Find out how the different life insurance options work so that you will know which one is best for you – the choices can be complex in some cases.
An Overview of the Different Types of Life Insurance
If you have children or other dependents or loved ones to take care of or have debts that would need to be paid off if you died, then you probably need some form of life insurance coverage. In generations past, you would essentially have only two choices: term or whole life coverage. But there has been a virtual explosion of new products coming available during the past 20 years or so, and finding the right type of insurance policy for you may be harder than you anticipated. The new types of life insurance that are available now can do many things that traditional older policies could not accomplish. But you will need to know the characteristics of each type of policy in the marketplace today in order to choose the one that’s best for you.
Term Life Insurance
Term insurance is still the simplest-and cheapest-type of coverage. Term insurance offers only a pure death benefit with no cash value buildup. And, like the name says, it only remains in force for a predetermined amount of time, or term, such as 10 or 20 years. The insured simply pays the monthly or annual premiums to the life insurance company in return for the death benefit protection, and once the term is up, then both the premiums and the coverage cease. If the insured dies after the term has finished, then no death benefit will be paid. Term insurance can be renewed at the end of the term, but the premiums will usually be more expensive than they were before, and the insured may not be in as good of health. Most insurance companies will not issue term life insurance to those age 75 or 80 or above. This is one of the main drawbacks to term life insurance, along with the fact that premiums will increase as you get older. For this reason, term life is most commonly sought after by younger insureds who are still in good health and can better afford the lower premiums while they are working.
There are several types of term coverage, listed as follows:
Guaranteed Level Term Life Insurance – This is the most common type of life coverage available in the market today. The premiums in these policies are guaranteed not to go up during the term, but this assurance makes this type of policy more expensive to begin with. Level term policies are typically issued for periods of 10, 20 or 30 years. This type of policy may work best if you are looking for term coverage for a specific length of time and do not plan on renewing the coverage at the end of the term.
Annual Renewable Term Life Insurance – This type of short-term coverage renews annually. It can provide short-term protection if you don’t need long-term coverage, but the premiums usually increase each year. The premiums will rise substantially after 20 or 30 years, thus making it unaffordable for the majority of prospective insureds.
Return of Premium Term Life Insurance – As the name implies, this type of term coverage refunds some or all of the premiums that are paid for the policy, assuming that the insured is still living at the end of the term and the death benefit has not be paid. This additional form of protection usually comes in the form of a rider that can be added on to other types of term coverage such as guaranteed level term insurance. For example, someone could by a 30-year guaranteed level term policy and pay an additional amount per year in order to receive a refund of 60% of premiums that are paid at the end of the term. Most ROP riders are for 15, 20 or 30 years. Although return of premium riders may sound attractive at first glance, some financial experts feel that investing the money that you would use to pay for this type of rider would give you more bang for your buck over time. However, this type of policy is still cheaper than whole life and may be appropriate for you if you don’t wish to risk your money in the markets but do feel that it is likely that you will still be living at the end of the term.
Decreasing Term Life Insurance – This type of term life policy pays a progressively smaller death benefit as time passes, even while the premiums stay level over the term. It is designed to provide protection for insureds who have greater liabilities at the beginning of the term and fewer or no liabilities at the end. For example, consider a 45 year old homeowner who has $100,000 left on their mortgage along with a car loan and credit card debt, and whose children will soon be in college. He or she could take out a decreasing term policy that initially provides $500,000 of coverage and then systematically shrinks by a certain amount until it only provides $100,000 of coverage when the homeowner retires. The decrease in the death benefit allows the premiums in the policy to remain level as the homeowner ages. Mortgage Term Insurance is probably the most common form of decreasing term insurance. It is designed to pay off your mortgage in the event of your death, so the death benefit is calculated to shrink at the same rate as your mortgage, with the term ending when the mortgage will be paid off.
