Life Insurance 101: Permanent Coverage


[This is part 4 of a 9-part series. For a full overview of topics, see the Life Insurance Basics page.]

As discussed in Chapter 3, term insurance is temporary life insurance and most people outlive their coverage. Conversely, permanent life insurance covers the insured for their entire life which is why it is often referred to as "whole life" insurance. It is more complicated and more expensive than term insurance, but it tends to have more features and options than term coverage, which can make it an attractive addition to a family's overall financial plan. There are many types of permanent life insurance such as, ordinary, adjustable, universal, and variable. Most companies have designed their own unique products with special features. For additional information on the types of permanent life insurance visit the Life and Health Foundation for Education (LIFE) website.

A significant difference from term coverage is that permanent life insurance has a "living benefit" as well as a death benefit. That living benefit comes from the cash surrender value that grows inside of the policy. When premiums are paid, the insurance company takes out two typical expenses: administrative costs (running the company and profits) and mortality costs (paying the death claims). Once those charges are deducted, the remaining cash is added to the cash value and interest (crediting rate) is applied. The gain (cash in excess of premiums paid) grows tax-deferred just like an IRA. For most commercial whole life policies, there will be zero cash value for the first three to five years and there will usually be surrender charges that will reduce cash value if the policy is "cashed in" early, usually within the first 10 years. However, over time, a well performing policy will generate a cash value that can be significantly higher than the total premiums paid.

The owner of the policy can obtain the cash surrender value by terminating the policy. A significant portion of the cash value is also available without terminating the

coverage through a policy loan. The owner borrows their own money, doesn't have to repay the loan, and most of the loan interest will be put back into the policy's cash value. The loan is a tax-free event in most cases, even if there is a gain in the policy. It can be an excellent source for an emergency fund.

The premiums for whole life are higher than term coverage. The same factors used to determine term premiums are used for whole life: insured's age, gender, tobacco use, and health factors. However, there is another factor for whole life: the number of years premiums are paid. Unlike term coverage which is pay-as-you-go, the policy owner can usually choose how long they want to pay. A policy can be "paid up" with a single premium, pay-for-life premiums (pay until age 99), or just about anything in between. It works just like a mortgage: the longer you pay, the lower the monthly premium, but the more paid overall. A young servicemember could have a very affordable premium in a pay-for-20-year plan and retire with a fully paid up policy that would continue to grow in value and be in place for their whole life. Note that the growth rate of the cash value is affected by how long premiums are paid. By paying up the policy sooner, a higher rate of growth is achieved.

When shopping for whole life insurance, it is important to review the illustration for the policy. The illustration will describe the performance of the policy in a tabular format. It should show premiums paid and the guaranteed cash value and death benefit for each year of the policy. The guaranteed columns are based on the guaranteed crediting rate (interest). This is usually very nominal, around 3 percent to 4 percent, and should be listed. There will also be columns showing "projected" performance at a higher crediting rate which may or may not be indicative of current performance. It is important ask about the policy's crediting rate history. It is also important to ask about the portfolio that funds the policy. Most standard whole life policies are backed by fixed instrument (bond) portfolios and have a steady, nominal return. Variable Life policies are backed by equity (stock and mutual fund) portfolios and the policy owner usually selects the funds. Variable policies can enjoy higher rates of growth, but they can also suffer significantly during market downtimes.

Because permanent coverage is more expensive, it is not the ideal insurance for the large temporary needs of young families (mortgage, college fund, debt). However, adding some whole life to the life insurance portfolio can ensure that tax-free funds will be available no matter when death occurs. This can be valuable for estate planning, funeral expenses, and immediate spousal income. A frequently asked question is which should I buy, term or permanent? The answer depends on a number of factors, including how long you need the coverage, how much you can afford, how much risk you can tolerate and how much flexibility you need. A decision guide that can help you with the selection process is available on the Life and Health Foundation for Education (LIFE) website. The next chapter in this series will discuss underwriting.

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