Life insurance offers important financial planning advantages if it is properly fitted to your needs and offered at a competitive price. Discover the best type and time to buy this invaluable piece of the financial planning puzzle.
Life insurance is among the most useful, and most maligned, of all the purchases that you will ever make. If properly tailored to your needs and purchased at a competitive price, life insurance offers important advantages, including:
- Income replacement for your survivors
- Investment/forced savings for you
- Reduced income and transfer tax liability
- A ready source of cash at a time when it's likely to be needed most
- Funding of small business buy/sell agreements
If life insurance can offer all of the above advantages, why aren't there long lines of people outside their insurance agents' offices demanding to buy more? Probably because people fear that one or more of following may come true:
- The policy will be overpriced when compared to similar policies offered by other companies
- The policy will offer poor investment returns
- The policy will not enjoy all possible tax advantages
- The policy will not function as planned to facilitate a buy/sell agreement
- The policy will be sold by an unethical insurance agent who will try to sell the individual the highest premium policy possible, whether it meets the individual's needs or not
Besides these possible financial disadvantages, key emotional factors may keep people from buying needed life insurance:
- By their nature, life insurance policies require current outlay for an expected advantage in the future (which may never be seen by the policyholder, only his or her beneficiaries)
- Many people remain uncomfortable about thinking of their deaths
Differences between term or cash value policies
Life insurance policies can be divided into two main categories: term insurance and cash value insurance.
At its most basic level, term insurance provides a death benefit only. If you die while the policy is in effect, the insurance company pays.You don't die within the term, they don't pay. Such a policy is pure protection only.
This should not be underestimated if you have younger children or children with special needs, especially if your spouse will not be able to earn enough to provide for them in the event of your death. Many business succession plans include term policies to provide cash should the sole-proprietor, partner or key shareholder die unexpectedly.
Of course, a term policy has no investment or cash value component to it. Although it's called term insurance because the coverage runs for a specified term, such as a year, most policies may be renewed at the option of the insured for as long as he or she is willing to pay the premiums.
While the some term insurance must be renewed annually, term policies are often written for much longer terms, such as five, 10 or 15 years. Although the cost of term insurance usually rises as the insured ages, level-term policies are also available. These policies keep the premium at the same dollar amount throughout the term, although the premium will often jump more sharply for the next term than would be the case for the year-to-year rise for an annual term policy.
Cash value insurance
Cash-value policies provide a death benefit and an investment/savings feature. With nearly unlimited types of cash value policies, you'll want to focus on the important differences between many of the options.
Cash value insurance is much more expensive than term, particularly at younger ages, but typically provides insurance throughout lifetime at a level premium. A policyholder normally can receive the benefit of these cash values during lifetime in one of two ways:
- By taking a loan against them
- By cashing in the policy, in which the policy will no longer be in force but the policyholder will receive the cash surrender value
Weighing the pros and cons of term policies
The primary advantage of term life insurance is that it requires a low cash outlay due to its pure insurance protection.
Term policies are usually favored by people who fall within one or more of the following categories:
- Younger, cash-strapped people with relatively large financial responsibilities, such as young marrieds with small children
- People who are using the insurance policy for a specific business purpose, such as funding a buy-sell agreement or as security on a major asset purchase
- People whose insurance needs will only last for a definite time period, such as until retirement (when a company pension and or Social Security kick in, for example)
- People who have no trouble saving money, and who believe that they can invest the savings at a higher return that they would get if they left the money in a cash value policy
The biggest disadvantages with term policies include:
- Premiums rising at the end of each term, sometimes reaching the point of being very hard to afford
- Fewer income tax advantages available for some types of cash value policies
If you do decide to purchase a term policy, make sure it's a guaranteed renewable policy. This means that at the end of the policy term you can renew without taking another medical exam, and without regard to how bad your health may be at the time of renewal.
Weighing the pros and cons of cash value policies
The main advantage most small business owners find with cash value policies is steady price of the premium as long as the insured keeps the policy. Although some modern cash value policies give the insured the flexibility of, within certain limits, changing the amount of money to be deposited into the cash value side fund, many stick with the traditional cash value policy.
