Are you sick and tired of researching? Well, you're not alone. The life insurance landscape is complex. There could be as many kinds of policies as there are insurance companies. Terms such as whole life, term life, cash surrender value, variable life are sure to baffle any newbie in the field.
What can you do?
If you’re thinking of purchasing life insurance – you will need an understanding of the basics. You have to learn the different types, how they work and how much they cost. After that, you can select which among them is the right insurance for you.
Basic Types Of Life Insurance
There are four basic types of life insurance, namely: term, universal, whole, and variable. But the question is:
Can you make sense out of these types at all? Which one would best serve your purpose?
Here is a quick rundown of the basic types of insurance with their advantages and disadvantages.
1. Term Life Insurance
A term life insurance will pay a benefit in the event of death of the insured during a specified period. This period or term may be one, five, ten or twenty years – sometimes even longer. It is then renewed annually once the policy reaches the end of the term. Common term life insurance policies will allow the owner of the policy to renew up to the age of 95.
The Good news:
Term life insurance is the least expensive way to have insurance coverage and therefore is the most popular. Many financial planners advise buying a term life insurance instead of whole life insurance so you can invest your savings. This is a general view but I advise you to consider your own needs and circumstances.
Remember: determining what product is most appropriate for you will depend on a score of factors.
Advantages Of A Term Life Insurance
Death Benefits – Death benefits are usually tax-free so the beneficiary is able to receive the entire amount. If it was properly owned, it can also be estate tax-free.
Flexibility – Life insurance will provide cash to deal with the detrimental effects of the insured’s demise. It also enjoys a favorable tax treatment that is not available to other instruments. Many life insurance policies are designed to be adjustable to the policyholder’s needs. Should the need arise, cash-value life insurance may be considered as a tax-favored repository of accessible funds.
Note: the assets backing these funds are generally held in longer-term investments that bring higher returns.
Cash values – allow more tax to be deferred during the insured’s lifetime. Cash value withdrawals use the first-in, first-out (FIFO) method so withdrawals equal to the premium are income tax-free.
Less expensive – Life insurance premiums are easily affordable. However, you might say that in life insurance, you have to die to win. Here is another scenario. You pay your premiums every year because you want to protect your family. Twenty years go by and you are as healthy as an ox. You don’t get anything back from everything you paid for the life insurance. It is quite fair since you only paid for death benefits – and at least, you’re still alive.
Downside Of A Term Life Insurance
It would have been a different story if you had purchased a permanent policy instead of a term life insurance. Unlike term life insurance, you could keep a permanent policy forever. Should you stop in 25 years, you would likely get back a good portion of the premiums you have paid.
If you include all your dividends you may even get back all your premiums from that point. However, dividends are not guaranteed in life insurance so insurers are not allowed to project them at all.
2. Universal Life Insurance
Universal life (UL) insurance was created under the umbrella of permanent life insurance. Its main feature is to provide more flexibility than that found in whole life insurance.
Unlike term life insurance, universal life insurance is a permanent policy. This means it is meant to provide insurance coverage for your entire life.
Think about it this way:
In universal life, you use the same formula to compute the premium as you would in whole insurance. However, in universal life insurance, the cost of insurance (COI) is computed differently. In traditional insurance, the monthly premiums are guaranteed to stay level for your entire life. With universal life insurance, the cost goes up as you get older, all the way to the age of 100. This is also called as a rising cost of coverage.
Term insurance has no cash value so when you cancel a policy, you get nothing. Universal life insurance technically offers some sort of a cash return to the insured.
Here are the three main ingredients that make up universal life (UL):
1. Death Benefits. You can choose from 2 basic options when deciding how you want death benefits to be paid to your beneficiary.
Type A Death Benefit. This is popularly called level death benefit. It starts off with one amount and stays level for the life of the policy while ignoring the actual cash value. Type B Death Benefit. This is also called a variable death benefit. It is a combination of a specific death benefit plus the cash value of the policy. Note that the cash equivalent is an accumulation feature that builds over the life of the policy.
2. Cash Accumulation Portion. Here, the insurance company allocates a portion of your premium payments into an interest-crediting strategy. You have a say in this matter. One popular vehicle is called equity-indexed universal life insurance.
It allows policyholders to tie accumulation values to a stock market index such as the S&P 500. Policyholders get the benefit of a fixed interest rate and a growth potential of a policy linked to indexed returns.
3. Flexible Premiums. While its flexibility is very attractive to many people, it also tends to confuse some. In term life insurance, you pay a certain amount monthly or annually for a pre-determined death benefit amount. In universal life insurance, premium balances and death benefits are constantly shifting. The added cost might be the same as other permanent policies but the changing values could be ambiguous for others.
3. Whole Life Insurance
I whole life insurance, both death benefits and the premium stay the same throughout the life of the policy. In this scheme, the cost per $1,000 of benefit goes up as the insured person grows older. So if the person lives up to 80 years old and beyond, it could get pretty high.
Look at it this way:
Insurers could adjust the premium according to the insured person’s age but that would be burdensome to older people. Insurance companies just charge a higher premium than what’s needed to pay claims in early years. They invest the difference, use the money to level the premiums and help pay the insurance for the older ones.
