Lauren In Tokyo

Monday, May 28, 2007

Insurance basics

I'm trying to get a handle on all the advice that is coming in from left and right (though unfortunately not from you, dear reader) regarding my insurance quandary.

The basics are easy. There are two types of life insurance. Term insurance and Permanent insurance. Permanent insurance is usually sold as Whole Life insurance, though it is a broader category encompassing several species of policy types.

Term insurance is very simple. It is insurance that provides coverage within a specific term (5, 10, 20, 30 years) from the start of the policy. If you die at any time during the period that the policy is in effect, the insurance company pays your beneficiaries (kids, wife, etc) the value of the policy. If I insure myself for 1 million dollars in a 30 year term policy, I hope (!!) to die before the term ends so that my heirs can get the benefits of the policy.

If the term expires and I do not renew it for another term, the insurance vanishes and no one inherits anything. Many term policies can be renewed, though some do not allow this. Of those that allow renewal, some may disallow renewal in the case that the owner is above a certain age (65). Another issue is that the premiums increase significantly because the policy holder's age at the time of renewal is very high (in the actuary's eyes).

At the other end of the spectrum, we have Permanent life insurance. The big differentiator between Permanent Life and Term Life is that while Term life is only insurance, Permanent life also acts as a sort of investment vehicle. Therefore where you would only pay a small premium for actual coverage (as under Term life), you also need to pay an additional premium to increase the cash value of the investment held in the policy.

Special regulations permit the value of the cash to increase without being taxed (until withdrawal). This provides a means of increasing asset value without getting hit by taxes until the very last minute. Ideally, this means that you can save a large chunk of the principal because it has accumulated tax-free for so long.

A Permanent life policy is just a savings account with life insurance attached. That is the easiest way to describe the difference between the two. Another way to look at it is that a Term policy with a strict savings deposit program would be the same as a Permanent life policy.

Since we can now compare apples to apples, we can easily see that at the end of the term we want to compare, the difference between the two policies should be negligible. For comparision purposes, I will assume that both policies have the same payout. On top of that, the term insurance policy will be supplemented with a savings deposit program so that the premiums (in aggregate) align with each other.

The policies I have been looking at are 30 year payment terms. The permanent life policy is approximately 4 times more expensive per month than the term life policy. If I opt for the term policy and put the remaining 3/4ths in an interest bearing savings account, at the end of 30 years I will have accumulated 22.5 times the premium amount (of the Permanent life policy).

The bare minimum comparison requires that the policy scheme that has more accumulated value at the end of the term be more economically advantageous.

Beyond the basic comparison, it is also necessary to consider that the Permanent policy also provides additional value at the time of death by paying both the accumulated value and the remainder up to the policy value. So the remainder is an additional benefit in favor of Permanent life.

I'll need to look at the numbers again and see how it all works out, but I have a feeling that Permanent Life is a huge racket compared to the more straightforward Term Life policy.

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