There are many different types of insurance, from auto insurance to health insurance, from homeowner’s insurance to malpractice insurance, and yet only life insurance offers a policy with a cash value component. Why is that?
When I ask that question, “Why are there two types of life insurance and only one type of all the other kinds?” I get many interesting answers, but rarely do I get the correct answer.
The correct answer is that all other types of insurance insure a potential event (you might be in a car accident, you might have to go to the hospital, your home may be damaged by a hurricane, etc.), life insurance insures a known event: we all will die.
Additionally, other types of insurance allow for multiple claims, while we only die once. And lastly, each passing day brings us closer to that known event (an admittedly morbid thought, but true nonetheless).
It is those three differences that allowed for the development of the broad category of life insurance known generically as cash value.
Cash value life insurance is guaranteed to be in force at the time of death (provided all premiums have been paid), whereas term insurance is actuarially designed to end before the insured dies. So why would anyone buy a product that is designed to not pay a benefit?
First, understand that term insurance will provide a benefit if death occurs while it is in force. It’s just that it’s designed to end before death occurs. Second, term insurance certainly provides peace of mind, knowing that should death occur while it is in force, a claim will be paid. This is not unlike the benefit all other types of insurance provide when no loss is incurred.
Unfortunately, many people buy term insurance out of ignorance, thinking that it is the same product as permanent insurance with a much lower premium structure. They think this way in part because the media constantly exhorts them to buy term and invest the difference. If that makes sense, wouldn’t it then also make sense to rent and invest the difference?
Since cash value insurance is designed to pay a claim and term insurance is designed not to, it stands to reason that the reserve required to pay claims on cash value policies is much greater than the reserve required for term policies. And therein lies the reason for the disparity in premiums between term and cash value – it is highly unlikely that a death claim will have to be paid on a term policy. Accordingly, very little must be reserved for death claims, thus lowering the premium substantially.
This is not my opinion. LIMRA, a life insurance industry organization which tracks such statistics, reports that less than 2% of death claims are made on term policies. How can that be? Think about it. Life expectancy is late 70s for males and early 80s for females, depending on which mortality tables you consult. Very few term policies are still in force at life expectancy.
The equity in a cash value policy is actually the reserve to pay future claims. Although most pundits refer the reserve as a “savings component”, that is just an analogy.
So the fundamental difference between the two products is that term insurance provides peace of mind and whole life insurance provides an income tax free return of approximately 4-6% at life expectancy.
In conclusion, while there are valid reasons for procuring each type of life insurance, thinking that they are the same product with different premium structures is no longer one of them for those of you who took the time to read this entire piece.