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There are two broad categories of life insurance, and the data suggests that many households are not purchasing the most cost-effective.
Americans purchased 4.1 million term insurance policies in 2021, representing 40% of all individual policies purchased that year, according to the most recent report. data of the American Council of Life Insurers. About 6.3 million policies, or 60%, were permanent life insurance.
But this does not seem to coincide with the general recommendation of financial advisers.
“Most people just need temporary insurance,” said Carolyn McClanahan, a Jacksonville, Fla.-based certified financial planner and a member of the CNBC Advisory Council.
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How Term Life Insurance and Permanent Life Insurance Differ
Life insurance is a form of financial protection that pays money to beneficiaries, such as children or a spouse, if the policyholder dies.
Term insurance only pays a death benefit for a specific term, perhaps 10, 20, or 30 years. Unless renewed, coverage expires after that time.
By contrast, permanent insurance policies, such as whole life and universal life, offer continuous coverage until the policyholder dies. They are also known as cash value policies since they have interest-bearing accounts.
Permanent insurance is generally more expensive, the advisers said. Policy premiums are spread over a longer period, and those payments are used to cover insurance costs and build cash value.
“Term insurance will likely be the most cost-effective way to address the income needs of survivors, especially for minor children,” said Gaithersburg, Maryland-based CFP Marguerita Cheng, also a member of the CNBC Advisory Council.
Premiums can vary greatly from person to person. Insurers base them on the face value of a policy and the policyholder’s age, gender, health, family medical history, occupation, lifestyle and other factors.
Reasons You May Need Permanent Life Insurance
There are three main reasons why it may make more sense to buy a permanent policy, despite the higher premiums, said McClanahan, founder of Life Planning Partners. This would aim to ensure that there is an insurance payout on death, no matter when it occurs.
For example, some beneficiaries, such as children with special needs, may need financial assistance for a long time, and the policyholder’s lifetime savings would not be adequate to fund their needs, McClanahan said.
Some policyholders may also want to leave a financial legacy for family or charities. Additionally, others may have a relatively minor health complication with the potential to worsen later. At that point, the policyholder may not be insurable, in which case, it would be beneficial to purchase a permanent policy today to ensure coverage later, McClanahan said.
Some buyers buy permanent life insurance for cash value, thinking they can borrow against that cash value or use it as a retirement savings account. But that’s a “horrible reason” to buy a permanent policy, McClanahan said, adding that the The main reason to buy a policy is always a need for insurance.
On the one hand, there may be taxes and penalties to access the cash value of a policy. Withdrawing or borrowing too much money from a permanent policy could inadvertently cause the policy to lapse, meaning the homeowner would lose their insurance.
Instead, policyholders should treat cash value as an end-of-life emergency fund, like the last asset someone uses, similar to home equity, McClanahan said.
Prospective buyers should consider the “three Ls” when deciding how much life insurance to purchase: liability, loved ones and legacy, said Cheng, chief executive of Blue Ocean Global Wealth.
For example, if you die, how much money would you like to leave for obligations like a mortgage, student loans, or car loans? How much money would loved ones, such as your spouse and children, need if they suddenly lost a policyholder’s income? How much would you like to leave as a legacy for causes that are important to you?
Thinking about these questions will help guide the term of a policy, Cheng said.
Cheng offered his personal situation as an example. She purchased a 20-year term policy with a $750,000 death benefit when her three children were all under the age of 18. Her husband also works and has a regular income. If Cheng had died prematurely, each child would have received $250,000 to fund her education. She also bought $250,000 of permanent insurance, earmarked for Cheng’s husband, to help pay her mortgage.
Combining term and permanent insurance policies can help make buying insurance more cost-effective than buying permanent insurance alone, the advisers said.
Those buying a term policy should be sure to buy “convertible” term insurance, the advisers said. This gives policyholders the option to convert their term policy to a permanent policy once the term ends, but without having to go through another round of medical underwriting. At that time, the person may be denied coverage if they have health problems.