in premiums to keep the policy in force. Don’t try to accumulate large amounts of cash value – you’re unlikely to ever realize the benefit of it.

How to Compare Permanent Life Policies

When comparing permanent life proposals, every policy has three variables: the death benefit, the premium and the assumed interest rate used to grow the accumulation account. To make a fair comparison between two proposals, hold two of the three variables constant and see which proposal produces the best result on the third. Some people prioritize the highest death benefit. Others focus on keeping premiums within a budget, or building accumulation value by a specific date.

Whatever variable you’re solving for, make sure the assumed interest rates in each proposal are identical – and realistic. Don’t let one proposal use 5% while another uses 5.5%. The assumed rate should be comparable to current CD rates or long-term Treasury rates. And be aware that the rate shown on a proposal is not necessarily the effective rate you’ll earn, because commissions, mortality charges, administrative expenses and other fees are deducted before the interest is credited.

Buy Term and Invest the Rest?

A long-running debate in financial planning concerns whether to buy term insurance and invest the difference in premiums, or to buy permanent coverage. The argument for term is straightforward: term is cheap, and if you take the difference between a term premium and a permanent premium and invest it in mutual funds, you may accumulate more wealth over time. Many people have canceled whole life policies as a result of this logic.

The argument has merit – assuming you actually follow through and invest the savings, and assuming the investments perform as expected. But for many people, their need for coverage is genuinely permanent, and term insurance may expire before they die. There’s no single right answer. What matters most is that you make a deliberate, informed choice rather than simply accepting whatever you’re sold.

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