Modified Term Life Insurance – These less common vehicles vary in how premiums are paid into them. They can come in the form of any other form of term coverage, except that their premiums may rise over time or be paid in some other alternative fashion than with other traditional forms of term coverage. This type of policy is generally employed in specialized financial planning situations, such as where you might have more money in the future to make premium payments than you do now. One common form of modified term insurance is increasing term insurance, where your premiums go up over time. Your financial advisor can help you decide whether this type of coverage is right for you.
Guaranteed Renewable Term Insurance – This type of term life insurance is guaranteed to be renewable when the term expires, even if you are no longer able to meet underwriting requirements. So if you take out a policy when you’re in your 20s or 30s, then you can rest assured that you’ll be able to renew your coverage for another term when you’re in your 50s or 60s, even if you are in poor health by then. Of course, this form of coverage comes at an additional cost. It also often comes as an additional rider that can be purchased on top of other forms of term coverage.
Convertible Term Life Insurance – This form of term coverage can be converted into a lesser amount of paid-up permanent coverage when the term expires. This form of coverage can be useful if you think you will need it at the end of your life, as you won’t have any more underwriting requirements to worry about.
Family Income Benefit Term Insurance – This type of term protection typically doesn’t pay out a lump-sum death benefit, but may instead make payments over a set period of time, such as monthly or annually for 10 or 20 years. This type of policy is popular with insureds who are concerned that their beneficiaries may misuse the money that is paid upon their death if they were to get it all at once.
Permanent Life Insurance
Permanent, or cash value life insurance is designed to provide lifetime death benefit coverage for the insured(s) who purchase it. A permanent policy is considerably more complex-and expensive-than term insurance. However, the death benefit coverage will last as long as the policy is in force. Permanent insurance also contains a savings account that accumulates cash value on a tax-deferred basis, and at least a portion of this money can usually be accessed at any time by the policy owner with no tax consequences and be used for any purpose. Many policies also allow the policy owner to take out a loan against their policy using the cash value as collateral.
There are five main types of permanent insurance, listed as follows:
Whole Life Insurance – This type of policy is also called “ordinary life” or “straight life”, and it is the oldest form of cash value life insurance, with its roots going back well over 100 years ago. Whole life insurance gets its name from the fact that the death benefit coverage is designed to last your entire life instead of just for a limited, specific term. Those who buy whole life policies when they are young will have lower premiums but will pay into the policies for a longer period of time. Older policy owners will have higher premiums because they have a shorter amount of time to make premium payments. Whole life insurance pays the policy owner dividends on a periodic basis, such as quarterly or annually, which are based on a guaranteed rate of interest. You can access this dividend money either partially or fully at any time and use it for any purpose, as long as the policy is still in force. Unlike a term policy, whole life policies have level premiums as long as the policy is in force and will not increase over time. The dividends paid by the policy are also usually guaranteed. Some whole life policies also allow you to pay higher premiums for a shorter period of time, such as until age 65, at which time the policy becomes “paid-up”, meaning that the policy will now stay in force with no additional premium payments. Most final expense policies are whole life policies with fairly small death benefits and correspondingly small premiums.
It is usually possible for you to take out a loan from your policy if you prefer to do that instead of simply accessing the cash value component directly. However, this option will charge you interest as long as the loan is outstanding, and this can reduce your cash value over time. As with other forms of cash value policies, you can use whole life policies to fund retirement, higher education or the purchase of a new car. But the death benefit that is paid out will be reduced by the value of any outstanding loans.
Whole life insurance is a good idea if you want an iron-clad guarantee that the policy death benefit will remain in force until you die. However, it is also the most expensive form of life insurance available, and the cash values generally grow at a fairly low interest rate.
Variable Life Insurance – This type of life insurance policy invests the cash value that accumulates in it into variable mutual fund subaccounts that invest in stocks, bonds, cash and real estate. Both the amount of cash value in the policy and the death benefit will rise and fall based on the performance of these subaccounts, and it is possible to lose money inside this type of policy. If the subaccount values fall below a certain level, then you will have to make an additional deposit of premium in order to keep the policy in force. Variable and universal variable accounts both took major beatings in the 2008 crash, and these policies have not been very popular since then. If you decide to invest in one of these policies, the insurance company will provide you with a prospectus for each subaccount that they offer.
