Picking the right type of life insurance policy can be seem as overwhelming as picking a specific card from a deck of cards. The good and bad news is that you, as a consumer, have options – the good, the bad & the ugly. There are two basic types of life insurance, those policies that are designed is for a specific period of time and does not build up a cash value and those policies that are designed to last for the rest of your life (hopefully) and will build up cash value.
To guide you through this, you should keep in mind what your goals are and your needs. Life insurance as is all insurance, is a financial leverage tool. You pay a certain amount (or percentage) of an insured risk. If an event occurs such as a death with Life insurance or your home burns down with Fire insurance, you receive a much larger amount of money than the amount paid in (premiums).
So when looking at life insurance, remember to not get distracted and that the primary goal of a life insurance is to protect against the loss of earnings/income from someone who is financially dependent (as an example – note there are other reasons for insurance). Everything else is an add-on and potentially a distraction from the bottom line.
The first type of coverage referred to above is term life insurance. Term insurance comes in a few variations – though the basic and constant is that term insurance provides a death benefit for a set premium and does not accumulate a cash value. The most common type of term insurance currently is guaranteed level premium term insurance where you buy a certain amount of coverage and the premium is guaranteed level for a set number of years such as 10, 15 or 20 years after which time, the premium either increases significantly or the policy terminates. Another common type of term insurance is annual renewable term insurance, where the premium increases each year.
The second type of coverage encompasses any type of permanent policy (those that accumulate or can accumulate a cash value). This category includes whole life, universal life, variable life, equity indexed life and the numerous sub-categories. Each of these types of coverages has multiple sub-types.
Whole Life Insurance is the oldest and generally best known type of permanent (cash value) life insurance policy. Whole Life insurance policies typically have a guaranteed level annual premiums, guaranteed death benefit and a guaranteed cash value which can be increased by projected dividends. Dividend options can be used to modify the premium you pay, the death benefits or how much cash value accumulates. Different companies have different dividend options. The most common are Dividend to Purchase Paid-Up Additions (cash value & death benefit are increased), Dividends to Purchase One Year Term (additional death benefit), Dividends to Reduce Premiums, or you can receive dividend in cash (not too common). Other types of whole policies include endowment policies (not commonly sold anymore – however, a lot are still in-force) and excess interest whole life policies. There are other types, these are the most common.
Universal Life (UL) – formally known as Flexible Premium Adjustable Life, allows the policy owner flexibility as to the amount and timing of premium payments. Furthermore, the face amount of coverage can be changed (down at any time, up with evidence of continued insurability). Universal Life is unique in the sense that this type of policy “unbundles” the pricing elements that make up a traditional cash-value permanent policy—interest earnings, mortality costs, and company expenses—and prices them separately. Ideally, this gives you better transparency into the moving parts of your policy. In practice, however, this can get a little complicated. With a traditional whole life policy, you have but one responsibility: to pay the premiums when due. If premiums are paid when they come due, the policy will never lapse, and eventually it will mature as a death claim, period.
Universal Life is different. If the policy owner fails to fund it adequately, Universal Life may turn out to be temporary rather than permanent life insurance. The company may change pricing elements subject to certain limits set forth in the policy. So the company may raise the expense charges and mortality costs and lower the amount of interest credited to the accumulating funds. If these policies are handled incorrectly, they can turn out to be more expensive as you grow older, the cash value can erode, and the policy could end up lapsing if premium payments aren’t high enough to continue to fund the policy.
Guaranteed Universal Life policies comprise one of the fastest growing segments of the life insurance industry. These policies guarantee the death benefit as long as all scheduled premiums are paid in full when due. These policies may or may not accumulate a cash value—they are designed to provide coverage past age 95/100 and up to age 120. Most insurance policies will terminate (mature) at age 95 or 100 and cash out at that time, leaving the insured to self-insure. In essence, they function as a lifelong term life insurance policy, where you have the option to accumulate a cash value. A note of caution: if you miss a scheduled premium or pay less than the total premium due, you may lose the guaranteed death benefit.
Variable and Variable Universal Life: As with Universal Life polices, Variable Life and Variable Universal Life policies provide death benefits and cash values to beneficiaries. But here’s the crucial difference: whereas the premiums paid into most standard Universal Life polices earn interest within a life insurance company’s General Account, as it’s known, Variable Life policies earn interest on a portfolio of investments that you, as the policy owner, choose from a selection offered by the company (key: check the selections).
