Life Insurance 101: Coverage Types


[This is part 2 of a 9-part series. For a full overview of topics, see the Life Insurance Basics page.]

Part one discussed Servicemembers Group Life Insurance (SGLI).  There were a couple of things to remember: First, SGLI only covers active duty and some reserve service. Second, although $400,000 of coverage is very generous for a group plan, it is probably not enough coverage for most families and the spouse coverage under SGLI is particularly inadequate. So most servicemembers need to consider individual policies, especially when they retire or separate. The remaining articles in this series will discuss several aspects of individual life insurance.

Let's start with a discussion of the two basic types of coverage: term and permanent.

One analogy is that term coverage is like "renting a house" and permanent is like "buying a house." Term coverage is pure protection. You pay as you go and your family is protected for the term of your contract just like rent and a lease.  Terms are usually a specified number of years such as a 20-year term or 30-year term. Or, term can provide coverage to a certain age term, such as to age 65. It is temporary protection. Only about 1 percent of all term plans result in a death claim since most people outlive the term.

Permanent coverage is protection for your whole life which is why it is often referred to as "whole life" insurance. Because the insurer knows they will eventually pay a death claim, the premiums are higher for permanent coverage. However, permanent coverage can have a living benefit as well as a death benefit. It comes in the form of a cash surrender value inside the plan. Over time, cash value in the policy grows tax-deferred much like equity in your home when you have a mortgage. The policy owner has access to some of this cash through policy loans. Or if there comes a time when the coverage is no longer needed, the policy can be surrendered for the cash value. In a well performing policy, this cash value can be significantly higher than the premiums paid into the plan.

Term plans are excellent for young growing families when the need for financial protection is greatest. A mortgage, college education for the children, car loans, etc. represent significant "temporary" liabilities that need protection.  A significant amount of term coverage can be purchased at a reasonable cost. Permanent coverage is better suited for longer term needs such as estate settlement costs, a source of income for the surviving spouse, or a legacy for children or grandchildren.

When discussing permanent coverage, many financial planners will suggest "Buy term and invest the difference." The theory is that you invest the difference in premiums between a term and whole life plan and your investment would grow such that when the term expired, the value of the investment would replace the coverage. There are a few problems with this approach. First, the "difference" is not always sufficient to reach the goal. Second, while well intentioned, many people simply do not execute the plan. Competing priorities for funds often disrupt investment plans.  Third, the burden is on the investor to achieve results rather than on the insurer to pay off. However, assume everything worked according to plan and the investments grew to equal the original term plan coverage, but then the insured dies just as the stock market or real estate market takes a tumble. The value of those assets is reduced when the family needs them most. The family is now forced to sell assets at a loss. If the insured had just a modest whole life plan in place, the family would receive a tax-free benefit that could sustain them until the markets recovered. Most families would be well served with an appropriate mix of term and permanent coverage. In the next two installments we will take a closer look at term and permanent coverage.

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