The financial industry promotes the idea that life insurance is something every sensible person should have. In fact, life insurance makes sense only in certain circumstances. For many people, it is unnecessary. For many more people, it costs more than it should. The prudent wealth builder will be very careful about how much life insurance he or she buys.

Almost nobody understands life insurance fully. Not lawyers. Not accountants.  Not even the financial planners and insurance agents that sell it.

There’s a good reason for that. Most policies – especially permanent life insurance policies – are complicated. They are written and sold using language that is incomprehensible to ordinary people.

To make matters worse, life insurance is sold using rhetoric that pulls on the heartstrings of potential buyers, inducing them to spend more than they might need to.

It would take a book to explain this in detail. But if you are considering the purchase of a new policy or want to understand a policy that you currently own, the following should be helpful.

Broadly speaking, there are two kinds of life insurance: term life and permanent life.

Term Life Insurance

Term life insurance is relatively simple. When you buy a term policy, you are paying a stated amount of money (the premium) for a stated amount of coverage (the death benefit) given to someone you choose (the beneficiary) if you die within a certain amount of time (the term).

Example: John Doe, a 40-year old executive, buys a million-dollar term life policy. It has a 30-year term. The cost is $100 a month the first year. Each year after that, the cost goes up. If he dies before he’s 70, his wife Helen gets $1 million. And that’s tax-free. (Life insurance benefits go to the beneficiaries tax-free.)

Sounds good to John. What can go wrong?

• If he fails to keep up with his premium payments during the term, Helen gets nothing.
• If he lives past 70 without extending the policy, Helen gets nothing.

But there’s another thing: What if Helen doesn’t need $1 million if he dies? What if she’s gainfully employed? What if all John needs is a $100,000 policy to cover his funeral expenses and some other odds and ends?

Wouldn’t he be wiser to get a  $100,000 policy and cut his monthly premiums by 70% or 80%?

Permanent Life Insurance

Permanent life insurance is complicated. First of all, it comes in a variety of forms – whole, universal, and variable being the most common. But let’s not worry about that. Let’s stick with the basics.

When you buy permanent life insurance, you are paying for two things: a life insurance policy plus a tax-deferred savings account.

Because of the investment aspect, permanent life insurance is considerably more expensive than term. How much more expensive depends on how much you want to invest and how much the insurance company is going to charge you in management fees, sales commissions, and administrative charges.

So for a million-dollar permanent life insurance policy, John might pay in $300 a month – of which maybe $100 would go towards the insurance and the rest towards his savings account and various fees and commissions.

Those fees and commissions can be costly. With some policies, they can be 50% to 100% of the initial premiums.

It is for this reason that one should be skeptical about permanent life insurance. The question is always: Would it be smarter to buy term insurance separately and put the rest of the money into a tax-deferred savings account?

There are 4 upsides to permanent life insurance:

• As the name implies, your coverage lasts forever.
• The savings portion of it accumulates tax-deferred. Over a 30- or 40-year period, that savings can make a considerable difference.
• The obligation to pay the premiums can work as a sort of forced savings for people that don’t feel they would have the willpower to regularly contribute to a separate savings account.
• Because of the savings component, your policy has a cash value that builds tax-free over time. You can borrow against it while you are still living. And the “loan” can be paid off by the policy’s death benefit after you die.

As for the downsides:

• As with term life, if you fail to keep up with the premium, the policy lapses.
• Permanent life usually requires a medical exam. If the exam indicates that there is a statistical probability that you might die earlier than would be typical for someone your age, you will likely pay more for the same amount of death benefit.
• Because of the high costs of fees and commissions, the cash value of most permanent policies is very low for at least the first 10 years. Much of your “savings,” in other words, go to enriching the agent and the insurance company, not you.
• Over the long term – in 30 or 40 years – the cash value of the policy may not be what you expected it to be. In selling permanent policies, agents are allowed to show you “expected” returns based on “expected” stock and bond market averages. But these are not guaranteed.

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