Practical Persepectives: Key Financial Issues for You and Your Family

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Getting Back to Basics With Life Insurance

Soon after marrying, Nathan and Penelope decided they needed a financial advisor. With successful careers and a beautiful home, they had a lot to lose: If one of them died prematurely, the survivor might not be able to pay the mortgage. Among the first topics they discussed with their CPA was life insurance.

Both Nathan and Penelope had some passing familiarity with the concept of life insurance, but they wanted to learn more. Specifically, they wished to determine not only what policy would best suit them immediately, but also what options they should keep in mind for the future, such as when they start a family. Their advisor agreed that getting back to basics was an excellent idea, so he began by explaining the two fundamental types of life insurance: term and permanent policies.

Term Coverage

Under a term policy, the buyer makes regular premium payments in exchange for a set sum that will be paid to his or her designated beneficiaries should the policy owner die during the specified “term.” Nathan and Penelope could select the term, which can range from one to 30 years, depending on their preference when they buy the policy.

The main reason many, if not most, people buy term coverage is its low cost. The catch is that, at the term’s end, the policy must be renewed — an often inconvenient task that generally triggers a premium hike. In addition, term policies carry no cash value.

Permanent Coverage

Unlike term policies, permanent ones never expire as long as the premiums, which generally remain constant, are paid. Permanent policies typically have two parts: 1) an insurance component providing a death benefit, and 2) an investment component providing cash value in a savings account.

For instance, a basic “whole life” policy would give Nathan and Penelope lifetime coverage and a savings account paying tax-free interest at their insurer’s offered rate. They could use this account to cover the premiums, buy more coverage or simply amass savings.

There are, of course, some risks to whole life coverage. The couple may grow dissatisfied with their insurers’ interest rates, fees and commissions. Or they may be tempted to borrow excessively against their policy’s cash value, potentially nullifying its coverage.

Insurers also offer variations on whole life coverage. Universal life policies, for example, offer a variable rate on the tax-free savings account. That means, when interest rates are up, the couple could earn more cash value. Of course, the opposite is also true — as interest rates fall, they could earn less.

Nathan and Penelope could also opt for a variable universal life policy. Here the tax-free savings account is typically invested in mutual funds. They’ll likely enjoy low premiums and, if their investments do well, a valuable savings vehicle. But a drop in the stock market could mean their investments don’t cover the premiums, potentially leaving them without coverage or having to pay additional premiums to retain their coverage.

A Lifelong Matter

Being a young couple, Nathan and Penelope expressed an interest in a term policy for the time being. Their advisor saw the logic in this but noted that, eventually, they should likely transition to permanent coverage — both for their mutual financial security and for estate planning purposes.

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