Listen to anyone trying to explain life insurance to you and it can be confusing. Variable life, term, adjustable life, universal life, second to die, whole life. Which should you choose, do you need life insurance, and how much do you need? These are difficult questions to answer but we will try to capture the issues in a nutshell.
The concept of insurance is simple. It is designed to protect against a risk, plain and simple. In life insurance, the risk is death. Insurance is not an investment. Insurance policies may have an investment component, but insurance alone is a vehicle to transfer the risk to another party.
All the policies available can be broken down into two basic types, referred to as permanent insurance or temporary insurance. Insurance in its purest form is temporary insurance, or term insurance. With temporary insurance, you pay a premium and that premium offers you protection for a specified period of time, typically one year. After that period of time, the policy will expire unless it is renewed by paying the premium for another period. Temporary insurance is cheaper in terms of current cash outlays, but the lower cost does have its drawbacks. First, the cost of temporary insurance increases as one ages. Insuring a 25 year old is less of a risk than insuring a 50 year old. Second, coverage may no longer be available at a specific age, typically 65. Finally, temporary insurance offers no wealth accumulation, which is the primary difference between temporary insurance and permanent insurance.
Permanent insurance offers the basic protection of term insurance and includes an investment component, called cash value. The annual premiums for this type of insurance are higher than temporary insurance, but a portion of the cash outlay is invested in a savings vehicle. Over the years, the cash value increases due to additional contributions and investment earnings. Eventually the investment earnings are adequate enough to cover the premium associated with the insurance component, and at that time cash outlays can be reduced or eliminated and the insured is afforded “permanent” insurance protection. It is important to remember that the insurance component of permanent insurance is still a term policy. The premiums increase as the age of the insured increases.
However, if the earnings of the cash value are adequate, the cost of the premium is offset by the investment earnings. In theory, if all goes according to plan, the insured is left with an asset in the form of the cash value and insurance which is paid every year from the investment earnings. Two other benefits associated with permanent insurance deal with renewal and taxation. Permanent insurance policies can extend beyond the age when temporary insurance ceases, age 65. This provides insurance available for estate planning purposes. The other main benefit associated with permanent insurance is that the increase in cash value is not currently taxed, so the investment earnings are tax deferred. Finally, permanent insurance policies have varying features designed to increase the choices of the underlying investment and to provide the insured with flexibility in adjusting the premiums on an annual basis. These variations are known as Universal Life, Variable Life, or Adjustable Life.
Which type of insurance should you consider? As in all cases, the answer is “it depends”. One issue is whether or not you can afford the premium. Temporary insurance is cheaper and it is more important to have the insurance protection than the investment component. Another issue is how much insurance you require and whether you need that protection after age 65 for estate planning purposes. It can be argued that even though the premiums for temporary insurance increase as the insured gets older, the need for life insurance is less if the insured has accumulated assets during his lifetime. In effect, the insured becomes self insured. For example, if the life insurance needs to provide protection for the survivors are $500,000 and if the insured has liquid assets of $500,000, then the need for insurance is $0 (this, of course, ignores the dreaded estate tax consequences, if any). Another issue to consider is the underlying investment in the permanent insurance policy. The insured needs to evaluate that investment compared to other investments including commissions, expenses, risk and income taxes.
Now that you are understand all the issues, the remaining question is how much life insurance do you need. This is a separate discussion.