Insurance can be a very complicated topic, and life insurance especially so. One of the reasons is that people don’t like to think about dying and especially not dying younger than they’d like. But another reason has to do with the complicated nature of life insurance and all of the various types available.
There are many different types of life insurance policies and two similar policies can offer wildly different benefits based on the addition or subtraction of just a few words. I can think of almost nothing worse than being caught in a situation where I don’t receive the benefits that I desperately need, all because I misunderstood the type or terms of the insurance that I paid for.
The response by most people when confronted with a complicated situation like this is to ignore the issue and hope for the best. But most of us do need some type of life insurance, so it’s best to understand the differences between the main types of policies.
This post contains a very brief overview of the main types of life insurance available today. Having a basic understanding of the different types of insurance available can help you narrow down the multitude of options available. That way you can start to find the policy type that will serve best to protect yourself, your family and your assets.
Two categories of life insurance: Term & Permanent
There are two main categories of life insurance: Term and Permanent. A term policy lasts for a specified period of time (5, 10, 20 years, etc.), and a permanent policy lasts until the policy holder’s death as long as someone continues to pay the premiums.
Term policies tend to be less expensive, because they have an end date and may not have to pay out a death benefit. Permanent policies tend to be more expensive because as long as someone continues to pay the premiums they will have to pay out a death benefit someday. Permanent policies also tend to be more expensive because the policies can include complicated provisions and options that you can adjust later on.
A Term policy is almost always the best option
Before going any further, I want to say that there are probably some people for whom each of these types of policies is a fit, but many people are sold permanent life insurance policies (whole, universal, variable) when a term policy would be much better – and less expensive – for them.
The insurers tend to make more money from permanent policies, so the commissions (what the insurance salesperson earns when selling a policy) tend to be much, much larger for permanent policies than term policies. Since the salesperson is incentivized to sell permanent policies, more permanent policies are sold. This is another place where working with a fiduciary advisor, who is legally bound to look out for your best interest, can help you analyze your insurance needs and options and make sure you don’t end up paying more for insurance coverage you don’t need.
For most people in their prime working years, life insurance is there to provide financial support for their spouse and/or children if they were to suddenly pass away. A term life insurance policy does this quite well. A 45-year-old can buy a 20-year term policy that expires at 65, by which time the need for the policy should be past if they have saved for their retirement and their children are grown and supporting themselves.
A permanent policy will be more expensive and by the time you reach 65 or 70 you may not need coverage any more. At that point you might face the difficult decision of either continuing to pay the premiums or stopping and losing any future benefit.
A term policy is as simple as it gets in the life insurance space. Proponents of permanent policies will argue that you can use their policies to build cash value and invest as well, but these options are more complex and expensive. You are almost always better off buying a term policy and investing in a separate IRA or brokerage account.
Types of Life Insurance
1. Whole Life Insurance: policy is permanent, premium is set, death benefit is set
Whole life insurance, sometimes called “ordinary life” insurance is a type of life insurance which is guaranteed to remain in force for as long as the premium payments are made until death or until maturity if a maturity date is part of the contract (typically maturity dates can be 10, 20 years or to age 65). The premium for a whole life insurance policy is typically fixed (meaning the premiums will always be the same, also called a “level premium”) at the time the contract is purchased. Because the premium is fixed and there is no end date to the policy, a whole life policy is typically more expensive than a term life policy, which I will cover later.
Upon the insured’s death and payout of the policy, the payout is typically paid tax free. When discussing insurance, you will often hear the term “cash value”. This when talking about the whole, universal and variable life insurance variants. As the premiums are paid in a whole insurance policy, part of the premium pays for the death benefit and a portion goes into the cash value of the policy and builds over the whole life of the policy. In some cases a policy can be cashed out prior to the insured’s death (policies differ, but usually the premiums paid must be more than the value of the life insurance), in this case the dollar amount paid over the value of the insurance will be taxed as ordinary income.
2. Universal Life Insurance: policy is permanent, builds cash value you can use to offset premiums, option to adjust death benefit
Universal life is similar to whole life in that it provides a death benefit and remains in force as long as the premium payments are made. A main difference is that later on in the policy you can use a portion of the cash value of the policy to pay your premiums, lowering your out of pocket costs for the policy. The interest rate is typically tied to a market rate, so as rates change your ability to tap into the cash value to adjust your premium fluctuates as well. Within most universal life policies there are also options to adjust the death benefit. Raising the death benefit amount will probably require additional underwriting, while lowering it will probably not. In either way you can expect to pay some additional fees to make the change to the policy. The ability to tap into the cash value and adjust the policy are benefits of a universal life policy, but the added complexity comes with an added cost versus a whole life policy.
3.Variable Life Insurance; policy is permanent, option to invest cash value in mutual funds, option to adjust death benefit (VUL)
A variable life insurance policy, is similar to a universal life policy, but whereas with a universal policy the cash value grows within a savings account in the policy, with a variable life policy you can invest your cash value in mutual funds. But, rather than in a brokerage account where you have access to all manner of investment options, with a VUL you only have access to the fund options available with that insurer. With a variable life policy the death benefit is typically fixed, as it is with a whole life policy. You can also find a sub version, a variable universal life (or VUL) policy which possesses the investment options of a variable policy along with the policy flexibility traits of a universal policy. As I stated above, along with the additional options and flexibility involved in a variable or VUL policy comes additional expense and complexity.
These 3 types of insurance, Whole, Universal, Variable, can generally be categorized as Permanent Insurance since the policy and the death benefit remains in effect, with no termination date of the policy, as long as the premiums are paid.
4. Term Life Insurance: expires at the end of the term, set premium, set death benefit, easy to compare between providers, less complex
Term life insurance differs from the types of insurance discussed above in that it is not permanent, as the name implies it is only in effect for a set term. Typical term lengths are 10, 20, or 30 years. Term life policies are typically much cheaper than permanent life policies for this reason. With a permanent plan the insurer knows that they will have to make a death benefit payment as long as the insured continues to make their premium payments. However, with a term policy once the term is up the insurer is off the hook for the death benefit. A possible downside to term insurance is that you might outlive your policy. If your need for insurance still exists after the term has expired you will likely have to pay more in premiums for an additional term. Term insurance is by far the least complicated type of life insurance. There are only two components to decide on: the length of the term, and the value of the death benefit. Because of this it is much easier to compare between term plans from different insurers, and there are many places online where you can compare quotes for the same policies from different companies.
The four types of insurance listed above are the main types of life insurance offered, but by no means are they the only kinds available. There is declining benefit insurance where the value of the death benefit declines over the term of the policy. These are usually designed to match the mortgage amortization schedule on a home, so that if the insured dies prematurely the death benefit from the insurance policy will pay off any remaining mortgage balance.
There are also joint life insurance policies where two people are covered with the same insurance. These can be designed to pay out when the first person dies or after the second person dies, depending on the underlying reason for the insurance.
Final Expense Insurance, often called burial insurance, is a policy designed for older individuals who want to make sure their final expenses are covered and their family do not have shoulder the costs after they pass.
When evaluating insurance, you should ask yourself the question “what am I insuring against?” and keep this Einstein quote in mind.
“Everything should be made as simple as possible and no simpler”
For most people the simplest answer is a term policy that protects their family during their prime working years. If your situation requires something different or you were too intimidated to look into life insurance before, you now have a bit more information to help you with your search.
If you want to have a more detailed discussion about any of the above insurance types or want to know more about what strategies might be the right fit for your particular situation, feel free to email me at email@example.com or schedule a free introductory consultation.