Life Insurance 101
What is life insurance?
A life insurance policy is a contract between an insurance company and a policyowner that requires the insurer to pay a sum of money, called a “death benefit,” upon the death of the person whose life is insured under the contract. The money is paid to whomever is designated as the “beneficiary” under the policy (often a spouse or children). The policy owner may be someone different from the insured person, for example, where a business buys a policy on the life of a founder or executive of the business.
What are the different types of life insurance policies?
A “term life” policy is a policy that insures the life of the insured person for a specified period of time called the “term” of the policy. The term is often 10 or 20 years. After the term expires, the insurer is no longer obligated to continue the insurance, though the policy owner may be able to buy a new term policy from that insurer or another insurer, but likely at a higher price and only after new underwriting that may include a medical examination of the insured person. A term life policy typically does not have any savings account component and therefore has no cash value.
A “permanent” policy is one that has no specified term and obligates the insurer to continue insuring the life of the insured person for as long as the policy owner keeps the policy in force. Keeping the policy in force may require the owner to keep paying money into the policy, but a permanent policy does not expire or terminate due simply to the passage of time. Permanent policies typically have a savings account feature that allows the owner to build up “Cash Value” of the policy by paying more in premiums over time than the insurer deducts in fees. If the cash value is higher than any surrender charge that may be in effect, the policy owner can typically access any cash value that is greater than the surrender charge by either withdrawing or borrowing money from the policy. There are several types of permanent policies:
A “whole life” policy is a permanent policy that has a specified premium that, if paid, will keep the policy in force until the death of the insured. Whole life policies generally have lower lapse rates and are therefore less risky than universal life policies.
A “universal life” policy is a permanent policy that does not have a required premium but instead has a “flexible premium” that allows the policy owner to pay premiums in whatever amount and at whatever time the owner wants. The policy may nevertheless lapse if the owner does not pay enough premiums to cover fees deducted from the policy’s cash value. There are three types of universal life policies:
"Traditional" universal life
A universal life policy in which the savings account earns interest at a specified percentage (e.g., 5%). The percentage may be changed by the insurance company but is typically subject to some minimum amount.
Indexed universal life
A universal life policy in which the savings account earns interest according to the performance of a specified index or indices, such as the S&P 500. For example, if the policy is indexed to the S&P 500, and the S&P 500 goes up 6% in a given year, the savings account in the policy will earn 6% interest. The interest is typically subject to a yearly minimum (e.g., 0%) and is often subject to yearly maximum (e.g., 10%). The maximum percentage may be changed by the insurance company to as low as its guaranteed minimum (often 3 or 4%) as specified in the policy.
Variable universal life
A variable universal life policy is one in which the money paid into the policy is invested - at the policy owner’s direction - into mutual fund-like sub-accounts. The sub-accounts are held outside the policy, and the policy’s cash value will rise or fall according to how the accounts perform in the securities markets. Variable universal life policies have the highest lapse rates and are generally considered to be the riskiest kind of life insurance to buy because there is typically no guaranteed minimum return in the sub-accounts, so poor returns in the sub-accounts can combine with policy fees to drastically reduce policy value. On the other hand, the sub-accounts would typically have no caps on returns, so the upside to the policyholder can be greater than with an indexed universal life policy. Variable universal life policies can perform very well with proper selection, management, and maintenance of the sub-accounts.
What kind of life insurance policy is right for me?
What kind of life insurance policy is right for you depends on your objectives. If you simply want Death Protection, meaning insurance that will pay money if the insured person dies, then a Term Life Insurance Policy is the right policy for you if you need Death Protection only for a limited period of time (such as during the key earning years of the insured person). If you want Death Protection for a longer period, then a Permanent Life Insurance Policy, while probably more expensive than a Term Life Insurance Policy, would allow you to keep the policy in force for as long as you want. A term policy will generally expire after a period of years (such as 20 years), and getting a new policy after that time may be expensive and would likely require new Medical Underwriting. If you want Death Protection but also want an investment that may have tax advantages compared with non tax-advantaged investments, then a Cash Value Life Insurance Policy may be appropriate for you, though some Cash Value Life Insurance Policies are very risky investments, particularly for people who do not have large amounts of money available for investing. If you want an investment that may have tax advantages over non tax-advantaged investments, but you do not want Death Protection, then it is very unlikely that you would benefit from buying a life insurance policy.