Life insurance, like any type of insurance, is constantly evolving in the marketplace. As insurance companies continue to create new products and tweak older ones, their offerings become increasingly more complex, harder to understand and sometimes, are sold to policy holders for the wrong reasons. Term insurance has remained fairly constant, but permanent, cash value life insurance policies are often sold as an investment with an emphasis on the investment benefits of the cash value portion–not on the protection that actual insurance provides.
Term Insurance vs. Permanent (cash-value) insurance
As a quick review: Term insurance is pure protection. For example, if a person buys a level 20-year term policy for $100,000 worth of coverage, he or she will pay annual premiums for 20 years to maintain that $100,000 worth of coverage. At the end of the 20 years the policy will terminate and the insured will either have to apply for new coverage or convert the term to a permanent policy. Term life insurance is cheap – and serves its purpose in providing a set amount of coverage, for a set number of years. Note: There are many types of term insurance of varying duration, premium type and convertibility, but the overall concept remains the same.
The market for permanent (cash value) life insurance is much larger and more complex than it is for term. Whole Life, Variable Life, Universal Life and Indexed Universal Life are the most common types of cash value life insurance policies. Each works slightly differently, but all have a cash value component. The general concept underlying each of these policies is having insurance coverage with a cash accumulation aspect (and a flexible premium) that should last your entire life.
As a policy holder pays the premiums, a portion of the money goes toward the protection component (known as the “cost of insurance”) while the remaining amount builds in the cash value component. As a result, permanent life policies tend to be much more expensive than term insurance policies. The cash value (depending on the type of policy) can be invested (at the policyholder’s instruction) in the insurance company’s fixed account or, a select lineup of mutual and/or index funds.
The “sizzle” of the permanent life sale is the flexibility that the cash value provides the policy holder, as well as the tax treatment of the cash value. For many (but not all) permanent insurance policies – if you, the insured want to skip a premium payment you can do so – the insurance company will simply deduct the missed premium amount from the cash value. This may seem great, but if you get into the habit of skipping premiums, your cash value will eventually evaporate and your policy will be in jeopardy of lapsing.
The second “sizzle” of the permanent life sale is the tax-free treatment of the cash value. Withdrawals from the cash value of a life insurance policy are tax-free. Everyone loves tax-free income, but again, if the policyholder makes too many withdrawals, and the policy lapses then you have not only lost the insurance coverage, but have also created a taxable event for the “tax-free” withdrawals.
Life insurance policies are complex and becoming more so every year. Insurance serves an important purpose in the holistic financial/estate planning world by providing you and your family protection against all types of unforeseen adverse events. If you are going to buy a policy purely for protection and peace of mind, then that policy should be constructed specifically for that purpose. If you are looking to leverage the advantages of the cash value, then you may need to sacrifice some of the protection benefits of term life in order to get the potential income upside of cash value life. The trouble arises when the purpose and the function of insurance policies are not aligned.
- Insurance is an essential part of a holistic financial and estate plan.
- But, insurance offerings have become increasingly complex and policies are often sold to people for the wrong reasons.
- If you want simple protection, stick with term insurance. If you want to utilize the cash value, then make sure you understand all the pros and cons of permanent (cash value) life.
Advisor is not a licensed insurance broker or agency and does not sell or solicit the sale of any insurance products.