Universal Life Insurance – This is one of the most popular forms of cash value life insurance in the marketplace today for several reasons. There are three basic types of universal life insurance:
- Guaranteed Universal Life (GUL) – This is the cheapest form of UL and also has the lowest level of cash value accumulation. It is also known as “flexible premium adjustable life insurance.” These policies are designed to last until ages 90, 95, 100, 110 or 121. It is essentially a hybrid product between a whole life policy and a term policy. But only the age option of 121 is guaranteed to produce a return of the cash value and pay out the face amount of the policy. But this type of policy can be issued without a medical exam, thus making it attractive for those in poor health. Those who opt for a lower age for payout will essentially only receive the amount of death benefit that the policy has grown to. Guaranteed universal life insurance pays interest into its cash value instead of dividends at prevailing market rates, and there is always a guaranteed minimum rate at which interest will be paid. The premiums paid into the policy can be flexible, meaning that they can change over time. Many ULs also come with a “no-lapse” guarantee, meaning that the policy will always remain in force as long as a minimum premium payment is made. (But in most cases, you will have to pay more than the minimum amount required in order to accumulate any substantial cash value.)
- Variable Universal Life (VUL) – This type of policy is essentially a hybrid between a variable life policy and a universal life policy. It has all of the flexible features of a UL plus the variable account features of a variable life policy. Most VULs allow you to make flexible premium payments, and the death benefit will fluctuate according to the performance in the subaccounts. Variable universal life insurance policies are just about the single most complex type of financial product in the marketplace today. They charge substantial fees for policy and investment management and are generally more suitable for high-income investors and insureds. As mentioned previously, the popularity of these vehicles declined substantially after the market crash of 2008.
- Indexed Universal Life – This product is the new kid on the block. It is similar to a UL in structure and basic characteristics, but instead of investing in variable mutual fund subaccounts like a VUL, it bases the amount of interest that it credits on the performance of an underlying financial benchmark, such as the Standard & Poor’s 500 Index. And unlike VULs, it is not possible to lose money in this type of policy because the principal (cash value) is guaranteed. The worst-case scenario is that you won’t earn any interest during a crediting period because the underlying benchmark or index performed poorly. These policies are rapidly gaining popularity because of their potential to earn superior returns compared to ULs coupled with their guarantees against downside losses.
Accelerated Benefit Riders
Accelerated benefit riders have become the darling of the life insurance industry because they offer insureds the chance to access some or all of the death benefits in their policies before they die. These riders are available for both term and permanent products, although they are more commonly used in the latter type of policy. ABRs allow insureds to receive a payout from their death benefits under certain circumstances, such as if the insured becomes disabled, has a critical or chronic illness or is placed into a nursing home. These riders can be real lifesavers for insureds with health issues who need funds to pay for one or more of the aforementioned conditions and have no other source of funds to draw from. Of course, they do come at an additional cost, but the price is often worth it for many, especially those who may not qualify medically for standalone long-term care or disability insurance. However, some ABRs do require additional underwriting.
Putting it All Together
Even after reading this article, you may still feel like you have no idea what type of policy is best for you. There are a few questions that you can ask yourself that will point you in the right direction. Do you want your policy to accumulate cash value? If so, then permanent insurance is what you need. Are you comfortable risking your money in the markets? If so, then a variable or universal variable policy would be appropriate. If not, then a guaranteed or indexed policy is the way to go. Another question is, will your cash flow be steady or variable? If it will be the former, then a whole life policy with fixed premiums could be an option. If it will be the latter, then you’ll probably need the flexibility of some sort of universal life insurance. And your financial advisor or insurance agent can also help you to find a policy that fits your needs and preferences.