Do You Need Permanent Life Insurance?

Whether or not you need life insurance is a question that many people struggle to answer. It doesn’t help that insurance agents are often perceived as pushy sales people who stand to make larger commissions if they sell more expensive products. It is true that some insurance agents are commission hungry but I think that it is also common for people to dismiss good insurance advice due to the perceived conflict of interest. It is common for life insurance to be absolutely necessary for a family to be financially secure, but it is important to choose the right type of insurance.

If you have anyone, like a spouse, child, or even dependent parent, relying on your ability to generate income or provide services, you have a need for life insurance. When you die, your ability to generate income stops immediately, but your family’s expenses do not stop. Think about a family with $5,000 of monthly expenses, all covered by a single income. To continue covering those expenses for 20 years after the earner’s death the family would need to have about $900,000 to invest assuming a 5% after-tax return and 2% inflation. 

That is more cash than most people keep lying around, especially in the early stages of adult life. It’s not only the income earner that requires life insurance. In the example of a single income family, one spouse may be at home caring for children and managing the household. Those functions have an implicit monetary value which needs to be replaced on the death of the spouse providing them. In the early stages of adult life expenses tend to be high with things like mortgage payments, retirement savings, and child care costs, while financial assets tend to be low. 

With high expenses and a total reliance on the ability to generate income, there is a substantial life insurance need for most younger people with families. At retirement, human capital is considered to be depleted, and you should be able to rely on your financial assets like pensions and investments to fund your lifestyle. Your ability to generate income is less critical at this stage as your family will probably be fine financially if you die. So life insurance needs are typically highest at the start of adult life, and decline over time until retirement when they are typically zero for most people. 

Based on this declining need, it is extremely important to choose the right kind of life insurance. The two main types of life insurance are term life insurance and permanent life insurance. Within each category there are quite a few variations in terms of how the policy is structured and paid for. Term insurance is the lowest cost type of life insurance. Based on the typically declining needs for life insurance, term insurance is probably the most sensible choice for most people.

With a term insurance policy you are locking in your premium, or cost of insurance, for a fixed number of years. At the end of that term, your premium will go up, and it will often go up a lot. Term insurance policies come in many term durations, but the most common are 10 and 20 year terms. Ideally you will purchase a policy with a term that approximately matches the duration of the insurance need. For example buying coverage on your life until your kids are expected to be independent, or until your mortgage is paid off.

Permanent life insurance does not renew or expire. It covers your life forever as long as you pay all of your premiums. In other words, it is insurance coverage that is guaranteed to pay out eventually. Permanent life insurance comes in multiple forms. The simplest no-frills type of permanent insurance is called Term 100. It is a lot like a term insurance policy, except the premium is guaranteed until age 100. Term 100 policies do not have any cash value or built-in investment component.

Whole life insurance similarly has premiums payable until age 100, but the policy also builds up a cash value. You can borrow against the cash value or use it as collateral for a loan from a bank. You also get to keep the cash value if you cancel the policy. In most policies, the cash value earns non-taxable interest over time.

Limited-pay whole-life insurance is similar to whole life, but the premiums are paid for shorter number of years, and then the policy is guaranteed until death. A Pay 20 policy would be a whole life policy with premiums payable for 20 years, and then the policy would be paid up forever. Participating whole life insurance receives dividends from the insurance company. Those dividends can be paid out in cash, used to pay premiums, saved within the policy, or used to purchase additional paid up insurance. Policy dividends are credited to each policyholder at the discretion of the insurance company based on a  number of factors. The whole process is a little bit opaque which makes me uneasy, but insurance companies will often boast that they have never missed a participating policy dividend.

Universal life insurance is permanent insurance with a built-in investment component. The Policy holder is able to choose what the money is invested in. This can be a good thing or a bad thing depending on the investments available and the discipline of the policy owner. Many permanent life insurance policies have the option of over funding, or adding extra cash to the policy in excess of the cost of the premiums, up to a limit. Overfunding a policy allows the extra cash to grow tax-free inside of the policy. While this may be interesting to some people, in general I would not say that permanent insurance is a very good investment. It has high built in costs, including the cost of insurance, and liquidity constraints.

Permanent insurance is interesting in situations where there is a specific need at death, and liquidity concerns for the estate. For example, a family cottage passing from a deceased parent to their children may result in a substantial tax bill. If there are no other liquid assets in the estate, and the child does not have liquid assets to pay the taxes, then the cottage may need to be sold. Permanent insurance could be used to avoid this situation. 

For most people in most situations, term life insurance is the simplest and most cost effective option. For example the $900,000 policy that I mentioned at the beginning of this video would cost about $40 per month for a 30-year old female. On the other hand, structuring this policy as a non-participating whole life policy would cost around $400 per month. Remember, not all insurance agents want to sell you the most expensive product, but it is worth noting that in this case, the insurance agent is looking at the difference between around a $500 commission for the term policy, and a $5,000 commission for the permanent policy.