Term Insurance vs. Permanent

There are two basic forms of life insurance, term and permanent policies. Each one breaks down into subcategories based on different options designed to meet the needs of the consumer.

Term Life Insurance
As the name implies, term life insurance is issued for a specific period of time from one year to age 100. The purpose of term insurance is to cover a need within the issue period such as protecting an income stream while raising a family or to pay off a mortgage or business debt in the event of an untimely death. Some term insurance policies offer a guaranteed conversion feature. This policy provision guarantees that the policy owner can convert the policy to a permanent insurance policy at the same underwriting status as assigned to the term policy. Consequently, term insurance can be utilized to fulfill a current insurance need at a low cost until cash flow is available for permanent insurance.

Permanent Life Insurance
Permanent life insurance is designed and priced to pay a death benefit or be surrendered for the cash value when the insurance is no longer needed. There are three types of permanent life insurance: whole life, universal, and variable universal life.

Whole Life is the oldest of these policy types. It features guaranteed minimum premiums, guaranteed minimum interest rates credited to the cash value, and guaranteed death benefits payable at death. Some whole life policies charge an extra premium to protect against unforeseen contingencies. This is a pricing technique held over from early insurance pricing nearly 200 years ago. Additional premium was added to protect against unknown contingencies such as wars and acts of God. This contingency premium was to be refunded to the policy owner periodically if such catastrophes never developed. Today these distributions are titled a “dividend” and as such are often confused as a measure of performance rather than a refund.

In the last 50 years, competitive pressures compelled companies issuing such policies to use dividends as a marketing tool to compete with new permanent policies such as universal life. Since the crediting of dividends is not guaranteed, companies can project dividends that enhanced policy values on the sales illustrations. By today’s standards, dividend policies depend on the insuring company’s return on assets to meet their dividends projections for the life of the contract. Since dividends are not guaranteed, and no company has fully met their dividend projections on the long term, it hardly seems prudent to invest the extra premium for a benefit that can be secured for less. Whole life is still marketed however, and to a consumer, it's difficult to understand what is guaranteed versus what is a projected value. In addition, it is inflexible and overpriced.

Universal Life
This policy type is a product of the computer age and is often referred to as Flexible Premium Adjustable Life. Due to the capacity of computers to conduct and maintain countless calculations, actuaries are able to expose the moving parts in a life insurance policy. Interest crediting rates, mortality costs, even expenses and premium taxes can be illustrated with ease. This allows for flexible premiums and face amounts, along with interest rates that reflect current portfolio yields. For the first time, policies could be designed to better fit changes in insurance needs and family budgets.

Universal life policies illustrate two interest rates, the “guaranteed minimum” and the “current” rate. The “minimum” is a contract guarantee while the “current” is credited as a product of the insurance company’s return on assets. The current rate is the basis for the “projected benefit” column in the illustration. It is important to understand that the cash values of the whole life and universal policies are invested as a general asset of the insurance company until surrendered or paid as a death benefit.

Today the most popular feature of universal life is the guaranteed death benefit feature. This feature provides the lowest cost guaranteed benefit ever offered in a life insurance policy. In addition, these guarantees can be structured for varying life expectancies.

Variable Life and Variable Universal Life
Variable policy cash values are not an asset of the insurance company and are managed as a separate asset in select funds much the same as a 401(k) portfolio is self managed. Although the insurance company is the custodian of the funds, the policy values are segregated from the general assets of the company and not subject to their creditors in the event of insolvency.

There is a critical difference however from managing a 401(k) allocation versus a variable life allocation. Variable Life policies have significantly higher expenses due to monthly insurance costs. As a general rule, monthly expenses of 2% to 4% or more are charged for insurance and administration costs. Consequently, a 10% return for 401(k) allocation could net one-half that in a VUL policy with the same allocation. As a result, asset management is more difficult with variable policies than a typical 401(k) or an IRA. We recommend two rules of thumb for successful VUL ownership:

      1. Over fund the policy in the early years to maximize tax free           growth inside the policy.
      2. Manage the portfolio as a sophisticated investor or retain a           professional asset manager.

The obvious benefit of variable universal life is that assets can be grown in a most favorable tax environment, which, if successful, can reduce long term insurance costs or grow the tax free death benefit to larger amount than the original policy. However, there are no guarantees and the margin for investment failure is narrow. One must weigh the risk of investment results in variable life policy against the guarantees offered by competitive universal life policies.