Permanent insurance provides lifelong protection, and the ability to accumulate cash value on a tax-deferred basis. Unlike term insurance, a permanent insurance policy will remain in force for as long as you continue to pay your premiums. Because these policies are designed and priced for you to keep over a long period of time, this may be the wrong type of insurance for you if you don’t have a long-term need for life insurance coverage.
Why would someone need coverage for an extended period of time? Because contrary to what a lot of people think, the need for life insurance often persists long after the kids have graduated college or the mortgage has been paid off. If you died the day after your youngest child graduated from college, your spouse would still be faced with daily living expenses. And what if your spouse outlives you by 10, 20 or even 30 years, which is certainly possible today. Would your financial plan, without life insurance, enable your spouse to maintain the lifestyle you worked so hard to achieve? And would you be able to pass on something to your children or grandchildren?
Cash Value—A Key Feature
Another key characteristic of permanent insurance is a feature known as cash value or cash-surrender value. In fact, permanent insurance is often referred to as cash-value insurance because these types of policies can build cash value over time, as well as provide a death benefit to your beneficiaries.
Cash values, which accumulate on a tax-deferred basis just like assets in most retirement and tuition savings plans, can be used in the future for any purpose you wish. If you like, you can borrow cash value for a down payment on a home, to help pay for your children’s education or to provide income for your retirement. When you borrow money from a permanent insurance policy, you’re using the policy’s cash value as collateral and the borrowing rates tend to be relatively low. And unlike loans from most financial institutions, the loan is not dependent on credit checks or other restrictions. You ultimately must repay any loan with interest or your beneficiaries will receive a reduced death benefit and cash-surrender value.
If you need or want to stop paying premiums, you can use the cash value to continue your current insurance protection for a specified time or to provide a lesser amount of death benefit protection covering you for your lifetime. If you decide to stop paying premiums and surrender your policy, the guaranteed policy values are yours. Just know that if you surrender your policy in the early years, there may be little or no cash value.
Cash Value vs. Face Amount
With all types of permanent policies, the cash value of a policy is different from the policy’s face amount. The face amount is the money that will be paid at death or policy maturity (most permanent policies typically “mature” around age 100). Cash value is the amount available if you surrender a policy before its maturity or your death. Moreover, the cash value may be affected by your insurance company’s financial results or experience, which can be influenced by mortality rates, expenses, and investment earnings.
“Permanent insurance” is really a catchall phrase for a wide variety of life insurance products that contain the cash-value feature. Within this class of life insurance, there are a multitude of different products. Here we list the most common ones.
Whole Life or Ordinary Life
If you’re the kind of person who likes predictability over time, Whole Life insurance might be right for you. It provides you with the certainty of a guaranteed amount of death benefit and a guaranteed rate of return on your cash values. And you’ll have a level premium that is guaranteed to never increase for life.
Another valuable benefit of a participating Whole Life policy is the opportunity to earn dividends. While your policy’s guarantees provide you with a minimum death benefit and cash value, dividends give you the opportunity to receive an enhanced death benefit and cash value growth. Dividends are a way for the company to share part of its favorable results with policyholders. When you purchase a participating policy, it is expected that you will receive dividends after the second policy year – but they are not guaranteed. Dividends, if left in the policy, can provide an offset (and more) to the eroding effects of inflation on your coverage amount.
Variable Life insurance is offered via a prospectus and provides death benefits and cash values that vary with the performance of a portfolio of underlying investment options. You can allocate your premiums among a variety of investment options offering different degrees of risk and reward: stocks, bonds, combinations of both, or a fixed account that guarantees interest and principal. This type of insurance is for people who are willing to assume investment risk to try to achieve greater returns. With Variable Life you’re shifting much of the investment risk from the insurance company to yourself. Good investment performance would provide the potential for higher cash values and ultimate death benefits. If the specified investments perform poorly, cash values and death benefits would drop accordingly.
Unlike Whole Life and Variable Life where you pay fixed premiums, Universal Life offers adjustable premiums that give you the option to make higher premium payments when you have extra cash on hand or lower ones when money is tight.
Universal Life allows you, after your initial payment, to pay premiums at any time, in virtually any amount, subject to certain minimums and maximums. You also can reduce or increase the death benefit more easily than under a traditional Whole Life policy.
Most Universal Life policies will also provide a guaranteed rate of return on your cash values, with one important exception. It is possible that you will not accumulate any cash value if any, or all, of the following circumstances occur: administrative expenses increase, mortality assumptions are changed, the insurance company’s investment portfolio underperforms, premium payments are insufficient.
In recent years, there’s been considerable interest in what’s commonly referred to as Universal Life with Secondary Guarantees (also known as a “No-Lapse Guarantee”). With an ordinary Universal Life product, the policy could lapse under certain circumstances (e.g., interest rates fall below projections, insurance costs or administrative expenses rise, etc). When you buy a policy with a “secondary guarantee,” you’re guaranteed that the policy won’t lapse even if the above factors come to pass.
One of the most attractive things about Universal Life policies with Secondary Guarantees is that they provide lifelong coverage at rates that can be considerably lower than other forms of permanent insurance. That’s one of the main reasons why these policies have become so popular for estate planning purposes. If you have a federal estate tax liability (in 2008, estates valued at over $2 million are taxed), your main concern is liquidity at death. When you die, you don’t want your heirs to have to hastily sell off assets in order to pay estate taxes. With a Universal Life policy with Secondary Guarantees, the death benefit is guaranteed for life and you have the flexibility of adjusting your premiums, a valuable feature since estate tax rates and exclusion amounts keep changing from year to year.
