Life insurance policies: What’s the difference between term vs. permanent?

At first glance, finding the right life insurance can seem intimidating due to the complex acronyms and  terminology used in policy descriptions. The good news is life insurance basically boils down to two options: term — or temporary — insurance, and permanent insurance. Each has its own benefits and features, and there’s no one-size-fits-all approach.

When choosing the type of life insurance policy that’s best for you it’s important to keep in mind the primary purpose of all life insurance: to provide a benefit to an individual, group of individuals, or an entity in the event of death. The decision to purchase insurance is usually driven by a desire to protect family members or to fill a specific financial need such as safeguarding business interests, estate planning, or a combination of these factors. In addition to choosing the type of insurance to buy, the amount of coverage needed and the associated cost of premiums are key considerations. The amount of coverage needed and the associated costs are key considerations. Premiums are based on the insured’s age, gender, and health at the time of application. The type of policy you choose is also influenced by factors such as time horizon and various features of the available products. Let’s take a look at the core elements of each type of life insurance.

Term life insurance

Term life insurance provides affordable coverage that lasts for a limited period of time, and is usually the least expensive insurance you can buy. Most policies are designed for premiums to remain at a level rate for a set number of years, but some have premiums that increase annually. Upon the term policy’s expiration, if renewal is permitted, the premiums may increase significantly. If you pass away while the policy is in force, the death benefit of the policy will be paid to the beneficiary, typically in a tax-free lump sum. Any time the coverage is no longer needed or wanted, premium payments may be discontinued, causing the policy to lapse. Key features of term insurance include:

• Term length: Common term lengths include an annual renewable term, 10-year-level premium term, 15-year-level premium term, 20-year-level premium term, and 30-year-level premium term.
• Option to convert: Some term policies have the option to convert to a permanent policy without additional evidence of insurability. This option is usually available for a specific amount of time.
• Cash value: None. Term insurance doesn’t build equity.

Term insurance is often purchased to meet a specific need or combination of needs. Common reasons to buy term insurance include:

• Income replacement.
• Mortgage or debt protection.
• Children’s college funding.
• Funding a buy-sell agreement.
• Key person protection for a business.

Permanent life insurance

Unlike term insurance, permanent life insurance can provide lifetime coverage and a cash savings component. Because of its long-term protection and ability to build cash value, permanent life insurance policies have significantly higher premiums compared to term insurance. Common types of permanent life insurance include whole life, universal life, indexed universal life, and variable universal life insurance.

All types typically provide a tax-free death benefit upon the insured’s passing. If the policy has cash value, it’s accumulated tax-deferred and may be withdrawn or borrowed against as needed. Some policies also have options to purchase riders that cover premiums in the event of a disability, provide long-term care benefits, etc. The two primary types of permanent life insurance are:

• Whole life: A whole life insurance policy provides a guaranteed death benefit, guaranteed premiums, and guaranteed cash value accumulation. Nonguaranteed dividends may be credited and can be used to grow the cash value of the policy, purchase additional insurance, pay the premiums of the policy, or be paid in cash to the policyowner. Whole life policies are oftentimes the most expensive permanent policies due to the guaranteed elements.
• Universal life: A universal life policy differs from whole life in that it can have flexible premium payments, may or may not have a guaranteed death benefit, and may or may not build cash value. The types of universal life products differ in how the cash value grows:
• Current assumption universal life: With this option, the insurance carrier declares an interest rate each year, subject to a guaranteed minimum. Cash value is credited with the declared rate on a monthly or annual basis. Rates may change on an annual basis at the policy anniversary. The death benefit will remain in force as long as cash value is sufficient to cover the monthly policy expenses.
• Guaranteed universal life: Under this policy, the death benefit is guaranteed to remain in force regardless of cash value performance, provided premiums are paid timely.
• Indexed universal life: With this option, cash value tracks the performance of a specified index such as the S&P, MSCI EAFE, Russell 2000, etc. Interest credited is subject to a floor (typically 0%) and either a ceiling (cap) or a participation rate. The timing of the interest credits can be every one, two, or three years, depending on the selected strategy. Index caps and participation rates are subject to change upon the policy anniversary at the carrier’s discretion.
• Variable universal life: With this alternative, cash value may be allocated to various subaccounts tied to mutual funds. Specific policies may contain some restrictions on allocation, but all offer a range of equity (stock) and fixed income (bond) funds. This can make variable universal life the riskiest permanent option but also provides the highest upside potential and the most flexibility.

Permanent life insurance can be purchased for a variety of reasons. In addition to the temporary insurance needs listed previously, some additional uses include:

• Legacy planning — for family or charity
• Estate tax planning
• Asset diversification
• Retirement income planning
• Executive compensation

To decide which type of life insurance policy is best for you, connect with your financial, estate planning, and insurance advisors. And remember, as life evolves, it’s wise to periodically review your life insurance goals and objectives in conjunction with your broader financial and estate plan. What may have been appropriate years ago may no longer be applicable today.