Life Insurance – The Basics

By Randy

(Randy is a Certified Financial Planner with 20 years of experience as an investment banker and he will be contributing weekly to the Boulevard R blog)

I very frequently get asked about life insurance. There are few areas in financial planning both as important and as confusing as the subject of life insurance. While a thorough explanation of the various life insurance products available could fill a book, I’ll try to highlight the differences between two of the most common types, term and whole life, in more simple terms.

Term Life Insurance: As the name implies term life provides a stated amount of coverage for a fixed term. Think of this is being similar to your auto insurance where the coverage remains in force as long as the company is willing to renew the policy and you pay the premium. Most term policies will offer a “fixed” premium and guaranteed renewal for 10, 15 or 20 years depending upon the policy. Unlike whole life, term policies are pure insurance and disappear when you stop paying the premium or the guaranteed renewal period is up. Since it is pure insurance, the annual premium is usually the lowest of all forms of life insurance because you are paying only for the insurance.

Whole Life: Whole life (or Variable Life) is essentially a term policy combined with a savings account. The annual premiums are generally much higher than for term insurance alone because you pay an extra amount of premium that is accumulated as savings. Normally you pay the premiums until a predetermined age, usually 65, and then the policy is “paid up”. In other words the savings have now reached a point where it approximates the amount of the policy coverage and you no longer need to make premium payments. This “cash value” then can be used to maintain the death benefit for the rest of your lifetime or be drawn out for retirement or other needs. It’s really this savings component that differentiates whole life from term life.

Pro and Cons: So which form of life coverage is better? The answer is it depends upon your situation. If you are looking for the most coverage at the lowest cost then term is probably the best. However, if you anticipate that you will need coverage much later in life, term may get to be hard to renew as you get older. Remember most term policies end after 20 or fewer years so if you are in poor health when your term policy runs out you may find you are uninsurable. If your family health history or long term need for coverage suggest health issues might become a factor then term life may not be your best choice. If, on the other hand, you have a young family and a working spouse, you may only need coverage while the kids are growing up, in which case term could be an excellent choice.

With whole life policies the coverage is guaranteed for life as long as you pay your premiums so deteriorating health issues become irrelevant. As a savings vehicle whole life has the advantage of allowing your interest or investment gains to accumulate tax deferred or even tax free so it can be an effective supplement to those who are looking for a way to put away a few more dollars for retirement. The problem is that whole life insurance tends to be laden with lots of commissions and fees so in spite of the tax advantages it is not necessarily a very efficient way to save. If you don’t really need the permanent insurance that comes with a whole or variable life policy then you can probably find other, more efficient ways to save.

This is only a very superficial overview of the life insurance world but hopefully clarifies at least some of the fundamentals. Everyone’s situation is slightly different so it’s important to assess your exact needs and if appropriate pursue the issue with a trusted advisor before you buy.

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