In general, there are two basic (and quite different) categories of life insurance: temporary and permanent.
Temporary life insurance, also known as term life, is a no-frills way of insuring yourself for a specific period of time—for example, one, five, or ten years. When the temporary life insurance can be automatically renewed every year at increasing rates, it is called annual renewable term (ART) insurance; when the premiums are constant for a longer term, it is referred to as level premium term insurance. In the latter case, as I explained earlier, your monthly premiums are guaranteed for the term of the insurance, and the insurance coverage ends at the end of the term.
The important characteristics of a term policy are its temporary nature and its lack of a savings component. This might seem an odd comment at first, since insurance should have nothing to do with savings. But you will see in a moment that permanent life insurance does have a savings component.
Temporary coverage, of course, is great for temporary needs. For example, it may be advisable for young couples, with considerable human capital to protect, who have just purchased a house and financed it with a large mortgage, have dependents, and so forth. They may have term life insurance of perhaps 8–10 times their annual salaries. Some financial advisors believe that, as these individuals age, this factor can be reduced to 6–8 times their annual salaries, and then perhaps even to 4–6 times—but never less. Of course, renewing the term insurance will cost more as you age because the probability of dying increases. In fact, in order to ensure they can continue to buy temporary coverage at all, some purchase term insurance with a guaranteed renewable clause. This means that, even if their health deteriorates, when the original period is over they can purchase a replacement policy (for the same or lower amount of coverage) without having to undergo a medical examination, which the insurance company usually requires in order to reduce adverse selection.
So much for temporary insurance coverage. What is permanent coverage? This type of coverage is usually referred to as whole life, universal life, or level life insurance. There are various types and flavors of permanent coverage, but the main idea is that your monthly or quarterly insurance premiums also contain a savings component. So, if you pay $100 per month, perhaps $60 goes toward the insurance premiums while the remaining $40 goes to a side savings fund and grows on a tax-deferred basis.
Why the savings? With (short) term insurance, the cost of buying a new policy would increase each year because the probability of dying increases as you age. Remember insurance is more expensive at older ages. In fact, by the time you are 80 the premiums are prohibitively expensive—assuming you can find a seller. Level or permanent insurance is a system whereby you overpay in the early years in order to subsidize the later years. Although the premiums are also fixed for a level life insurance policy (as its name suggests), level insurance premiums are higher than term premiums for the first part of your life whereas term premiums exceed level premiums later on. This is where the savings come in. Since you are overpaying in the early years, the excess over the pure premiums is being invested in a side fund. In fact, this tax-deferred savings component is what often gives rise to non–human capital reasons for purchasing insurance. For example, the tax shelter provides an efficient method of accumulating savings to finance the tax bill on your appreciated physical assets that your estate may face upon your death.
In some cases, you can actually control where those excess premiums are invested. For example, you may be able to choose to invest in insurance company mutual funds or bonds. As you age, some of the savings will be depleted to make up for the fact that your annual level premiums are lower than what they should be. With these so-called variable policies, you can withdraw (or cash in) the excess savings at any time, so you have access to an emergency fund in times of need.
In sum, were it not for income taxes and the possibility that your insurability might change over time, buying life insurance would be a simple decision. Everybody would be advised to “buy term and invest the difference.”