Life Insurance – Part 2 – The Basic Types

• IRON100
• March 3rd, 2010

In writing this post, I am a little concerned that I may be too basic in my descriptions of various forms of life insurance, but I would as soon start here and get berated for the over-simplistic approach. At least from this perspective, I can tailor what I am about to write to fit the widest audiences for the subject of life insurance. At this point, however, I will not discuss the topic of annuities, because I believe that subject deserves a bit of special treatment, and I will do that at a later time.

Life insurance is sold in two basic forms. One form is term insurance, and the other is often called whole life or permanent insurance.

Term life insurance is essentially life insurance for which a death benefit will be paid only within a specific period of time. There is a specific reason for that. The reason for a term is that, if one is saving money routinely for family needs, college education and retirement, as one builds personal and family wealth, one soon will not need life insurance to pay the necessary final expenses for the income provider's death. The family's assets, built up over time, can and indeed should provide for that. As a result, unless there are specific health concerns that would drive insurance premiums up, term life insurance is the cheapest form of insurance one can buy. Terms are specific to policies and variations of the policy, but terms typically cover 10 to 20 year terms. I will provide a link from Pacific Life (mainly because I like the general definitions, not so much because I am providing an advertisement for them (as I definitely am NOT). Study those definitions. Below are my major comments regarding them.

Term life insurance allows one to budget funds for catastrophic occurrences in the life of a bread winner, without committing to many funds to it. Term insurance allows one to invest, save, and plan as term plans are now very inexpensive for amounts at or just under a million dollars. Term life insurance is definitely not an investment either. It is and should be considered a necessary expense to protect the well-being of remaining family members should the bread winner (or bread winners) pass away. As one will see in these definitions, there are various terms that can allow coverage that, if properly sized, will not necessarily break the budget and provide the necessary coverage.

Permanent insurance or whole life insurance is designed to be coverage that lasts an entire lifetime and can build a residual cash value over that lifetime. It is often sold for its investment value, but in truth, and here is the real kicker, it provides little investment value (if it is traditional whole life insurance) because most people with sufficient skill (and one can learn these skills)  can outperform the rate of return provided by the policy. Any of the other types of policies either are tied to a financial index (say the Standard and Poors 500 stock index) or actually invests some of the premium in equity indexes. Those policies are normally called variable life insurance policies.

The other forms of insurance (lump sum single premium permanent or whole life policies) and last survivor life insurance can have some benefit to certain individuals, but in the former case, a term life plan or other survivorship plan is probably cheaper than the whole life version of that policy. I am working on a post regarding the latter case, as with the change in estate tax laws that are coming, if one wants to leave an estate to charity, one must PLAN for the variability in estate tax laws to use the insurance to mitigate it if one wants to leave an estate to a charity or to establish a foundation, if one has such resources. Trusts can be used for that purpose also, but one has to be careful about their legal structure to make that work properly.

I will over time begin to discuss these survivor issues  from the perspective of a business owner. Estate planning will become ever more important in an environment for which tax rates are highly likely to increase as U.S. deficits continue to expand. It is something everyone will be faced with.

The bottom line here is that life insurance should, in my opinion, be viewed as a necessary expense and not as an investment. Typically, whole life or permanent life insurance is sold as an investment, but that investment is typically locked into a cash value, whose return mimics a bond rate, if traditional, and an index rate if variable. As an investor, one requires liquidity and flexibility (that is, the ability to move those assets over time). Handing one's money to an insurer tends to destroy the flexibility aspect, particularly when it is a whole life policy. Term insurance is normally the best option for those who wish to have investment flexibility.

In the next few installments, I am going to discuss how to figure out how much insurance one needs and about estate planning tied to insurance (that is, survivorship insurance for the partner of a deceased person).

More information is coming down the pike on Friday. Thanks again for all who are reading these posts. Your questions and your support are fantastic. If you have questions or would like us to comment on topics, or even if you would like to post on a topic, send a note to buffalotrader100@gmail.com.

Tickers: estate planning, expense, investment, survivorship, term life insurance, whole life insurance

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