Term life, Whole Life, Universal Life: What's the Difference?
Life insurance basically comes in two flavors: term and permanent. What flavor you choose will depend on your reason for buying it.
If you’re looking for a basic low-cost life insurance plan that will provide protection for a limited time, then term life insurance is probably for you. The premiums are relatively cheap and it will do the job of taking care of your family should you die prematurely.
On the other hand, if you would like insurance that extends until death at an old age, then you probably want a permanent policy. Also known as “cash value” life insurance, a permanent policy can provide lifetime coverage, but at a steeper price — the premiums are much heftier.
At its core, life insurance is a risk management tool. This is true regardless of the type of insurance. With life insurance, you are simply shifting the financial risk of your untimely death to a life insurance company. While they can never replace you, they can replace your money.
Let’s dig a little deeper into the basic types.
Term Insurance
So how does term insurance work? It's pretty straightforward. You pay for the cost of insurance for a desired death benefit. In effect, it's "pure" insurance. It doesn't pay dividends or accumulate cash value. If you die while the policy is in force, it pays proceeds to your beneficiaries. If you don't die (that's good news) and the policy expires, then you and the insurance company shake hands and walk away.
As the name implies, term insurance doesn't provide coverage permanently. Rather, it's available for a certain term. At its purest form, its premium increases every year because, well, as we grow one year older, we are one year closer to dying. This type of term product is called annual renewable term insurance (or ART). And then after a certain age, say age 70, it is no longer available even if you want to buy a policy.
In real life, however, ART is not sold very often. People generally prefer the predictability of paying the same premium every month/year. The typical term products sold in the marketplace provide level premium for a period of years. When you hear someone say, "10-year term" or "20-year term," it simply means that the premium stays the same—or is "level"—for 10 years or 20 years instead of increasing each year. You pay a little more upfront for lower premiums in later years.
For a healthy person, term insurance premiums are generally quite affordable, especially at a younger age, like 35, 40, or even 50.
Permanent (or cash value) life insurance
Permanent insurance appeals to those who want something that covers beyond the early financially vulnerable years—like lifelong life insurance protection.
Why do you want life insurance beyond the vulnerable years to protect against the untimely death of a breadwinner?
Perhaps you want to leave your family a meaningful amount of cash free of income tax. Or possibly your assets are tied up and you want to buy life insurance to create liquidity that will pay estate taxes so your heirs don’t have to sell or erode your assets to come up with the cash to pay the taxes. Businesses, including many Fortune 500 companies, take advantage of tax benefits of permanent life insurance to finance their executive benefit obligations. Banks buy life insurance by the bundles because life insurance cash value legally meets their capital reserve requirements. And so on.
For those interested in such things, permanent insurance is the way to go. It comes with cash value that accumulates free of income tax. This cash value element is what enables the policies to be in force until death (as intended), as opposed to for a certain term.
Compared to term insurance, permanent insurance is less straightforward. There are two main types of permanent insurance:
Admittedly, there are many ways to slice and dice life insurance products. For example, you can break down universal life insurance further—variable UL, indexed UL, no lapse guarantee UL, and so on. Regardless of the labels though, permanent insurance is fundamentally either whole life or universal life.
Here is where it gets a little tricky. When it comes to shopping for permanent life insurance, cheaper (premiums) is not always better.
For example, universal life generally doesn't guarantee death benefit or cash value. In other words, it is not guaranteed to stay in force. In fact, UL policies are often so poorly designed that not only will the policies not last until death, but they are on track to lapse (as in the policy ceasing to exist) in a few years. To keep it in force, the carrier requests you to make additional payments, effectively raising premium. If you don't fork up the requested payment(s), the policy will eventually lapse, which means you will end up with nothing, nada, after years of premium payments. You would have been better off with a term policy.
To counter this rather significant shortcoming of a potential policy lapse of the traditional UL products, carriers now offer UL products with "secondary guarantees" that is guaranteed to stay in force as long as you pay premiums on time. These are typically called "no lapse guaranteed UL" or "NLG" products. The biggest shortcoming of these products is that there is virtually no cash value accumulation. So if at some point you want to cancel the policy or otherwise access its cash value, you are out of luck.
On the other hand, while premiums are generally higher for the same amount of coverage, whole life insurance provides guaranteed death benefit and cash value as long as you pay premium.
We don’t have the space to devote to the mechanics and design of universal or whole life (nor do most people find it appealing to read about), but suffice it to say, when it comes to permanent life insurance (especially with universal life), policy design and policy administration are critically important.
