What it means
Term life insurance pays only if the insured person dies within a set period, such as 20 years. Permanent life has no end date, so a payout is certain to happen eventually, which is why it costs far more.
The premium is set to cover the rising cost of insurance as the policyholder ages, usually by charging more than the early years strictly need. The extra premium goes into a cash value account inside the policy.
The cash value grows at a rate set by the insurer, or by the performance of investment options in some designs, and the policyholder can borrow against it or surrender the policy to receive it. Loans and withdrawals reduce the death benefit if they are not repaid.
Whole life offers fixed premiums, a guaranteed death benefit and a guaranteed cash value schedule. Universal life gives the policyholder flexibility to vary premiums and death benefits, and variable universal life lets the cash value be invested in funds.
The more flexibility and investment exposure, the more the policyholder carries the risk. In business, permanent life has several uses.
Companies buy it on key staff, fund buy-sell agreements between partners and use it in estate planning, because proceeds typically pass to beneficiaries free of income tax in many countries. Whether it is the right tool depends on whether the long-term need for cover justifies the cost.
The nuance is that permanent life combines insurance and savings, and the combination is expensive and hard to compare. Fees, charges and commissions take a large part of the early premiums, and surrendering a policy in the first few years often returns much less than was paid in.
In practice
Real-world examples.
Example
A founder with a young family buys a whole life policy of $500,000. He pays a fixed premium for life and knows his family will receive the benefit whenever he dies. The cash value builds up in the background for later use.
Example
Two partners in an engineering firm each take out a permanent policy on the other. When one partner dies, the proceeds let the survivor buy out the share from the estate without borrowing. The policy therefore acts as a funding plan for a known future cost.
Example
A retired business owner uses a policy loan against her cash value to cover an unexpected repair bill. She repays it over two years, and the policy stays in force with the full death benefit. Had she not repaid, the loan would have reduced the payout.
Formula
Calculation
Net cost of the cash value benefit = (permanent premium - term premium) x years - cash value at the end
Suppose a $250,000 permanent policy costs $3,600 a year, while a $250,000 term policy costs $300 a year. The extra premium is 3,600 - 300 = $3,300 a year. Over 20 years the extra paid is 3,300 x 20 = $66,000. If the cash value after 20 years is $58,000, the net extra cost is 66,000 - 58,000 = $8,000, or 8,000 / 20 = $400 a year for the guaranteed lifelong cover.Case study
Seen in the real world.
Hartwell and Sons is an illustrative, fictional family company whose owner, Margaret, wanted to leave the business to her children without forcing them to sell it to pay inheritance costs. She estimated the costs at about $800,000.
Her adviser compared a 30-year term policy at $2,400 a year with a permanent policy at $11,000 a year. The term policy would expire when Margaret was 88, while the permanent policy would remain in force for life.
Margaret chose a mix, with $400,000 of permanent cover for the certain need and $400,000 of term cover for the earlier years. The illustrative lesson is that the choice between term and permanent cover depends on whether the need ends on a date or lasts for life. Margaret planned to review the mix every five years.
Watch out
Common mistakes.
- Buying permanent cover as an investment without comparing its returns and costs to alternatives.
- Surrendering a policy in the first few years, when charges mean the cash value is much lower than the premiums paid.
- Borrowing heavily against the cash value and not repaying, which can cause the policy to lapse.
Questions
People also ask.
Is permanent life better than term life?
Neither is better for everyone, since term is cheaper for a temporary need, while permanent suits a lifelong need such as estate planning or a business succession plan.
What happens if I stop paying premiums on a permanent policy?
Depending on the policy, you may use the cash value to keep the cover going for a time, convert it to a smaller paid-up policy or surrender it for the cash value. The policy documents list these options.
Is the cash value taxable?
Rules vary by country, but in many places growth is tax deferred and loans are not taxed, while withdrawals above the premiums paid may be, so tax advice is wise. A tax adviser can confirm how a particular policy is treated.
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