Life Insurance: Rent Or Own?
Once the importance of life insurance is recognized and the search is started for a suitable policy, one of the first choices the prospective buyer commonly faces is whether to purchase Term or Whole Life insurance. While the distinction between these two types of coverage is fairly clear, understanding how each serves two different budgeting mindsets may not be. This article not only defines Term and Whole Life policies, but also answers the important questions of who typically buys which kind and why they do so.
Term Life Policies
Term life insurance provides protection against financial loss resulting from death during a specified period of time, or term. Term insurance is composed of mortality costs and contract expense, and is characterized as providing “pure protection” because it pays only death benefits and does not contain any cash-value features. Coverage stops at the end of the contract period, which is contractually quite similar to property lease agreements, and is the reason why term insurance is sometimes referred to as “renting” insurance.
Advantages of term insurance include:
- Lower initial cost.
- Allows dollars to be invested elsewhere.
- Pure death protection.
Disadvantages of term insurance include:
- Absence of a savings element.
- Expiration of the contract after a specified period.
- Typically, an annual increase in cost.
The increasing annual premium structure of term insurance results from the decreasing life expectancies of contract owners as they age. However, level-premium rate structures can give a contract owner the same rate for a specified number of years. Term insurance is appropriate for:
- Young couples, especially those who need a large amount of insurance.
- People who do not want to invest in a cash-value insurance vehicle.
- People who cannot afford the higher premiums of cash surrender policies.
- People whose insurance needs decrease over time.
- People who have temporary needs.
Whole Life Policies
If term insurance is rented, then a whole life policy is owned. The premiums due are put towards a contract that is designed to provide lifetime coverage. Whole Life often is called traditional life insurance to distinguish it from term insurance. The cash value in whole life insurance arises because of the level-premium system and the necessity to account for prepaid premium.
Whole life is a form of insurance offering “permanent” protection at a level premium for the entire lifetime of the insured. Premiums remain fixed and are paid for life. Because premiums are deliberately higher than the cost of insurance during the early years when mortality expenses are lower, the premium level can remain constant throughout the life of the contract. The excess charge early on makes it possible to build up a reserve, which will be needed, together with interest earned, to keep premiums level. This allows older contract owners to pay the same premium in later years when mortality expenses rise.
The cash value of a whole life contract serves a variety of purposes:
- It can be used for collateral for an insurance company loan.
- If the insured decides to terminate the contract, the contract cash value can be received at that time.
- The cash value balance may be remitted to the insurance company to purchase a reduced “paid-up insurance contract.”
The advantages of a whole life insurance plan include:
- A forced savings element.
- Loan privileges.
- A variety of premium payment plans.
Whole life policies are appropriate for people who feel a need for forced savings and for people who want lifetime coverage. Disadvantages include:
- A higher cost of death protection.
- A low rate of return.
- Lack of flexibility.
Making the Decision
After learning the technicalities of term and whole life contracts, many people must then ask themselves some potentially challenging questions to clearly discern what kind of policy is right for their circumstances:
- What kind of saver have I proven to be so far in life?
- How much does my current budget realistically provide me for insurance coverage, or even more importantly, where can I trim the wants within my current budget to satisfy this important need?
- Do the returns available within a whole life contract justify maintaining a cash balance there versus other fixed-income yielding investments?
Many prospective life insurance buyers recognize that the term vs. whole life choice is a bit of a trick question, as some combination of the two are suitable for different stages of life. Owners of whole life contracts commonly choose the more affordable extra coverage that term insurance provides directly prior to starting a home mortgage or family, when the need for life insurance typically becomes more clear. Once the mortgage is paid or children have left home or finished college, the parent allows the term contract to expire, but now has the remaining whole life contract that in many cases has grown in value either in the amount of coverage it provides or the amount of cash value accrued within it. This scenario is sometimes referred to as the “pyramid” of life insurance coverage, where the insured always holds a base of whole life, adds an additional amount of term during the peak years of financial risk, but eventually allows the term coverage to expire as the home mortgage is retired and/or the children are no longer financially dependent.
While policy choices at first can appear daunting and costly, life insurance is often viewed as the primary requisite of any financial plan. This crucially important protective base is designed to financially insure the future lives of remaining family members in the case of the insured’s death, which may include payment of college tuition costs, a home mortgage and/or other debts that a family commonly must rely on to serve its members’ needs.
Whether renting or owning, life insurance is a purchase that serves the interests of the ones you love, after you can no longer do so.