There are many different types of insurance, from auto insurance to health insurance, from homeowner’s insurance to malpractice insurance, and yet life insurance is unique. It is unique because of three characteristics not found in the other types of insurance.
First, whereas all other types of insurance insure a potential event (you might be in a car accident, you might have to go to the hospital, your home may be damaged by a hurricane, etc.), life insurance insures a known event: we all will die.
Additionally, other types of insurance allow for multiple claims, while we only die once. And lastly, each passing day brings us closer to that known event (an admittedly morbid thought, but true nonetheless).
It is those three differences that allowed for the development of the two broad categories of life insurance, known generically as term and permanent (within each category there are many types of policies).
Permanent insurance is guaranteed to be in force at death (provided all premiums are paid), whereas term insurance is actuarially designed to end before the insured dies. So why would anyone buy a product that is designed to not pay a benefit?
First, understand that term insurance will provide a benefit if death occurs while it is in force. It’s just that it’s designed to end before death occurs. Second, term insurance certainly provides peace of mind, knowing that should death occur while it is in force, a claim will be paid. This is not unlike the benefit all other types of insurance provide when no loss is incurred.
Unfortunately, many people buy term insurance out of ignorance, thinking that it is the same product as permanent insurance with a much lower premium. They think this way in part because the media constantly runs articles exhorting them to buy term and invest the difference. Whenever I hear that, I always ask the person why two types of life insurance even exist, and not once has the person replied correctly.
Since permanent insurance is designed to be in force at death and term insurance is designed not to be, it stands to reason that the reserve required to pay claims on permanent policies is much more than the reserve required for term policies. And therein lies the reason for the disparity in premiums between term and permanent – it is highly unlikely that a death claim will have to be paid on a term policy. Accordingly, very little must be reserved for death claims, thus lowering the premium substantially.
This is not my opinion. LIMRA, a life insurance industry organization which tracks such statistics, reports that less than 2% of death claims are made on term policies. How can that be? Think about it. Life expectancy is late 70s for males and early 80s for females, depending on which mortality tables you consult. Very few term policies are still in force at life expectancy.
The cash value of a permanent policy is in actuality the reserve to pay future claims. Although most pundits refer the reserve as a “savings component”, that is just an analogy.
So the fundamental difference between the two products is that term insurance provides peace of mind and whole life insurance provides an income tax free return of approximately 4-6% at life expectancy.
In conclusion, while there are valid reasons for procuring each type of life insurance, thinking that they are the same product with different premium structures is no longer one of them for those of you who took the time to read this entire piece.