Variable Universal Life
Variable Universal Life insurance is a flexible premium, permanent life insurance policy that allows you to have premium dollars allocated to a variety of investment options, offering varying degrees of risk and reward. These policies are a good choice for people seeking maximum flexibility. Should your insurance needs change over time, Variable Universal Life usually provides the flexibility to increase or decrease your amount of coverage. You can also make a lump-sum payment to increase the policy’s cash value. (The maximum lump-sum payment is subject to IRS limitations.) And, should an emergency arise and you are short on cash, you may be able to skip a scheduled payment and let the accumulated cash value cover the policy’s expenses. Keep in mind that the cost of insurance and administrative expenses are still incurred. As your insurance needs change, it is quite probable so will your long-term investment goals and risk-tolerance levels. With Variable Universal Life, you have flexibility to transfer funds between the investment divisions, tax free. So, you have the freedom to make decisions based on your needs and not on the tax ramifications.
Life insurance is a massive part of the American economy. With more than $20 trillion of life insurance coverage in force in the U.S., it’s even larger than the mortgage market.
Yet in most cases, one of the main forms of life insurance — permanent life insurance — is a bad financial idea for consumers. Most people overpay for it without seeing any benefit at all, it produces poor investment returns, and sales incentives may cause insurance agents to recommend policies that may not be the best fit for the consumer.
Here’s a closer look at some of the reasons permanent life insurance isn’t a good idea for most people.
Term life is often more appropriate
The concept of permanent life insurance is pretty simple: Pay an annual premium, and when you die, your beneficiaries collect a payout. It protects your family from a loss of income, immediately builds an estate and covers debts in the event of your passing. Permanent life insurance lasts until the death of the policyholder and includes a “cash-value” investment component.
Another form of life insurance called term life insurance lasts for a specific term, such as 10 or 20 years, instead of a whole lifetime, and is often used by people with growing families to guard against an economic catastrophe in case of an early death.
Term life is a better option for most people, because it’s much more affordable and offers insurance when it’s most needed. Term life doesn’t have any cash value, but the cash-value component of permanent life insurance offers poor investment returns.
It’s hard to keep up with the premiums year after year
But here’s a very damaging aspect of permanent life insurance: Many people are not covered by the policy when they die. In fact, nearly 88% of universal life policies (a type of permanent life insurance) never pay a claim.
This is largely because many people allow their permanent policies to lapse, and the No. 1 reason is they can’t afford the premiums due to a period of unemployment or other financial setback. Or they may decide it’s no longer something they want or need.
Term life insurance has just as low a payout rate, but term life is only meant to cover you for a specified number of years, typically when you’re young or middle-aged, and people who outlive their term life policies are generally happy to do so. But since permanent insurance is meant to cover you till death at any age, its low payout rate is cause for greater concern.
All of those paid premiums from a lapsed policy just go to the insurance company as pure profit, so the insurance industry isn’t bothered by lapse rates — in fact, it counts on them. A policy that never pays a claim is much more profitable to an insurer than a policy that pays a claim.
It’s not consumer-friendly
Insurance agents are incentivized to sell consumers overly complex and expensive permanent life insurance policies because of larger commissions. Because consumers often don’t understand the complexities of life insurance, they buy what the agent recommends — things like variable universal life insurance with an annuitized benefit option. If that confused you, don’t worry, it confused me, too, and I’m a licensed insurance agent.
So is permanent life insurance ever a good option? Not often, no. Term life insurance is the right option for the vast majority of people. It’s cheap, and it protects your family.
It only makes sense to buy permanent life insurance when you’ve maxed out your 401(k) and Roth IRA, which are far better investment options and are much more effective in safeguarding your financial future; when you know for certain that you’ll never lapse the policy; and when you are seeking certain estate-tax advantages, making it an option for some high-income individuals.
Owners of permanent life should re-evaluate their life insurance needs and look into alternative options before lapsing their policies. Premiums can sometimes be recovered by surrendering the policy for a cash value.
Another option is to sell the policy to a third-party investor; this is called a life settlement. (Full disclosure: My company is a life settlement brokerage.) If you qualify, an institutional buyer pays you an immediate cash settlement (averaging around 20% of your policy benefit), and you transfer ownership of the policy to the buyer. The investor will continue to pay the premiums until you die and will then collect the policy benefit. Life settlements can be complex, so make sure you do your research before pursuing one.
Your hard-earned dollars are at stake with any life insurance policy, so make sure you take the time to review your options thoroughly before deciding.
Peter Colis is a life insurance agent and the CEO of Ovid, a San Francisco-based life insurance settlement brokerage.
What is ‘Permanent Life Insurance’
An umbrella term for life insurance plans that do not expire (unlike term life insurance) and combine a death benefit with a savings portion. This savings portion can build a cash value — against which the policy owner can borrow funds, or in some instances, the owner can withdraw the cash value to help meet future goals, such as paying for a child’s college education. The two main types of permanent life insurance are whole and universal life insurance policies.
BREAKING DOWN ‘Permanent Life Insurance’
To borrow against the savings portion of a permanent life insurance policy, there is usually a waiting period after the purchase of your policy for sufficient cash value to accumulate. Also, if the amount of the unpaid interest on your loan plus your outstanding loan balance exceeds the amount of your policy’s cash value, your policy and all coverage will terminate.
Permanent life insurance policies enjoy favorable tax treatment. The growth of cash value is generally on a tax-deferred basis, meaning that you pay no taxes on any earnings in the policy so long as the policy remains active. Provided you adhere to certain premium limits, money can be taken out of the policy without being subject to taxes since policy loans generally are not considered taxable income. Generally, withdrawals up to the amount of premiums paid can be taken without being taxed.