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For the people in this forum who just don't like whole life or any from of cash value type of life insurance for one reason or another (most often due to a lack of understanding of just what it is and how it actually works), I thought I might throw out some information that may prove helpful. Please understand this is not to try to convince anyone to like it or that they should have any of it. This is simply help with a better understanding of it and how it works. I felt compelled to do this, as what I just saw published in the Motley Fool section about life insurance is full of misinformation, which I feel can lead people to incorrect ideas as to how it all works.

First let me point out that what life insurance is NOT designed to replace lost income as it's so often said. Life insurance is designed to pay immediate cash out to a beneficiary in the event of an insured's death. Please look at that sentence closely again. While it's obviously that a great majority of the time such cash is needed to replace income and so that's what life insurance is used for most of the time. But there are many other situations where there may be a need/want for immediate cash at the time of someone's death. And life insurance can do that because that's what it's designed to do.

Now here's something that might take you a little getting used to until you understand what's going on with life insurance. ALL life insurance is really term insurance. Many of the issues we argue about really have to do with how we may want to pay for that term insurance and/or how long we should need or want it.

You see, what you really pay for each year is akin to yearly renewable term insurance. And as you get older, that cost/premium for that term insurance (yearly mortality and expense costs) gets higher and higher like an exponential curve. As you keep your insurance over whatever period, you can pay each premium directly from earned income or from your investments. You also have a choice too of whether to use enough of your after-tax dollars to pay for the insurance, or . . . .you can pay for some of it with pretax earnings on amounts you choose to deposit with the insurance company.

Almost everyone chooses the latter these days. If you think not . . . just ask around and see who actually buys yearly renewable term insurance. Very often, if not most often, you'll find people buying 20 yr. level term, which has much higher premium than the yearly renewable term. They pay excess premium to the insurance company, which goes into the company's general account and is set up as reserves, to keep premiums level and the insurance company invests that excess premium to help pay for the higher cost of insurance as it rises over the years. So, why are they doing that when they might do better to buy yearly renewable term and investment the difference?

Whole life and other types of permanent life insurance work exactly the same way. One of the main differences of course is the length of time the coverage is to last. The longer the level premium payment period is the higher the premium (just like in level term contracts), because you must deposit more with the insurance company to pay for future cost of insurance. You're over paying in the early years, the reserves compounding on a tax-free basis, as those premiums become insufficient to pay for the insurance in later years.

Because permanent life insurance contracts are collecting so much in the early years, provisions are made to return what's held in the reserves should the policy be surrendered, as those reserves are no longer needed to pay for future life insurance costs at that point. While the policy is in force the value of those reserves that will be returned is what's called the Cash Value. It is not a “savings account” and it is not a cash value “account” – though it's often thought of in those terms. And you really don't make “deposits” to an account or to the insurance company, you PAY a premium, which is used as I've described.

Now that I've got to the Cash Value aspect, let me take a side step to explain a little what happens to this excess-amount/Cash-Value upon death. Another facet of keeping the premium level is that the actual amount of pure insurance coverage decreases as the Cash Value increases (particularly in a whole life type of contract – in universal life contracts there is an option to keep it level, but I won't get into that here). The amount of actual insurance coverage is referred to as “amount at risk.” The Death Benefit actually consists of two parts, the Cash Value plus the amount at risk. So, if or when you hear the non-sense that the insurance company “keeps your money,” what you're hearing is really something ignorant of how it really works. The insurance company always pays out “your money.”

As the reserves are compounding to pay future costs of insurance, they are afforded special tax treatment in our tax code. And it's the tax advantages of both the policy's reserves as well as the death benefit that can make permanent policies very effective and attractive in many situations.

And since a certain amount of reserves must be maintained to cover the future costs, insurance companies also provide liberal loan arrangements against the reserves of the policy. Since amounts received from “loans” are never taxable, the liberal loan provisions in these policies can be used in a very low cost and effective way . . . much like other types of collateralized loans might. There are no immediate payback requirements for such loans, you don't have to try and qualify for such a loan, and the loan does not show up on any credit report.

The better you understand how and why life insurance contracts work as they do, along with the associated tax and legal rules associated with them, the more ways one can find where they become a very effective financial tool. Which is why there's certainly many more uses than just replacing lost income – particularly as you get older and you're financial situations become more complex.
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