Difference Between Term and Whole Life Insurance
Of the half-dozen major types of life insurance, the two oldest and most popular are term and whole life insurance. These two represent the two approaches or schools of thought in dealing with mortality risk. Understanding the difference between term and whole life insurance is vital to understanding the practice of life insurance today.
The best way to explain that difference is to begin by summarizing the fundamental principles of each type.
Term Life Insurance
Term life insurance offers coverage for a specified, limited term, ranging from 1 to 30 years. The premium payment is designed to cover the cost of insurance and the fixed costs of providing the product. The cost of insurance is the sum which, if invested, would make the specified death benefit available by the time the insured reaches his or her life expectancy. Thus, term life premiums are determined by the applicant’s age, state of health, and duration of insurance need. Because term life is pure protection that covers only the cost of insurance and provides no cash value, its premiums are much lower than those charged for comparable coverage by permanent insurance programs such as whole life insurance. The simplest form of term insurance is annually renewable term (ART), in which rates rise each year to reflect the increasing probability of death. More popular are the level-premium term products that incorporate terms of 5, 10, 15, 20 or 30 years. These often allow renewal at end of term for a higher level rate that is determined after an evaluation for insurability.
Whole Life Insurance
As the name implies, whole life insurance is designed to remain in force for the whole life of the insured. (This is slightly inaccurate since whole-life policies mature at the insured’s age of 95 or 100 years.) Whole life insurance originated in response to complaints by owners of term life insurance policies that they were paying premiums for years but received nothing in exchange. So, insurance company managers set about devising a product that would meet these objections.
Whole life insurance is purchased by premium payments, which are usually expressed as an annual sum but which can be paid monthly, quarterly, or biennially as well as annually. Each premium payment is split up and allocated to two separate accounts by the insurance company. The first account reflects the cost of insurance, or mortality risk. The second account is functionally equivalent to a savings account. The remainder of the premium is allocated to this account, where it draws interest at a rate guaranteed by the insurance company. The second account is called the “cash value” of the policy. (In the early years of the policy, part of the premium is devoted to amortizing the fixed costs of administering and managing the policy, so it takes a few years before significant cash value accrues.) The cash value of a whole life insurance policy accumulates until the policy matures (when the insured reaches 95 or 100 years of age), at which point the cash value equals the death benefit. When this happens, the policy becomes superfluous and the insured trades the policy for its value in cash.
The Fundamental Difference Between Term and Whole Life Insurance
The major difference between term and whole life insurance is the duration of insurance need. Many consequences follow from this fundamental difference. Term life insurance conceives insurance need as temporary. A death benefit compensates dependents with money for the loss of the deceased. This implies that the deceased’s wealth bequest was not enough compensation. With increased age, wealth increases, suggesting the possibility that the policyowner will eventually self-insure when wealth has risen sufficiently. Insurance compensates dependents. With increased age, the number of dependents normally decreases. Insurance replaces lost income. Eventually, in retirement, the policyowner will have no earned income to replace. (Investment income can be passed on as a bequest.) All these arguments support the concept of term insurance, a time-limited product designed only to protect dependents from mortality risk.
Whole life insurance is permanent insurance. Although basic insurance need may be temporary, certain insurance needs may be permanent. An individual wishing to spare others the expense of providing for his or her final expenses, including burial, will need a policy in place at the time of death. Since this time is unpredictable, only permanent insurance can fill this need. A business owner may wish to perpetuate the business by providing partners the wherewithal to purchase the remaining interest after his or her death. Again, this requires a permanent policy due to the unpredictability of the death date. Lenders or investors may wish to cover the risk of losing a key person in the business to death. This may require a permanent policy, depending on circumstances. Specialized forms of whole life insurance have developed to insure final expenses, business succession and key persons. Most estate-planning insurance needs are also met by whole life policies.