Advantages Of A Whole Life Insurance
Guaranteed insurance for life – With whole life, there are two prevailing guarantees. First, you are assured of a guaranteed premium to pay. Since it is level, the amount you must pay won’t increase. Second, your beneficiary will receive a guaranteed, lump-sum payment in case of your death. You also have the option to make your business as your beneficiary.
Cash value accumulation – Aside from staying covered for life, you can build a significant but stable cash asset. It will be independent on the rise and fall of the stock market every time.Should you need money suddenly, you can borrow against the cash value portion of your policy. It’s also a good stand-by fund for future needs: college money, down payment for a home, business loan, etc.
Tax benefits –A whole life insurance has several tax benefits. One is the tax-advantaged build-up of cash value. It means you defer paying taxes on the dividends that you are accumulating. Second, beneficiaries typically won’t have to pay income taxes for the death benefits.
If the policy pays a $30,000 death benefit, then the beneficiary receives the entire $30,000 tax-free.
The downside of A Whole Life Insurance
Whole life insurance will generally cost you more than a term or universal policies. This is largely due to the added guarantees that come with it. Whole life insurance does not carry the same flexibility as other policies. Should you want to increase your coverage or adjust your premium upward or downward, it might not be possible. Lastly, you could get lesser interest earnings from your cash value account compared to other instruments.
4. Variable Life Insurance
The main difference between a variable life insurance and whole life insurance lies in thecash value fund. With this type of policy, you don’t earn a specific rate of interest. Instead, you can invest this portion in an array of investment channels like mutual funds.
This gives you more control over what to do and where to invest the cash value option.
Cash Value: whole vs variable life insurance
In a whole life insurance policy, the cash value component works like a savings account. Its growth may be a little slow when placed alongside other investment instruments. However, the guaranteed minimum rate assures you of some return. There is also the contribution from the dividend payments of the insurance company as additional input.
A variable life insurance cash value works more like the funds that you use to invest freely. You can place them in a series of sub-accounts similar to a mutual fund. You can get a respectable return but there is also the risk of loss depending on the market’s behavior. The funds are primarily placed in the stock market.
Variable life insurance policies look better as an investment option than whole life policies.
The potential for higher, tax-deferred growth makes it look like a “super-IRA”. However, you can only invest in the sub-accounts through your policy. You are not at liberty to pick among the solid mutual funds available in the open market.
Fees for variable life insurance may be lower than whole life insurance because the product has more risks.
The same principle applies as when you are investing in stocks. It is risky because most people do not know much about the workings of the stock market. Many investors also don’t know how to react productively to the sudden shifts in stock prices. That is quite overpowering for an average person to handle effectively.
These factors make a variable life insurance a limited option both as an investment choice and an insurance choice. The same thing goes for other permanent insurance policy types.
5. Equity-Indexed Life Insurance
In universal life insurance, surplus premiums are reverted back to the policy.
Let’s look at it in detail:
This means that premiums in excess of the current cost of life insurance are credited back to the account. The cash account is credited monthly with interest that is set by the insurance company on a yearly basis.
There is normally a guaranteed minimum interest rate from 2% to 3%. Every month the cash account is also debited for the current cost of the life insurance to cover the death benefit. The monthly fees are also deducted from the cash account.
In contrast, indexed universal life policies are not directly invested in the stock market.
Instead, they use the financial value of the index to calculate the interest to credit your account. The carrier will usually assign a cap to the maximum amount that can be credited to your account.
Advantages And Disadvantages
One advantage of equity-indexed life insurance is you can receive an above-average return.
This happens when the selected index does exceedingly well. Another advantage is that policy loans are possible and they are generally exempt from income taxes. There is no strict obligation to repay policy loans. However, if you surrender your policy, outstanding loans become taxable in the year that the policy lapsed.
Death benefits are likewise, income tax-free. The cash values account will grow tax-deferred of income taxes just like an IRA. There is no cap on the amount of money you can contribute each year. The face amount of the policy is paid directly to the beneficiary in case of the insured’s death. There is no need to go through lengthy probate like in some wills. Lastly, equity-indexed life insurance allows one policy to be exchanged to another, also tax-free.
The downside is that it normally requires a long commitment. Policyholders usually borrow from the policy on its latter stages. Borrowing during the early part of the policy will greatly diminish the death benefit sum. An astute investor should also monitor the expense ratios.
The expense ratio for an EIUL will vary. It will depend on the index’s performance, date of death and amount of distributions taken. One should expect an average EIUL expense ratio within the 1% range.
6. No Medical Exam Life Insurance
As its name suggests, a no medical exam life insurance exempts an applicant from a medical examination before coverage. It does not require a physical check up to get an approved insurance policy. In other insurance types, the applicant needs to meet with a paramedical professional (or paramed) to get a clearance. This is a standard component of the underwriting process.
In the meeting, the parameds will ask the applicant some in-depth questions about the applicant’s health. They will also ask for blood and urine samples from the applicant. They test these samples for different adverse health conditions that could be considered risky for the insurance carrier.
Some medical conditions revealed by these tests disqualify applicants for life insurance coverage.
Persons with ailments like diabetes, heart enlargement, cancer, etc. may not qualify for what is called a “medically underwritten” policy. Therefore, no medical exam life insurance is approved much quicker. An applicant can get approval in as little as 48 hours and sometimes even sooner.