Because of this level-premium feature, cash value policies, which are also known as "permanent insurance policies" have lower lapse rates than do term policies. Once you get used to paying the specified amount each year, you're more likely to keep paying and thus keep the policy in force.
Cash-value policies are usually favored by people who fall within one or more of the following categories:
- People who believe that their need for life insurance will continue throughout their lives
- People who have trouble saving money on their own
- People who can afford the larger cash outlay for a cash value policy
- People in high income tax brackets who want to take advantage of some of the additional tax sheltering aspects of cash value insurance
The biggest disadvantage of cash value insurance is, you guessed it, its higher cash outlay when compared to term. Also, the investment return on cash value policies has typically been rather low, particularly for the first five to 10 years after purchase.
In fact, most cash-value insurance policies only make sense if the policy is held for your entire life. Some modern cash value policies give policyholders the right to choose from several mutual-fund-like investment options into which to invest the cash values funds. Although these policies offer the possibility of higher returns within the policy, they require the policyholder to make the decisions about policy investments.
Another fact about cash value policies that should be remembered: most of these policies are written so that the lifetime cash values are applied to partially pay off the death benefit, when it becomes due.
Henry Kashman owns a cash value life insurance policy that will pay $100,000 on his death. The policy now has a cash value of $25,000. If Henry dies tomorrow, his beneficiary will get $100,000, not $125,000.
You can get a cash value policy that will pay your beneficiaries both of these amounts (i.e. in our example, the whole $125,000), only you'll have to pay higher premiums for it. The reason that we mention this point is that our experience has shown that many cash value policyholders do not understand that their beneficiaries only receive the face amount of the policy at death — they blissfully think that they have provided more for their beneficiaries than they really have. If you have any doubt about how one of your cash value policies is set up, ask your agent.
Choosing between term or cash value insurance
Like many big questions in business, there's no simple answer to which type of life insurance policy—term or cash value—will be better for you.
If you are just starting your business, and have lots of personal financial responsibilities, term insurance may be the way to go. But if you do this, you must remember that the policy will provide no savings for you in the future. The idea that you should buy term coverage and put the difference between the term cost and the higher cash value policy cost into an outside investment just doesn't work for many people: They buy the cheaper insurance, then do not manage to invest what they have saved over the more expensive cash value policies.
A sound strategy to follow is to purchase the term insurance and set up an automatic withdraw arrangement under which an amount equal to the "difference" of the cost of a cash-value policy is deposited and invested in an investment you chose, such as mutual funds, etc. You are likely to realize as much, and probably more, savings growth using this strategy that waiting for the cash-value to accumulate decades in the future. Banks, brokerage houses and insurance companies can set up such an arrangement.
If you, on the other hand, are:
- Not in a business start-up situation
- Not strapped for cash
- Heavily burdened with personal financial responsibilities
- Of the mindset that your life insurance policies should be lifetime companions
You may want cash value insurance.
When you opt for cash value policies, you'll have myriad options to wade through. The traditional whole life/ordinary life policies will give you:
- A guaranteed premium amount
- A guaranteed death benefit amount
- At least a guaranteed minimum build up in the policy cash values.
Other, more modern cash value policies offer the possibility of greater investment returns, but these returns depend on how well the policy's individual investment fund performs.
Regardless of how well it appears that a life insurance policy performs as an investment, it is highly unlikely that purchasing it will make sense if you have no need for the additional death benefit protection. All life insurance policies—even those that emphasize the growth of cash values over death benefits—must provide for death benefits (for which a portion of your policy premium must go). If you don't need more death benefit protection, you shouldn't have to pay for it! By putting your money in a non-insurance investment, all of the money invested (less any applicable fees) would go to purchase your investment fund.
Comparing types of life insurance policies
Life insurance policies are complicated. They contain terms and provisions that are legalistic mumbo-jumbo to most of us. Added to this, there seem to be countless types and varieties of insurance policies.
Our summary comparison of the most common forms of term, cash value and specialized and hybrid policies tries to hit the high points of the most common types of in use. If something sounds unfamiliar, remember that various insurance companies—primarily for marketing reasons—create their own names for specific variations of the general insurance types noted here. However, you should be able to find a description of what type of policy it is buried in the first few pages of the policy.
The most common policies compared include: