What is Traditional Life Insurance?

The first emergence of American life insurance dates back to the 18th century -- 1759 to be exact. It was created by the very specifically and wordily named Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers, with the Episcopalians establishing their own fund about a decade later. Life insurance policies wouldn't become available to the public until the early 19th century, and they didn't do well. Less than half of the initial companies survived, mostly due to laws prohibiting women — the most obvious beneficiaries — from being able to claim the insurance protection for themselves or their children should their husbands die. The laws were changed in 1840 and the insurance business improved, developing into mutual life funds in the 1840s and then term life insurance policies during the Civil War. Traditional life insurance, however, has remained a valid model.

The model of traditional or whole life insurance is similar to that of a giant, empty water cooler. When a policy is first enacted, the bit of water on the bottom is the cash value of the policy — the initially paid premiums. The empty air is the insurance coverage, or the amount the insurance company owes in case of death. The top rim of the cooler is the total value of the policy, which neither the cash value nor insurance coverage may exceed. Your premium payments are like water pouring from a faucet into the cooler, and the insurance company's taxes, expenses and cost of the insurance is the spigot on the outside, draining a little out each time. The remainder of your payments continues to fill the cash value account of your policy, while the amount of air in the water cooler steadily shrinks. This represents that, as you pay more premiums, the insurance company owes less and less of insurance coverage as the cash value approaches the value of the total policy. When you die, your beneficiary receives the sum total of the insurance coverage and the cash value you had in the tank. This analogy doesn't include paper cups and office gossip, but you get the drift.

The primary benefit of whole life policies is peace of mind. There are no renewals; you are covered until you die. Insurance premiums are level, meaning whatever you are quoted when you purchase the insurance is the amount you will pay forever, no matter how old and decrepit you get. Your beneficiaries get the full amount of the policy, tax-free, regardless of whether you die two years or 62 years from now. Whole life policies also act as a savings vehicle, and you can borrow against the cash value of your loan, although this decreases the overall value of the policy if it is not replenished before your death.

The downside of traditional life insurance is that it may be safe, but it is somewhat inflexible. Term life insurance came into being to address that issue, by granting periods of time, usually 10, 20 or 30 years, that coverage would be in effect. The premiums on term life insurance policies are cheaper and offer competitive payouts in case of death, making them attractive to young couples with large financial responsibilities and little extra money to fund the hopefully distant payout on a traditional policy. Term life policies also give options to older policyholders that a traditional policy won't. Getting whole life coverage in the twilight years is difficult, and certainly unavailable at a rate that would be worth it. Term life policies don't have a policy loan option, but there may be better options for cash funding available through stocks and funds rather than using your life insurance.