When it comes to life insurance most folks fall into three camps:
- They have a policy but don’t know much about it.
- They don’t have a policy and aren’t sure why they need one.
- They know all about life insurance and have an advisor they work with that helps meet their life insurance needs.
This post will help simplify the types of life insurance policies so that you can make an informed decision.
Different Types of Life Insurance Explained: Two Primary Types of Insurance
There are two types of life insurance products- term insurance and permanent insurance.
What is Term Insurance?
Term insurance provides the insured with protection for a certain period of time. This can last from one year all the way up to 25+ years or until the insured reaches a certain age such as 80. These policies are sold with a premium guarantee. The longer the guarantee, the higher the premium, initially. So, if you die within your term period, your beneficiary is paid the amount of the policy at face value. If you live beyond the term period, no benefit is paid. These policies have no cash value or savings element.
There are several different types of term insurance:
Renewable Term – These plans give you the right to renew your plan for another period when your plan ends, regardless of your health. Your premium increases with each new term. The right to renew regardless of health is an advantage because otherwise your health may worsen and you may be unable to secure insurance at an affordable rate (or at all).
Convertible Term – A convertible term policy allows you to exchange your policy for permanent insurance, but only during the conversion period. The conversion period varies depending on your particular policy. If you exercise this option, you won’t have to submit any health information. The premium you pay after converting is often based on your “current attained age”, or your age on the conversion date. This policy most often gives you the maximum benefit for the smallest amount of upfront cash.
Decreasing or Level Term – Under a level policy, the face value stays the same during the entire period. With a decreasing policy the face value of the policy is reduced during the period. The premium will remain the same. Often times these types of policies are sold to protect a mortgage, i.e. the beneficiary can use the payout from the policy to pay off the mortgage, if the insured passes away.
Adjustable Premium – This allows the insured to take advantage of lower premiums based on assumptions that are less conservative, with an option to change them in the future. However, the premium can’t ever be more than the guaranteed maximum premiums that are in the policy.
All About Permanent Insurance
Permanent insurance is designed to give you coverage for your entire life. The premium is kept level by charging the insured a higher rate when they are younger. The premium that you pay when you are younger exceeds the cost of protection, so the extra money builds a reserve of cash which helps pay for your policy in your later years when your cost of protection will rise above the premium. Some policies require a premium to be paid for a predetermined number of years while others require the premium to be paid throughout the insured’s lifetime.
This policy is hinged upon the cash value saving element. The amount of cash generated varies from one insurance company to the next. A crucial point of permanent, or cash value life insurance, is that the policy’s cash value can be accessed by the insured while he or she is still alive.
There are two main categories of permanent insurance, which are traditional and interest-sensitive. Each has their own set of variations.
Traditional whole life policies are based on estimated plan expenses, mortality, and interest in the long-term. Cash values, death benefits, and premiums are all stated in the policy.
Interest sensitive whole life policies allocate investment earnings to reflect interest rate fluctuations. So, the advantage is that when interest rates improve, the result will reflect on interest sensitive insurance more quickly than traditional. However, interest rate decreases will reflect more quickly as well.
Universal Life Insurance – Universal life has three basic elements: cash value, premium, and death benefit. Your insurance company posts your premiums towards the cash value of your account. The company will also routinely deduct the cost of insuring you and expenses from the account, i.e. the mortality deduction charge. The cash value account’s balance accumulates based on the amount of interest credited.
Universal life is the most flexible of all the policies because it treats all policy elements separately and will allow you to skip or change premium payments, or change your death benefit more easily than other policies.
Indexed Universal Life Insurance – This is a permanent life insurance policy in which you can accumulate tax-deferred cash. The premium you pay for this policy can be directed into one more indexes such as the S&P 500 index. Your insurance company uses the performance of the index to calculate an interest rate which is given to you as cash value.
The biggest advantage to this policy is that If the index falls, you avoid losses and earn 0% interest while the index is down. If it rises, you gain a positive return.
Variable Universal Life Insurance – This policy offers permanent life insurance to the insured and allows you to allocate a portion of your premium to another account that is comprised of various financial instruments and funds that are within the insurance company’s portfolio. These could be stocks, bonds, money market funds, equity funds, and bond funds.
What’s great about this policy is that it allows you to get involved with various investment options while avoiding taxation on your earnings.You can also apply the interest that you earn on these investments toward your premiums, which will lower the amount you must pay.
Other Types of Life Insurance Coverage
Final Expense – This policy pays for funeral services. It typically covers people until they reach 100 years old. The biggest benefit of this insurance is that you don’t have to undergo a health exam to get approved. You only have to make a sworn statement that you aren’t in a nursing home or ill.
Types of Life Insurance Comparison: What Type of Insurance is Best For You?
There are so many types of life insurance policies available. For most people, term life is the best choice. However, the type of policy that you should choose depends on your goals.
Term life gives you the most protection for your cash outlay. It is a great fit for younger people and families who need to be protected affordably in case the primary earner passes away. A medical exam is required.
Permanent insurance protects you for your entire life and has an option for a guaranteed premium available. Permanent insurance policies accumulate in cash value so you borrow against your valance tax-free, use it for retirement, or other goals.
This type of policy make sense for individuals in several types of situations, for example:
- For those who want to create liquidity to pay federal estate taxes
- For people who are concerned about protecting their assets. The death benefits and cash value of an insurance policy is not subject to claims from creditors.
For a retired couple that is concerned about spending money that will reduce the inheritance that they are leaving for their children.
Why is Life Insurance So Complex
Life Insurance is so complex because they are legal contracts that must cover a large range of diverse conditions and situations. For example, policies must provide clear language about the following:
- Who’s covered and who isn’t
- Term definitions
- Extensions, Options, and Limits of Coverage
- Responsibilities and Duties of Each Party
It’s actually quite ironic that insurance contracts are so complicated because their intent is to provide clear rights and rules for both parties.
Simply stated, every policy does two things:
Lump Sum – Offers a lump sum payment to to replace the income that the deceased would have earned during the rest of his or her (working) life.
Settle an Estate – Pays taxes that are due at the death of the deceased and gives an inheritance to the policy beneficiaries.
Do I Really Need Life Insurance
Everyone hopes that they never need life insurance, but it’s essential that everyone have it. At it’s core, life insurance is meant to provide for your loved ones, should you not be around.
Not having resources available for your loved ones should you pass away is an irresponsible decision. Life insurance provides a solid foundation to your financial life and ensures that those you care for will be covered should tragedy strike.
There are many different types of life insurance coverage available. Now you are equipped with some basic knowledge that will help you make an informed decision. For more help, get the assistance of a trained professional who can show you a types of life insurance chart and other comparisons of specific policies.