Term vs. Whole Life
By Ronald J. Pawlikowski, CLU
Only a handful of debates arouse more passion than does term insurance versus whole life insurance. Unfortunately, most (and by most, I am including the majority of those who sell life insurance) do not understand the fundamental differences between the two products. If they did, there would be no debate, as they are different products that serve different needs.
This debate does not involve opinion, on which reasonable people can disagree. This debate involves ignorance on both sides, each believing that the product they favor is “better” than the other. I am here to tell you that neither product is better than the other, but that they are different products used for different needs.
To suggest they are the same product is like saying that a hammer is the same as a screwdriver, because they are both tools. Just because they are both tools, doesn’t mean they’re interchangeable. Oh sure, a screwdriver could be used in lieu of a hammer if all you had to do was to tap a small nail in the wall to hang a picture. But if you’re building a deck, you’d better have a hammer.
Those who favor term insurance usually look at the premiums and conclude that they can receive the same benefit for a fraction of the cost. They think that because the face amounts are the same, the benefits are the same. They are not. There is a very logical reason for the difference in premium between the two products.
A life insurance company incurs expenses just like any other business. These expenses include salaries, real estate costs, computer costs, etc. These expenses are all paid from the company’s primary source of income, which is a policy premium. In addition to paying its expenses, a life insurance company must also reserve a portion of its premiums to pay future death claims.
The amount that must be reserved is determined in part by the likelihood of paying a claim. And therein lies the reason for the disparity in premiums between term and whole life – 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. Virtually no term policies are still in effect at life expectancy.
A whole life policy on the other hand, will be in force the day you die (unless you choose to cancel it) and thus mature in a death claim. Accordingly, the insurance company must receive a higher premium to reserve for the eventual pay out of the claim. (By the way, that reserve is available, in the form of a policy loan, to the policyholder.)
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 6% at life expectancy.
So why would anyone buy term insurance if there is little chance that it will pay a claim? First, let me be perfectly clear: if you die while a term policy is in force, the life insurance company WILL pay the death claim. There is just a very small chance of that happening.
Unfortunately, most people buy it out of ignorance, thinking that they are buying the same product at a discount. They think this way in part because the media continually runs articles espousing them to but term and invest the difference. Whenever I hear that, I always ask the person why two types of life insurance even exist (after all, you can’t buy any other type of insurance that has cash value), and not once has the person replied correctly.
Generally, term insurance should be procured for one of two reasons: 1) the liability to be insured is short term in nature or 2) cash flow is insufficient to insure the entire liability with whole life.
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.