by Archie M. Richards, Jr., CFP^®
May 28, 2001

There are about 1,700 life insurance companies in the United States , each one offering unique policies. But every policy is derived from one or more of the three basic kinds of life insurance. Here's the key to all three: Every year, the risk of dying increases.

Let's say you're a thirty-year-old male in good health. You acquire a $100,000 "term" life insurance policy during that year, with a first-year premium of only $150. Chickenfeed, right? If you happen to get whacked by a truck during the year, your family receives a cool hundred grand. The insurance company is on the hook for $98,850 - a hefty piece of change. It has to sell a ton of $100,000 policies at $150 a shot to provide the funds when only one of the insureds dies.

But you don't die (whew!). Sixty-six years later, at age 96, the risk of your dying is a tad higher than it was at age 30. The $100,000 death benefit remains the same, but the premium for that 96th year is about $94,000. The insurance company is on the hook for only $6,000. If I were the insurance company, I wouldn't want my risk to run a penny higher.

It's called annually renewable term insurance. "Annually renewable" means that if your health falters, you can still renew the policy each year with no increase in the premiums that were agreed to up front. The deterioration of your health is the insurance company's risk, not yours. "Term" means a period of one year. The premium paid each year covers the risk of your dying during that year. As the risk increases, so does the premium. (If you acquire five-year term, the premium remains level for the first five years and rises to a higher level for the next five.)

Contrast all this with the second basic kind of life insurance - whole life, sometimes called straight life. Again, you're a thirty-year-old male in good health acquiring $100,000 of life insurance. But here, the premium doesn't rise. The cost is $1,100 in the first year - seven times higher than the $150 you'd pay for the term policy above. But when you reach old age, the premium is still only $1,100. At young ages, the whole life premium is too high. At advanced ages, it's too low. The extra portion of the premium (the difference between $1,100 and $150 in the first year) is invested by the insurance company in bonds. When old age is reached, those investments cover the risk of your dying. This "cash value" is also the amount you receive if you terminate the policy while still alive.

One of the things that makes life insurance confusing (there are a lot of those things) is that the time of a person's expected death doesn't remain constant. If you're 30, you're expected to die at, say, age 78. But on your 78th birthday, no one expects you to kick off during that year. Oh no; by then, you probably have another nine years to go. The longer you live, the greater your life expectancy. It's not until approximately age 108 that you're expected to die within a year.

The cash value of your whole life policy - the savings portion - grows slowly, probably no faster than 4 percent per year, after the insurance company deducts its costs. (Insurance companies are big bureaucracies; there are lots of costs.) Even though the savings portion compounds tax free, you're still better off buying a term policy, placing the difference in stock index funds, and holding for the long term. At age 30, you pay $150 for the term policy. The balance of the $1,100 ($950) you invest. As the life insurance premium grows, less and less becomes available for the fund. But despite this, the fund will almost certainly end up larger than the cash value of the whole life policy, even after tax.

Now for the third basic kind of life insurance. Here, the premiums are too low at the beginning. But they don't rise; they stay the same. With the premiums level and the risk of dying increasing, something has to give. Ah yes, the death benefit goes down.

It's called decreasing term insurance. The premiums stay level, and the death benefit falls. Decreasing term policies are often offered by banks to pay off mortgages in event of the breadwinner's premature death. As the mortgage balance declines, the death benefit from the decreasing term policy falls with it.

Isn't life insurance fun? The trouble is, you have to die to collect.