Demystifying Life Insurance

What kind should I buy?

Like most products today, you’ll likely have more choices than you want.  The key is to only pay for what you need.  Paying for bells and whistles is usually a waste of money.  Despite all the names, there are really only two kinds of life insurance:

1. Term (or “temporary” insurance)
2. Whole Life (or “permanent” insurance)

You’ve probably heard of Term, or “Temporary,” insurance. This is actually straightforward, simple insurance. It’s like your car insurance. You buy it to cover one year. If you get in an accident during that year, the car insurance pays for it.

Term /temporary life works similarly. You insure your life for the course of a year. If you die during that year, the insurance company pays. If you don’t, the policy just expires.

With term, you insure your life for a fixed dollar amount (like $250,000).  You also agree to a number of years, which gets you a fixed annual (level) premium for those years.  If you start the insurance when you’re young, it’s cheap. However, if you start it when you’re older, it’s expensive, since there’s a higher chance you will die.  If you die during the year, the face amount of the insurance (i.e. $250,000) is paid to the beneficiaries (whoever you named). If you don’t die during that term, the bad news is the policy expires unused. The good news is… you didn’t die.

Pros: Term insurance is pure insurance. It’s not an investment, it’s not a fancy product, it just does one thing effectively: Insures your life. It’s also very affordable when you’re young.

Cons:  Term insurance gets expensive when you’re older. If you no longer need insurance anymore (because your investments can support your dependents if/when you die), that’s fine. But if not, it can get prohibitively expensive. If you MUST have life insurance, such as for a special needs child, term may present some problems later on due to cost if not started early.

This might be important if you know that you’ll need life insurance later in life.

I’d rather put my money into savings.

Along with the key benefit of having affordable premiums when you are older, whole life also forces you to save money. While it’s not the best way to save money, since the insurance company will make money off your investments first, it does force you to save. Similar to a mortgage where your required mortgage payments help you pay down and force savings, these policies do the same.

But the “savings” or investment part comes at a higher cost – high overhead.

Basically, whole life is structured so you pay the same annual premium every year. It doesn’t go up as you age (when you are more likely to die).

So what happens to the extra money I pay?

Because the premium remains the same as you get older, the insurance company charges you more in the early years. This extra amount goes into a reserve fund. Part of this reserve fund is used to pay the agent’s commission as well as the insurance company’s administrative costs. The remainder gets credited to your account, where it begins to earn interest, tax-free. Over time, this reserve creates a cash value that you can access in the future.

If you die with a whole life policy in force, the company pays your beneficiary the face value. There is also a cash value you can use while you’re alive, in a few ways:  

(1) You can borrow money against it.  

(2) You can purchase additional insurance with it or use it to pay your premiums.  

(3) You can cash out: terminate your policy and just take the small amount of money built up.

While the features may sound good, you’re still paying for insurance so the fees and commissions will usually be considerably higher than for other types of investments that are not insurance.  You are paying for that insurance feature.    

Other types of Whole Life Insurance

Because whole and term are too simple, life insurance companies decided to create some more options, just to mess with all of us.  (Okay not really, but sometimes it seems that way!)  Two common ones are Universal Life and Variable Life.

What is universal life?

Universal life is a type of whole life policy. With universal, part of your premium pays for insurance, and another part is put into a separate account where it’s invested on your behalf. Universal is very flexible—you can change the amount of insurance you want at any time. And you can usually vary the premium payments. Similar to whole life policies, you will also build up a cash value over time.

What is variable life?

Variable Life is another type of whole life policy. It lets you invest part of the cash value in mutual funds through the insurance company. It really is variable—both the death benefit and the cash value will vary with how well your investments do. There is no guarantee on what you’ll get.