Ironically, the marketing history of insurance suggests that permanent insurance developed not because of objective need but because consumers believed that they were wasting their money by paying term life insurance premiums for years but getting nothing for it. There is no obvious merit in this attitude. Term life insurance buyers purchase a product called “risk reduction.” The fact that this product is intangible is irrelevant, since many services share this attribute. Moreover, term life insurance premiums closely track the actuarial cost of insurance, which is the amount of money necessary to accumulate the death benefit at a point coinciding with the statistically-estimated death date. (Anyone who doubts this statement has only to investigate the ease with which consumers can choose from among thousands of economically-priced term life policies.)
The desire to earn an investment return on premiums led to the creation of whole life policies, which add a savings program to the pure insurance function embodied in the cost of insurance. Part of the premium pays the cost of insurance, while another part is invested and used to generate a “cash value” or “cash surrender.” Since the insurance company must fund cash value accounts by investing conservatively enough to earn a guaranteed return, the rate of return inside most whole life policies cannot exceed the rate of return on fixed-income securities. (Participating policies, in which the policyowner may receive dividends based on the company’s performance, are an exception. The cash-value account investments include blue-chip stocks and real estate, offering a somewhat higher potential rate of return.) After calculating the premium difference between a whole life policy and a term life policy with the same death benefit, the consumer can invest that differential amount – and probably accumulate more wealth than would accrue in the cash-value account of the whole life policy over the duration of the term life policy. This strategy has taken the form of a maxim: “Buy term and invest the difference.”
This logic applies even to a comparison between garden-variety term insurance and a newer term product called return of premium insurance, in which all premiums are refunded back to the policyowner if he or she outlives the contract term. Unfortunately, the higher premiums commanded by return of premium insurance – 25-50% higher than other term life insurance – may negate the benefit of returned premiums. The policyowner can buy regular term insurance, invest the premium difference and come out at end of term with wealth exceeding the value of the returned premiums. Of course, success of this approach depends on the particular performance of one’s out-of-policy investments.
The moral of the comparison between term life insurance and whole life insurance is that an insurance consumer should choose permanent insurance based on a permanent insurance need, not on the cash value of the policy.
Advantages of Whole Life Insurance
The legitimate advantage of whole life insurance is that it can fulfill a truly permanent insurance need. As noted above, permanent needs do arise. Whole life insurance offers numerous other benefits.
Death benefits on all insurance policies are tax-free to beneficiaries. Whole life insurance offers other potential tax benefits. The cash value can serve as collateral for a loan and the proceeds are tax-free. At the insured’s death, however, outstanding loan values are withheld from the death benefit.
Insurance need may increase over time, for two reasons. First, the insured’s circumstances may change; as his or her income increases, a higher death benefit may be indicated. Second, inflation reduces the purchasing power of a fixed death benefit, suggesting the possible need for more insurance coverage. Whole life policies often offer the opportunity to purchase additional paid-up coverage (perhaps term insurance) to augment the death benefit, without having to demonstrate continued insurability. Using term insurance alone, the insured would have to replace the policy, thereby incurring substantial extra costs.
All of these points are sound, as far as they go. However, the reason for preferring term insurance is the possibility of investing the premium savings. The additional wealth gained thereby reduces the force of the foregoing arguments. That additional wealth itself reduces insurance need, and the higher investment return also offsets inflation. There is every reason for utilizing all the benefits of a whole life insurance policy already in place. But the above arguments do not fully neutralize the inherent advantages of term over whole life insurance. Indeed, some term policies offer the privilege of converting a term policy to whole life without requalifying for insurance, should the temporary insurance need become permanent.
Whole life insurance also offers more security against forfeiture of the policy. Term life policies expire if premiums are not met. Whole life policies often allow the cash value to be tapped for a loan or direct premium payments. Some whole life policies are designed to pay up premiums in full by a certain point, leaving the policy in force permanently. Again, these features are beneficial but do not justify a presumption in favor of whole life. Whole life premiums can be as much as 10 times more expensive than term premiums for a given death benefit. Term premiums are low enough to minimize the threat of forfeiture for non-payment. Whole life premiums are high enough to pose a serious threat of non-payment.
The settled verdict on the difference between term insurance and whole life insurance is that the choice should depend on the permanence of insurance need. In cases where insurance need is temporary, there is no reason to forego the potential economic benefits of term life insurance. Where a permanent need exists, whole life insurance is more suitable.
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