Whole Life vs. Term Life

The two main forms of life insurance you should understand are whole life and term life insurance. (It's also good to learn about universal and variable, which are variations of whole life insurance.)

But what's the difference between the two? With term insurance, you're covered only during the life of the policy, while you're paying the premiums. If you carry a term life insurance policy for 50 years, regularly pay the premiums, and then quit paying and die a year later, you're out of luck. (Well, you'd be out of luck regardless -- but in this case, your beneficiaries are out of luck, too.)

There are several forms of term insurance:

• Level term -- you pay a fixed premium for up to 20 years. This can be a good deal, since it protects you against the effects of inflation and unexpected changes in your health that would warrant higher premiums.
  
• Annual renewable term -- gives you the option of renewing your policy regularly, but at increasing premium rates.
  
• Decreasing term -- features a steadily decreasing death benefit. This might seem undesirable, but it can be sensible for many people. You may need a bigger benefit when you're a young breadwinner with a family to support than when you're a retiree with grown children and a nice nest egg.

Whole life insurance, meanwhile, is designed to cover you for your entire life. These policies charge you a fixed premium each year, one that's typically higher than term insurance. The advantage touted by insurance companies for whole life insurance is that, while part of the premium covers what term insurance would cost, the surplus resides in an account that pays interest and accumulates a cash value. As this "accumulation account" grows, your premiums can decrease over time. Eventually, in some cases, the interest earned can pay the premiums for you. So you won't be paying any more premiums, but you'll still be covered for the rest of your life.

The problem with whole life insurance is that insurance companies tend to offer low interest rates to policyholders, while the companies typically earn much greater returns because they invest the money in stocks and bonds. Policyholders are indeed earning a bit of money through the policy, but as an "investment," it leaves a lot to be desired.

Enter "universal" life insurance, a form of whole life insurance. With universal life, in years when the insurance company earns more on policyholders' accumulation accounts than they promised, they pass along the extra gain. This sounds good, but in some situations, because of overly optimistic assumptions insurers make about customers' returns, customers can end up paying more than they expected to. "Variable" life insurance policies, which invest in sub-accounts that look like (but legally are not and cannot be) mutual funds, carry the same danger.

With universal and variable insurance, the higher the initial assumed rate of return, the lower the annual payments will be. This is how some unscrupulous agents can sign you up -- through very attractive policies based on unreasonable assumptions. Since most insurers invest to a great degree in bonds, be skeptical of any promised universal rates much higher than the 30-year Treasury rate. With variable insurance, since most mutual funds have trouble beating the S&P 500's average historical return of 10%-12% per year, we'd be skeptical of any projected rates in that neighborhood.

Learn more about the less-exciting-but-still-critical topic of insurance in our Insurance Center or our 60-Second Guide to Insurance. You may not have thought about some kinds of insurance, such as disability or long-term care insurance, but they're vital for many people. And, of course, properly insuring your property is crucial, too. Take a little time to learn more, and you may be very happy you did, especially if some calamity occurs in the future.

And if you're in the market for insurance, another way to inform yourself about options is to spend some time at the websites of insurance companies. According to SNL Financial, the 10 largest insurance companies (as of 9/30/05) are:

• American International Group (NYSE: AIG)
• Berkshire Hathaway (NYSE: BRKa) (NYSE: BRKb)
• UnitedHealth Group (NYSE: UNH)
• WellPoint (NYSE: WLP)
• MetLife (NYSE: MET)
• Allstate (NYSE: ALL)
• Prudential Financial
• St. Paul Travel ers
• Aetna
• Hartford Financial Services