If you’re looking for a basic low-cost life insurance plan that will provide protection for a limited time, then term life insurance is probably for you. The premiums are relatively cheap and it will do the job of taking care of your family should you die prematurely.
On the other hand, if you would like insurance that extends until death at an old age, then you probably want a permanent policy. Also known as “cash value” life insurance, a permanent policy can provide lifetime coverage, but at a steeper price — the premiums are much heftier.
At its core, life insurance is a risk management tool. This is true regardless of the type of insurance. With life insurance, you are simply shifting the financial risk of your untimely death to a life insurance company. While they can never replace you, they can replace your money.
Let’s dig a little deeper into the basic types.
Term Insurance
So how does term insurance work? It's pretty straightforward. You pay for the cost of insurance for a desired death benefit. In effect, it's "pure" insurance. It doesn't pay dividends or accumulate cash value. If you die while the policy is in force, it pays proceeds to your beneficiaries. If you don't die (that's good news) and the policy expires, then you and the insurance company shake hands and walk away.
As the name implies, term insurance doesn't provide coverage permanently. Rather, it's available for a certain term. At its purest form, its premium increases every year because, well, as we grow one year older, we are one year closer to dying. This type of term product is called annual renewable term insurance (or ART). And then after a certain age, say age 70, it is no longer available even if you want to buy a policy.
In real life, however, ART is not sold very often. People generally prefer the predictability of paying the same premium every month/year. The typical term products sold in the marketplace provide level premium for a period of years. When you hear someone say, "10-year term" or "20-year term," it simply means that the premium stays the same—or is "level"—for 10 years or 20 years instead of increasing each year. You pay a little more upfront for lower premiums in later years.
For a healthy person, term insurance premiums are generally quite affordable, especially at a younger age, like 35, 40, or even 50.
Permanent (or cash value) life insurance
Permanent insurance appeals to those who want something that covers beyond the early financially vulnerable years—like lifelong life insurance protection.
Why do you want life insurance beyond the vulnerable years to protect against the untimely death of a breadwinner?
Perhaps you want to leave your family a meaningful amount of cash free of income tax. Or possibly your assets are tied up and you want to buy life insurance to create liquidity that will pay estate taxes so your heirs don’t have to sell or erode your assets to come up with the cash to pay the taxes. Businesses, including many Fortune 500 companies, take advantage of tax benefits of permanent life insurance to finance their executive benefit obligations. Banks buy life insurance by the bundles because life insurance cash value legally meets their capital reserve requirements. And so on.
For those interested in such things, permanent insurance is the way to go. It comes with cash value that accumulates free of income tax. This cash value element is what enables the policies to be in force until death (as intended), as opposed to for a certain term.
Compared to term insurance, permanent insurance is less straightforward. There are two main types of permanent insurance:
- Whole life (WL), and
- Universal life (UL).
Admittedly, there are many ways to slice and dice life insurance products. For example, you can break down universal life insurance further—variable UL, indexed UL, no lapse guarantee UL, and so on. Regardless of the labels though, permanent insurance is fundamentally either whole life or universal life.
Here is where it gets a little tricky. When it comes to shopping for permanent life insurance, cheaper (premiums) is not always better.
For example, universal life generally doesn't guarantee death benefit or cash value. In other words, it is not guaranteed to stay in force. In fact, UL policies are often so poorly designed that not only will the policies not last until death, but they are on track to lapse (as in the policy ceasing to exist) in a few years. To keep it in force, the carrier requests you to make additional payments, effectively raising premium. If you don't fork up the requested payment(s), the policy will eventually lapse, which means you will end up with nothing, nada, after years of premium payments. You would have been better off with a term policy.
To counter this rather significant shortcoming of a potential policy lapse of the traditional UL products, carriers now offer UL products with "secondary guarantees" that is guaranteed to stay in force as long as you pay premiums on time. These are typically called "no lapse guaranteed UL" or "NLG" products. The biggest shortcoming of these products is that there is virtually no cash value accumulation. So if at some point you want to cancel the policy or otherwise access its cash value, you are out of luck.
On the other hand, while premiums are generally higher for the same amount of coverage, whole life insurance provides guaranteed death benefit and cash value as long as you pay premium.
We don’t have the space to devote to the mechanics and design of universal or whole life (nor do most people find it appealing to read about), but suffice it to say, when it comes to permanent life insurance (especially with universal life), policy design and policy administration are critically important.
