What Kind of Life Insurance Do You Need?

Uninformed or unscrupulous advisors have been guilty of telling others NOT to purchase life insurance. Their reason for spreading this propaganda varies from being naïve as to how life insurance works, to being over desirous of wanting to manage more of their clients’ money.  Either way, those who listen to such advice lose out financially.

Andrew Carnegie realized life insurance was:

“The greatest national individual savings system with a form of flexibility that is not available through the banking system.”  He stated, “No other system gives the individual man protection for his family and at the same time releases his mind from worry in connection with the possibility of approaching old age and its economic uncertainties. Life insurance is definitely part of the fundamentals of America.”

Understanding life insurance serves a valuable role, what kind of life insurance do you need?

The answer to this question requires knowledge of what type of life insurance is available.  Frankly, there are only two types of life insurance:

  1. Term life insurance, and
  2. Permanent life insurance

Term life insurance provides coverage for a specific term or time period.  A term life insurance contract can be as short as one month, one year, or even up to a specific age of the insured.  Yet once the predetermined term has expired, the cost of continued coverage increases. This results in term life insurance becoming one of the most expensive types of life insurance to own, IF you keep paying for it for a long time.  Ultimately, the cost to maintain term life insurance coverage will exceed any benefits which might be paid in a claim.  It is important to know, less than 2% of all term life insurance sold ever pays a death claim.  Yet even so, term life insurance is still the best value money can buy when it comes to protecting the income of a young family’s bread winner(s).

Permanent life insurance provides coverage which can last an entire lifetime.  There are two types of permanent life insurance.  One type of permanent life insurance is more permanent than the other.  So much so, that the other life insurance classified as permanent life insurance should, in all honesty, be classified as “Term life insurance where the risk is assumed by the policyholder”.

The names of the two types of permanent life insurance are:

1) Whole life insurance, and
2) Universal life insurance.

Universal life insurance is life insurance that has been broken down into its two basic components,

a) The term life insurance coverage, and
b) The investment part of the life insurance policy.

In breaking apart these two components of permanent life insurance, the insurance companies which sells universal life assigns the liability portion of the policy, the investment portion, to the policyholder rather than assuming the risk themselves.  It also allows the policyholder to pay extra premiums to the insurance company which then accumulate in a separate account and are subject to earning interest. The promised interest rate earned is not guaranteed to overcome the ever increasing cost of the term insurance in the policy, which makes up the foundation of all universal policies, therefore extra premiums paid can also be invested or mirror some market index , or indexes, like the S & P 500, etc.

This is where risk becomes an issue.  As mentioned previously, there is a healthy expectation, which is sold to and held by policyholders, that interest earned on the extra premiums paid into the accumulated account of a universal life policy will offset the cost of the ever-increasing term costs associated with owing universal life insurance.  The fulfillment of any such expectation, unfortunately, happens so rarely that massive lawsuits have been filed, and won, by universal life insurance policyholders who believed they were purchasing a permanent life insurance policy only to have their policies lapse or become unaffordable due to the ever-increasing costs of the term insurance which, as you now know, is the basis of all universal life insurance products.

Whole life insurance is the best permanent life insurance policy to own in that it doesn’t split the term coverage from the investment portion of the contract. The insurance company assumes the risk and responsibility for both of these components instead of ditching the investment risk off onto the policyholder as they do with universal life products.

Furthermore, the term life insurance component found in whole life insurance has a fixed premium for the life of the contract, it can never increase like the term costs do in a universal life insurance product.  The reason behind this is the term insurance in whole life (aka, base insurance) converts to paid-up insurance at a predetermined contractual frequency throughout the life of the policy.  Once a portion of the base insurance has been converted to paid-up insurance there is no longer any further premium required on this piece of paid-up insurance. It belongs, in its entirety, to the policyholder. This conversion of base insurance being converted to paid-up insurance occurs throughout the life of the whole life insurance contract, allowing for the remaining term insurance in the policy to be purchased each year with the fixed predetermined premium, without ever having to increase it.

Paid-up insurance is, as noted above, owned exclusively by the policyholder, much as equity in real estate is owned by the one purchasing the property. Paid-up insurance can be leveraged and used as collateral for loans, or it can be surrendered (sold back) to the insurance company and the money paid for it will be returned to the policyholder. If paid-up insurance is used as collateral for a loan and money is borrowed from the insurance company, the insurance company will charge a predetermined interest rate on the money loaned until the loan is repaid. When paid-up insurance is surrendered the amount of paid-up insurance surrendered is subtracted from the total face value of the policy and the policyholder receives from the insurance company the cash surrender value of that surrendered paid-up insurance.

