The Purpose Of Life Insurance
Financial planning naturally focuses on the things you want to accomplish. What sometimes is missed is the fact that you have to be around to provide the income necessary to achieve these goals. What is your family supposed to do if something happens to you?
That question is the primary basis for life insurance. Life insurance is meant to protect your family from the financial effects of losing you. But that doesn’t mean all life insurance policies are created equal or will cover your family adequately. The purpose of this article is to provide a simple explanation of the differences between life insurance policies and help you determine which will benefit your situation the most.
There are 2 basic types of insurance, with a handful of variations on the themes. There is temporary insurance, usually called “term”, and there is “permanent” insurance.
Term Life Insurance
Term life insurance is considered the purest form of insurance. It is also usually the least expensive type of insurance. The insurance company charges you the same set premium for a certain number of years (the term).
5-year term insurance charges the same premium for 5 years.
10-year term insurance charges the same premium for 10 years.
15-year term insurance charges the same premium for 15 years.
At the end of the term, the premiums increase each year to reflect the increased costs associated with your getting older. The older you are, the higher the probability you might die. This is called the mortality cost, and it increases as you age.
The vast majority of people drop their term insurance at the end of their “term” because the premium increase is usually significant.
Additional Variations On The Theme
Sometimes you’ll hear the phrase “return-of-premium” term insurance. With a return-of-premium policy, you can pay a higher premium each year in order to have the right to receive all your premiums returned to you if you are still alive at the end of a specified number of years.
“Convertible” term insurance means you have the right to convert the policy into one of the permanent policies described below. Premiums are almost always higher, and you may have to demonstrate that you are in good health if you choose to convert.
Permanent Life Insurance
As the name suggests, permanent insurance provides lifetime coverage. The insurance company will charge you a set premium which won’t change for the remainder of your life. It does not increase as you get older. As you can imagine, the premium is substantially higher than any term insurance.
This type of permanent insurance is called “Whole Life Insurance”. Here’s how the policy works.
The larger premiums actually cover more than the insurance company’s costs and modest profits. This is especially so in the early years. This extra amount is used to create “cash value”. The cash value is invested by the insurance company in a fairly conservative investment portfolio. The invested cash value generates earnings which also help grow the cash value.
Each year, your cash value increases by the amount of the extra premium (the amount in excess of the insurance company’s costs) plus the earnings from the already existing cash value.
Theoretically, there is a point in time when the earnings from all this cash value will be large enough that the earnings can be used to pay your premium. This is informally called the “vanishing point”.
At this point, you would not pay premiums from your checkbook. Instead, the premium would be paid out of your cash value earnings. Typically, this should continue for the remainder of your life.
Additional Variations On The Theme
There is another type of permanent insurance. It’s called Universal Life. Universal life acts the same way as whole life insurance with two key differences.
First – the insurance company gives you some control in how the cash value will be invested. Instead of the insurance company investing the cash value, you get to make the investment decisions, choosing from several options the insurance company offers. You can be as conservative or aggressive as the choices allow.
If you’re aggressive – and if the investment fund does well – you could build up cash value faster and larger than would be the case in whole life. Of course, if your investment decisions don’t go well, you might have to pay a higher premium in future years.
Second – the insurance company gives you a premium range instead of one required premium. You can choose to pay higher premiums in the early stages so that you can maximize your earnings; you can choose to pay lower premiums if you want to; and you can switch back and forth as your personal cashflow allows.
As you have probably guessed, this can be dangerous. If you pick the wrong investment funds inside the policy, and/or if you don’t pay enough premium, the policy might collapse and terminate.
Universal Life is a riskier, but potentially better performing, type of insurance. Be very, very careful if you are tempted to purchase it.
There are a couple of other benefits to whole life insurance and universal life insurance worth exploring.
Tax benefits – the growth of the cash value inside the policy is not taxed. As long as the cash value remains in the life insurance policy, it will remain tax free, and all its earnings will remain tax free.
Purchase More Insurance – you can use the additional cash value to purchase something called “paid-up-additions”. These are small amounts of additional insurance on which all future premiums have been paid. By buying paid-up-additions, you can increase the amount of the death benefit your family would receive.
Borrow From Yourself – it is also possible to access some of this extra cash value for personal use. Most insurance companies allow you to borrow a portion of your own cash value. The amount you borrow is tax free so long as the policy remains in force.
The danger with borrowing is that you must pay interest on the loan. You must leave enough cash value in the policy so that the earnings will pay the annual premium and will pay the interest on the loan. As long as those two conditions remain, then you can conceivably access your cash value without paying any income taxes.
But, if the remaining cash value isn’t large enough, the policy would lapse at some point, and then a portion of the cash you borrowed would be taxed.
Borrowing can be a very tricky endeavor. Great caution is needed to make sure you don’t create a huge tax problem down the line.
What Should You Do?
We hope we’ve helped you better understand life insurance. Trying to give you a simple answer on how much insurance to buy and what type of insurance you should buy is an impossible goal, despite what sales people might say.
Ultimately, insurance is a tool. It should fit a specific financial need, and it should be structured with that need in mind. Whether you need temporary or permanent insurance, convertible or universal, or 5-year or lifetime coverage, please speak with an objective professional before you purchase any life insurance. You can also read our blog on Changing Life Insurance as well!
An ounce of research now will prevent more than a pound of pain in the future. Understanding life insurance will help you to choose the right insurance so your family is protected. The wrong insurance can leave your family vulnerable and damaged financially.