Many young men about to propose marriage struggle to choose the perfect wedding ring – whether to buy an elaborate and expensive diamond, or a simpler, less expensive gold band. Each ring serves the same purpose as a symbol of everlasting commitment, but there is a substantial difference in cost, as well as the possible reaction of friends and family and the expectations of the recipient.
Choosing life insurance can pose a similar conundrum. While all life insurance provides funds in the event of the insured’s death, the same factors – the purpose for which the funds are intended, the cost, and the needs of the beneficiary – have to be considered when selecting the type of life insurance most appropriate to your situation.
Types of Life Insurance
While the life insurance industry is adept at marketing buzzwords and catchy acronyms to sell their products, life insurance as a practical matter can be generally broken down into two groups: term and permanent insurance.
Term life insurance (or “pure” life insurance) is written to provide a specific death benefit, and protects an individual for a specific period of time in return for the policyholder’s payment of a premium. If the insured person is alive at the end of the contract period, the premium is lost – in other words, there is no payment by the insurance company to either the insured person or his heirs.
A new premium, reflecting the greater likelihood of mortality, is subsequently calculated by the insurance company and collected from the policyholder to provide a succeeding year or succeeding years of coverage. Since the likelihood of death increases with each year of life, the same premium payment would purchase a lower amount of insurance each successive year. To keep the same face amount of insurance in place, premiums rise each year to cover increased mortality risk.
Term insurance is available in a variety of different contract periods: annually, known as an “annual renewable term,” in 5-year, 10-year, 20-year, and 30-year increments. When the contract period extends beyond one year, the insurance company adds the individual mortality rate for each year and calculates an average premium which the policyholder must pay each year. The premium is the same each year of coverage, priced higher than what the actual mortality risk would require in the earlier years, and less than the mortality risk in the late years would require.
Term insurance is particularly suitable to those purchasers who seek maximum coverage at the lowest possible cost for a specific period of time. Parents, for example, whose incomes are currently stretched to cover current living expense while trying to save for future liabilities (such as the college costs for children) may purchase large amounts of term insurance until their children’s education is complete. Term insurance is also ideal when a specific financial obligation will end at a certain future date, such as home mortgage payments.
Permanent Life Insurance
Commonly referred to as whole life insurance, most permanent insurance is simply an extended term insurance policy with an accumulating savings element. The insurance is designed so that the investment portion increases at a similar rate as the mortality rate. As the investment grows, the portion of the face amount of the policy paid by actual insurance (as opposed to the investment component) decreases, and the face amount or death benefit remains unchanged. The face amount of the policy is paid to the beneficiaries at the death of the insured or at the insured’s age of 100, presuming that premiums are paid as required by contract.
Many financial planners discourage the purchase of whole life insurance, preferring to keep the savings and insurance elements separate. In my experience, a greater problem with whole life insurance is that younger people starting a family and incurring significant long-term debts are often under-insured, as the coverage they can afford for permanent insurance premiums is less than what is needed in their circumstances.
On the other hand, if you have a high income and problems saving – whether due to a lack of discipline, time to manage investments, or knowledge about investment opportunities – whole life insurance may be perfect for you. The higher premiums of whole life includes a forced savings element: the cash value of the policy which increases each year.
Whole life insurance is also ideal for people who have health issues or are worried that they might contract an illness that could lead to “un-insurability” as time goes by. A whole life policy can never be canceled as long as the premiums are paid as required by the contract.
Universal life insurance is a more flexible variation of permanent insurance designed to overcome the investment and management rigidity typically found in whole life policies. Effectively, the insurance and investment portions are separate, allowing the owner of the policy to vary the death benefit, accumulated cash value, and premiums as his or her circumstances change.
Unlike term insurance, which may not be available or can become prohibitively expensive as one ages, universal and whole life policies provide a method to ensure coverage for one’s lifetime and permanent estate concerns, such as burial expenses and estate taxes.
While the type and cost of a wedding ring is no guarantee of a successful marriage, the purchase of life insurance – whether whole life or term – is certain to benefit your loved ones. After determining that you need life insurance, your next step is to quantify the amount you need to carry out your wishes and meet financial obligations. After you’ve calculated the amount of insurance needed, you can choose which type – term or whole life – best fits your financial and personal circumstances.
Do you own term or whole life insurance?