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Permanent life insurance

What Is Permanent Life Insurance?

Permanent life insurance is a type of life insurance that provides coverage for the policyholder's entire life, as long as premiums are paid. Unlike other forms of life insurance, permanent life insurance policies include a savings component known as cash value, which grows on a tax-deferred growth basis over time. This makes it a core component within personal finance and financial planning, offering both a death benefit and a living benefit accessible during the insured's lifetime.

History and Origin

The concept of life insurance emerged in rudimentary forms centuries ago, with early mutual aid societies providing financial support to families upon the death of a member. In the United States, the formal sale of life insurance began in the 1760s, initiated by organizations such as the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers in Philadelphia.2 Over time, the structure of policies evolved to include features beyond simple death protection, leading to the development of permanent life insurance. The establishment of regulatory bodies and the increasing complexity of financial markets further shaped the modern forms of these policies.

Key Takeaways

Formula and Calculation

While there isn't a single universal formula to calculate the cost or cash value growth of all permanent life insurance policies due to their complexity and variable features, the basic components involve actuarial science. The premium calculation for permanent life insurance considers factors such as the insured's age, health, gender, and the desired death benefit amount. The cash value growth often involves a guaranteed interest rate or is tied to market performance.

The accumulated cash value (CV_t) at time (t) can be generally represented as:

CVt=Previous Cash Value+Net Premium+Interest/Investment Gains−Expenses−Mortality CostsCV_t = \text{Previous Cash Value} + \text{Net Premium} + \text{Interest/Investment Gains} - \text{Expenses} - \text{Mortality Costs}

Where:

  • (\text{Net Premium}) is the portion of the premium allocated to the cash value, after deducting charges for expenses and mortality.
  • (\text{Interest/Investment Gains}) represents the earnings on the cash value.
  • (\text{Expenses}) are administrative fees and charges.
  • (\text{Mortality Costs}) are the charges for providing the death benefit coverage.

Interpreting the Permanent Life Insurance

Understanding permanent life insurance involves recognizing its dual nature: insurance protection and a savings component. The cash value accumulation means the policy is not just an expense for coverage but also an asset that can be utilized during the policyholder's lifetime. This cash value can be borrowed against via a policy loan or withdrawn, although withdrawals may reduce the death benefit and could be subject to taxes if they exceed the premiums paid. The interpretation also depends on the specific policy type; for instance, whole life insurance offers predictable growth, while variable life insurance exposes the cash value to market investments and their associated risks and potential for higher returns.

Hypothetical Example

Consider Sarah, a 35-year-old professional, who purchases a permanent life insurance policy with a $500,000 death benefit. Her annual premium is $5,000. For the first few years, a significant portion of her premium covers mortality costs and administrative fees. As the policy matures, a larger share contributes to the cash value, which starts accumulating earnings. After 20 years, Sarah's cash value has grown to $150,000. She can choose to take a policy loan against this cash value to help fund her child's education, or she could surrender the policy for its cash value. Alternatively, she could maintain the policy, knowing that her beneficiaries will receive the death benefit upon her passing, providing long-term financial security for her estate planning.

Practical Applications

Permanent life insurance finds several practical applications in personal and business financial strategies. Beyond providing a death benefit for income replacement, it is often used for estate planning to cover estate taxes or provide liquidity to heirs. Businesses might use it for key person insurance or executive benefit plans. The cash value component can also serve as a source of funds for retirement income, college funding, or other significant expenses. Regulatory bodies, such as the National Association of Insurance Commissioners (NAIC), play a crucial role in overseeing the industry and ensuring consumer protection, affecting how permanent life insurance policies are designed and sold. Additionally, the Internal Revenue Service (IRS) provides guidance on the tax implications of permanent life insurance, including the tax-free nature of death benefits and the tax treatment of cash value withdrawals and loans.

Limitations and Criticisms

Despite its benefits, permanent life insurance has limitations and faces criticisms. One common critique is the higher cost compared to term life insurance for the same amount of death benefit in the early years. The complexity of some policies, particularly universal and variable life, can make them difficult for consumers to understand fully. Critics also point to potentially lower investment returns on the cash value compared to alternative direct investments, particularly after accounting for fees and charges. Some economic studies suggest that for certain households, combined private and public life insurance might be inadequate, indicating that even with permanent policies, individuals may not have sufficient coverage for their needs.1 The illiquidity of the cash value in the initial years, due to surrender charges, is another drawback.

Permanent Life Insurance vs. Term Life Insurance

The primary distinction between permanent life insurance and term life insurance lies in their duration and cash value component. Permanent life insurance provides coverage for the insured's entire life and includes a cash value that grows over time. This cash value can be accessed by the policyholder during their lifetime. In contrast, term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. Once the term expires, the coverage ends unless the policy is renewed, converted, or a new one is purchased. Term life policies do not build cash value, which generally makes their premiums lower than those of permanent policies for the same death benefit amount. Confusion often arises because both serve the purpose of providing a death benefit, but their structure, cost, and additional features differ significantly.

FAQs

Is the cash value of permanent life insurance taxable?

The cash value of permanent life insurance grows on a tax-deferred basis, meaning you do not pay taxes on the earnings until you withdraw them. If you take a policy loan, it is generally not considered taxable income. However, if you surrender the policy and the cash value received exceeds the total premiums paid, the gain may be taxable.

Can I withdraw money from my permanent life insurance policy?

Yes, you can typically withdraw money from the cash value of your permanent life insurance policy. However, withdrawals can reduce the death benefit and may be subject to taxes if the amount withdrawn exceeds the premiums you have paid into the policy.

What happens if I stop paying premiums on my permanent life insurance?

If you stop paying premiums on your permanent life insurance policy, several options may be available depending on the policy's terms. You might be able to use the accumulated cash value to keep the policy in force for a reduced death benefit or for a limited period. Alternatively, you could surrender the policy and receive the cash value, minus any surrender charges.

Is permanent life insurance a good investment?

Permanent life insurance offers both a death benefit and a savings component, but whether it is a "good investment" depends on individual financial goals and circumstances. While it provides tax-deferred cash value growth and a guaranteed death benefit, some financial experts suggest that for pure investments, separate investment vehicles might offer higher potential returns. It is often considered a tool for long-term financial security and estate planning rather than a primary investment vehicle.