Most insurance companies don’t penalize a policyholder when using their paid-up insurance as collateral to take a policy loan. Thus, the base insurance that is scheduled to convert to paid-up insurance occurs at the same rate it would have occurred without an outstanding policy loan. This provides growth for the policyholder even when money has been borrowed against the policy. This isn’t always the case when using a universal life policy as collateral for a loan.  Thus, whole life insurance is a unique financial tool capable of:

  • Increasing cash flow at the discretion of the policyholder
  • Make investments which otherwise would not financially be possible
  • Manage debt in a manner where the policyholder can keep a large portion of the interest which would otherwise be paid to creditors
  • Allow the policyholder to keep a significant portion of the financing costs associated with asset and consumable purchases
  • Provide a unique tax deduction when using policy loans for business purposes or investments

Whole life insurance offered by mutually owned life insurance companies pays dividends to policyholders who own participating whole life insurance.  This is something which universal life insurance policyholders can’t earn as universal life insurance policyholders are never granted participation rights in company profits.   Furthermore, paid-up insurance poses ZERO risk to the insurance company, namely because it has been fully paid for.  Mutually owned life insurance companies therefore, return some of the premiums which were paid for a whole life policy to the policyholder when the insurance company makes more money than what it takes to pay the operational expenses and claims filed with the company.

The return of premium, which is classified as a dividend, is not taxable until a policyholder surrenders more paid-up insurance and receives payment of more cash surrender value than what has been paid for the policy.  Of course, if a policyholder never surrenders any of the paid-up insurance, the policyholder can access the surrender values (cash values) of the policy via loans without ever facing taxes.  Paid-up insurance earns its own separate dividend.  Premiums that are returned to the policyholder (dividends earned) can be used to purchase more paid-up insurance creating a compounding annual growth rate that exceeds the guaranteed values of the whole life insurance contract. This growth is not taxable when it accumulates within the policy.

Because interest due on a policy loan which hasn’t been paid on time is added to the policy loan balance, a policyholder could risk a policy loan becoming so large over time that it would force the whole life policy to be surrendered unless the loan is paid off or the interest is satisfied.  To allow a whole life policy to lapse due to an excessive loan like this, would be poor money management.  Not only would the policyholder lose the policy, they could face a tax liability if the total loan value is greater than the cost basis of the policy at the time the policy lapses.  Therefore, it is vital to pay interest on all policy loans on time to keep the interest from compounding and making the loan balance rise.

Knowing what types of life insurance policies are available, allows you to determine what type of life insurance is needed.

  • If you have liabilities which would prevent your family from living the life you are currently providing for your family, then term life insurance may be the type of life insurance you need, age and health playing a factor
  • If you want to keep money in a safe place for an “opportunity, rainy day or retirement” you need participating whole life insurance
  • If you want to build an asset that allows you to leverage money and finance things in your life without having to use traditional methods to borrow money, you need participating whole life insurance
  • If you have liabilities, like a mortgage, or businesses partners you may need term, or participating whole life insurance, and maybe both types of insurance
  • If you are single and don’t believe you need life insurance, then you need to re-evaluate what Andrew Carnegie stated about owning life insurance. Everybody could benefit from owning life insurance.  The only drawback is:  Many people fail to realize this before becoming too old or unfit for the purchase of permanent life insurance

Most people would benefit greatly from owning both types of life insurance, term and whole life.  Doing so would protect their family, business partners, spouse, loved ones, etc., while at the same time allow them to build an asset which will help them sustain a lifestyle in retirement which keeps pace with the lifestyle they have become accustomed to throughout their working carrier.

Life is lived but once. When people understand what life insurance can accomplish in this life, they willingly purchase it throughout their lifetime which makes life less stressful and more abundant.  Once this life has passed, policyholders leave a tax-free legacy for the next generation to help them reach even greater heights than what this life afforded them. “Life insurance is definitely a part of the fundamentals of America.”  Don’t leave this life without it.

Dr. Tomas McFieDr. Tomas P. McFie

Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. Tom McFie is the founder of Life Benefits which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, How to Build Sustainable Wealth, can be purchased here.