Depending on how financially savvy you are, selecting your own portfolio can be an acceptable aspect of this type of policy or a very dangerous one. When an insurance company invests your premium into its General Account, it bears the risks inherent to investing and credits your policy with interest based on the account’s performance. There’s no direct link between the company’s investment portfolio and the declared interest rate on your policy. But with Variable Life policies, there’s a direct link between the cash value of your policy and the performance of the portfolio of sub-accounts you choose. You bear the risk. The cash value and death benefit of your policy is not guaranteed. (But some policies do guarantee that the death benefit cannot fall below a minimum level.) So if your portfolio does well, the earnings on the cash value of your policy may exceed what you would have earned through a standard Universal Life. But if the performance of your portfolio tanks, you’ll have to put in additional funds to keep your policy in force. That can get pricey and could endanger your policy. While you may see tax advantages with this type of policy—you are earning returns or income that you do not have to pay taxes on—there are fees associated with the policies that may offset the tax advantages. Federal and state premium taxes average around 3 percent of premiums. Mortality and expense charges assessed against cash values can range from .6 to .9 percent. Asset management charges can vary from 0.2 to 1.6 percent. And surrender charges can typically exceed the first year’s premium and last 10 to 15 years.
Overall, the costs of Variable Life policies can be higher than other types of permanent policies. You’ll get a legally entitled prospectus from an insurance company before you purchase either a Variable Life or Variable Universal Life policy. And you’ll definitely want to read it, even though it’s lengthy and tedious to pore through. If you have a tough time understanding it, find someone who does and have him/her explain it to you. (But if you have to do that, ask yourself: Is this the right kind of policy for me?) Many factors affect the performance and well-being of a Variable Life or Variable Universal Life policy. For advice on the investment accounts, always consult a properly licensed financial/investment adviser.
Equity Indexed Life Insurance. Equity-Indexed Universal Life (EIUL) is a newer form of UL insurance that is extremely complex and combines elements of variable life (which you’ll read about next) into the mix. The main difference between this and traditional UL is in how excess interest is credited. Most EIUL policies have two separate accounts that can be used to credit interest. One account has a fixed interest rate that is declared by the insurance company periodically. The second account provides an equity index option that offers you the opportunity to earn rates of interest based on positive equity (stock) market returns. However, the cash value of the EIUL policy is not exposed to losses due to negative market returns.
The amount of interest credited to your cash value is tied to the performance of the policy’s particular equity index. Companies use a range of indexes that include the S&P 500, Dow Jones Industrial Average, Lehman Brothers Bond Index, and FINRAAQ. In years where the index performs well, the interest credited to the policy’s cash value rises, and in years where the index performs poorly, the interest rate falls. Typically, EIUL policies guarantee that the interest rate will never fall below zero so that the policy won’t lose money if the stock market index declines.The first thing to watch out for is that these policies usually have a cap or limit on the amount of interest that can be credited to your policy. Therefore, if the cap is 10 percent, and the index return is 14 percent, you will only earn 10 percent. The reasoning is that this would offset the liability the life insurance company assumes in years where there is a negative return in the stock market index. The insurance companies can, at their discretion, also adjust what is called the participation rate, so that a policy owner receives a lesser percentage of the total return. This is an important thing to look for. Some companies will offer a 100 percent participation rate guaranteed for the life of the policy. But if a policy has an 80 percent participation rate, and the policy has a cap of 10 percent, the most you will ever earn on the policy is 8 percent (80 percent of 10 percent). There are also different indexing methods that are used in measuring the market return, which you should understand before signing a policy.
Joint & Survivor/Second-to-die: Joint-Survivor Life is a type of coverage that can be a part of any type of permanent cash-value policy. This type of coverage insures two people (usually spouses) and pays a benefit only at the second death. It’s used primarily for estate planning purposes, as the estate tax is usually only payable at the second death.
It’s essential with any type of permanent/cash value policy that you order an in-force illustration at least every two or three years, as it’s the only effective way to monitor the performance of a policy. Annual review packets are available at no cost through LifeInsuranceSage. An in-force illustration is a report of current values and assumptions compared with guaranteed minimum values.
Most life insurance needs are short term in need as if you are saving and investing in retirement plans, mutual funds, stocks, etc – then these investments should grow to an amount that will exceed the amount of life insurance that you have or need. There still may be a need for a small amount of life insurance. In terms of using life insurance as an investment, please refer to my
guest blog post, Why Life Insurance May Be The Greatest Investment Ever.
Questions and Answers on Life Insurance – The Workbook is designed to walk you through these decisions for yourself and to provide the tools for you to select and monitor your policy.
Background: Tony Steuer, author of Questions and Answers on Life Insurance, has been in the life insurance business for 20+ years as a life insurance agent and consultant. He is one of 30 licensed Life & Disability Insurance Analysts in the State of California. Also, he currently serves on the California Department of Insurance Curriculum Board as appointed by the Insurance Commissioner.
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