Two different kinds of policies with very different applications. Before I jump into explaining when you require each one, let me start by explaining the structure of each of these policy types.
Term Life Insurance Policies
Temporary life insurance is the terminology used for Term Life Insurance policies. The reason it is called ‘temporary’ is the policy usually ends at a pre-planned date. For example, if you decide you’re going to buy a Term Insurance policy today for a period of 20 years, that policy will end at the end of 20 years. If you decide you want to extend the cover beyond 20 years, you cannot make those changes to the existing policy. The terms that were decided when the policy was underwritten at inception, will be in force until the end date of the policy. There is also a concept of a Yearly Renewable Term Life which is available in some jurisdictions, where you have the ability to renew your contract without the need for new underwriting.
Although Term Insurance is the most cost-effective form of buying life insurance policies, it offers you no encashment values whatsoever. The policy has no investment content as there is no money invested in equities, indices, or ETFs- the returns of which would have been cashable later on.
Simply put, these policies are like a motor insurance policy or medical insurance policy on your life. If you survive the period of the policy, there is no payout or encashment, and the money paid into premiums turns into a cost. Hence, these policies usually tend to be roughly between about a third or a quarter of the premiums of a permanent structure, like Whole Life or Universal Life.
Permanent Life Insurance Policies
Essentially, Permanent Life Insurance is any life insurance contract where the underwriting decision is made by the insurer at the onset to have you covered lifelong. It could be anywhere between the age of 95 to 125, or even an undefined age, which would mean the policy runs lifelong.
When underwriters are determining the risk, they see your application, your medical history, and your financials to be able to cover you for the tenure of your life. The underwriting decision is taken by the insurer to cover you lifelong, regardless of the change in your health, change in your finances, or change in your medical condition. The insurer cannot withdraw their offer of cover once it is put in force. It becomes a one-way street contract that can only be canceled out by you due to non-payment of premiums or due to the cash value of the policy coming to zero.
You can decide to pay a lower premium than what they have designed for you, allowing the policy to finish earlier. Along the way, if you decide you want to have the policy continue for longer, you have the flexibility to go back to paying the premiums that were offered to you. If budget constraints are what is holding you back from going all-in with a Whole Life or Universal Life Policy then this is a better approach to use. These payment terms tend to be shorter than the duration of the policy. For instance, you could be 30 years old, buying a permanent life insurance policy until the age of 100, but you might choose to pay the premiums only for a period of 5, 10, 15, or 20 years. These payment terms are not set in stone and can change with your changing available cash situation.
Apart from payment flexibility and lifelong coverage, the policy contract also accrues an encashment value. These contracts usually have money invested in a host of mutual funds, ETFs, or indices where the returns from that investment portfolio pay for the cost of insurance. These returns are then also available to cash out at any time (usually after initial periods are over) if the need arises. When these investments are withdrawn from the policy, the policy can either come to a stop or the policy could continue if you choose to pay additional premiums.
Do You Require Permanent Life Insurance?
A permanent contract like Whole Life Insurance or Universal Life Insurance may not be applicable for everyone. For the masses, Term Insurance covering them till their earning years may be sufficient. If there is any liability that extends beyond their earning years, that can be sorted out with Term Insurance too.
- Wealth Transference
The place where Universal Life or Whole Life comes into the picture, is when you’re thinking about wealth transference. Today, there’s a growing school of thought that the next generation is not interested in receiving assets like property or other fixed assets which may be difficult for them to manage or liquidate. This is even more true for expat families than ever before. They would rather receive cash or liquid assets from their parents. Building cash equity into a life insurance policy ensures that they would receive that payout either on death or when the policy is cashed out at the end of it all.
- Succession Planning
With business succession planning, as in other estate planning situations, life insurance can provide an immediate influx of money. That sum, the death benefit, can be used by the beneficiary to buy out the deceased owner’s share of the business. For more on how to use life insurance for succession planning, read one of my earlier case studies here.
- Inheritance Taxes or Tax Mitigation
If you know that your beneficiaries will be liable for inheritance tax when you die, you could take out a Whole Life or Universal Life Insurance policy to cover the full amount of the tax bill. For more on how to use life insurance for easier management of taxes, read one of my earlier case studies here.
- Creating a Plan B
Since most of these contracts are airtight and only payout to named beneficiaries or the policy owner itself, business families have a huge advantage to be taken from this. For instance, if there’s been a bad business year and there are creditors, these policies can be used as a discrete backup. Creditors cannot claim against or from these policies. The fact that this contract exists is usually unknown to anybody other than the insurer, the broker, the client, and possibly the beneficiaries if the insured party decides to disclose that information. One of the benefits of this is it creates a Plan B bank account where money can grow towards withdrawals that can be taken out in the future. This creates a dual-purpose plan, one which pays out to the beneficiary in the event of untimely death and the other to create a separate fund available to cash out from or dip into if the need arises.
- Legally Move Money from One Jurisdiction to Another
If the policy is purchased, for instance, by an individual based in China using a quota system to pay the premiums in a foreign currency, the payouts could technically be paid to their beneficiaries in the jurisdiction of their choice anywhere in the world. A system like this may not be available in all countries, but if it applies to you, then this is a hassle-free way to move money from one jurisdiction to another.
When you’re purchasing your insurance, rather than asking, ‘should I purchase Term Insurance or should I purchase Permanent Insurance?’, you’ve got to think about it in a blended approach. It’s almost like going to a doctor and asking him to give you the one pill that will solve all of your problems. And what usually ends up happening is the doctor gives you a pill for your backache, specific vitamins for a deficiency, and maybe another medication for an ankle injury. It’s unlikely that you’ve got one pill that can solve all your problems.
Consider what your Term Insurance needs are and put in place an amount that is required to fulfill that time period. It could be for a loan or to cover yourself for your initial years of working. For the rest of your needs like mitigating inheritance taxes, transferring wealth, succession planning, or estate equalization, Universal Life may be the better option.