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Your Life Insurance Is Not About You

Jennifer Leigh Parker,|Special to CNBC.com
Tuesday, 8 Feb 2011 | 12:22 PM ET
Life Insurance
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Life Insurance

If you have a spouse or children, it’s time to consider a life insurance policy.

Life insurance policies can be complicated at best, unintelligible at worst.

Insurance companies are regulated on a state basis, which makes for different rules and regulations and more difficult comparisons.

A lot of people don't pay much attention to them because they get free or low-cost coverage through their employer. That's fine until you become unemployed or self employed and your insurance policy disappears.

So, here’s what you’ll need to know to get what you need to protect your loved ones, and avoid spending too much.

Term Vs. Whole

There are two basic types of life insurance: term and whole.

A useful analogy to explain the difference is buying versus renting. With term life insurance, you’re renting. It’s never really yours, and eventually your lease is up.

In contrast, you own a whole-life insurance policy, because the original policy amount must be returned to you. The monthly premiums are higher, but the money goes into a fund that grows over time. (For the cash-strapped or thrifty, there is a poor man's version called Universal life.)

The large majority of insurance policies are term-life. You pay for a certain number of years (20, 30, 40) for a certain amount of coverage $100, 000, $500,000, $ 1 million) and only received the benefit if you die while the policy is in place.

Whole life can be seen as a combination of insurance and investment.

Insurance specialist David Eidlitz of Northwestern Mutual recommends whole life policies simply because they are permanent.

“On a permanent whole life policy, you are investing into the general fund of the investment company. Once the money is there, it is no longer subject to risk. The mutual companies are owned by the policyholders, and they are not public. Given that there are no stockholders, mutual companies can hold their bonds to maturity,” he says.

The mutual companies Eidlitz is referring to include Guardian Life, New York Life, Mass Mutual, and Northwestern Mutual.

Policyholders earn interest on the money and sometimes small annual dividends, which vary by company, policy and the sum paid in, but offer low, single-digit returns that are attractive to conservative investors, who might otherwise prefer fixed income.

In that context, one of the main advantages to whole life policy is that the money you collect is tax-free, as opposed to other savings, investment and retirement vehicles, like a 401(k) plan.

You receive the money in one of two ways: the technical terms are death benefit and cash value, also known as . With the former, your designated loved one, the beneficiary, will receive the policy amount as a benefit upon your death. If you are still living and want to collect, you will be paid the policy's cash value.

Eidlitz explains how the death benefit works. "Say, you’ve set up a policy to pay out $100,000 today in 20 years. Your premium is fixed during that time. When you die, your family will get exactly $100,000. Cash value is different. You only get the cash value if you live. Cash value accumulates, and it is guaranteed to increase every year.”

Wondering what’s the catch? As with most investments, the whole life investment only makes sense at a specific life stage and income level. Here’s why:

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Alan Finkelstein, President of AFCO Industries, warns against buying whole life while you’re young.

“All insurance is is money," he says. "Term life insurance is the perfect vehicle for young people. By the time you are 55 or 60, you may not need the insurance. For whole life insurance, you pay a very high premium."

Policies are typically structured so that costs are frontloaded, with higher payments in the early years to generate cash for the insurers—which reinvest—and then draw upon later to pay policyholders.

Finkelstein also warns that whole life ties up you money that might be needed. Unlike loans from a 401(k), there are interest payments.

"If you take the money out, you have to pay 8-percent interest on it,” says Finkelstein, citing a common rate over the years, which in most cases is twice the rate you are earning on your money in the first place.

Borrowing has other consequences.

"If you borrow the cash value, and you don’t repay the loan, over the course of the years the policy can become under-funded and evaporate," says Jeff Zander, Managing Partner of Zander Insurance Group.

It seems much of the debate in whole versus term is centered on the cost of the higher monthly premiums versus the cash value.

Cost of Premiums

Over the life of the policy, term life is cheaper because whole-life policy holders pay higher premiums. In either case if the policyholder dies, the beneficiaries receive the same insured value. However, a surviving whole life policyholder has an asset in the cash value that can be surrendered at any point.

So the question is, “Do all the higher premiums lead to a substantial cash value?”

The answer, in many cases, is no. Most life insurance companies have very conservative investment strategies that allow for only modest capital growth, typically 3-4-percent return annually.

Experts thus suggest you might be better off buying term life and with the premium that would have gone towards a whole life policy, put the money in a suitable investment fund, which can grow—or shrink—over time as well as reflect your current risk tolerance. However, know that whole life investments have the benefit of growing tax deferred.

Finkelstein says the savvy strategy for investors growing wealth over time is to invest in term life insurance during the early part of your career – protecting your loved ones but minimizing the cost; then to convert the policy from term to whole life at retirement age.

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“You can convert all of your original term policy at 65 based on your health at 25,” he adds.

The premiums will be higher than term, and higher because you are converting at an older age, but you'll be more likely to afford them.

There's also the benefit of not having to submit to a medical exam, the industry's primary determinant of premiums.

When considering life insurance options, decide what applies to you. If you are a young couple considering having children, a 20-year plan might not last long enough to see your children out of school.

If you are 22 years into a term insurance plan, and you find you don’t need it anymore, you can simply cancel it. Term insurance gives you the flexibility to buy only what you need, when you need it.

"Buy insurance when you need insurance," says Zander. "Cash value plans have been sold by the insurance industry because it’s their most lucrative product. But young families carrying school loans or credit card debt are much better off paying down their debt instead of $2,000 per year for a cash value plan.”