Life insurance is an insurance type in which the policy holder pays a premium and the insurer pays beneficiaries in the event of the insured’s death. Term life policies typically pay fixed “death benefits” while whole life policies build cash value in tax-advantaged investment accounts. There are many different life policies which give the policy holder varying levels of flexibility in terms of duration, premiums, benefits, how money is invested, and payout methods.
Quick Life Insurance Facts
- Life insurance includes many types of coverage which vary by costs, structure, and duration.
- The four main life insurance types are term life, whole life, universal life, and variable life.
- Life insurance pays beneficiaries upon death in at least one of two ways:
- A “death benefit” paid upon death.
- “Cash value” that grows as part of a tax-deferred investment fund (like a 401k or HSA).
- Typically, cash value grows over time – the longer you hold the policy the better it pays.
- Typically, life insurance pays a minimum “death benefit” or, in some cases, a minimum “cash value.”
- In certain life insurance types, when a policy is properly funded, cash values can be borrowed through policy loans.
- Some life policies can be very risky, and certain types are even labeled as securities. It is possible to lose money by investing life insurance, although many policies include minimum and maximum payouts as protection against this.
- If you don’t understand your life insurance policy and your rates can go up, you may be priced out of coverage when you need it most. Beware of borrowing against your policy to pay premiums.
- If you know the terms of your policy, know when your premium is due, and handle your policy in a responsible way, life insurance may be a smart buy for you.
- A lot of the money you put into life insurance is “use-it-or-lose-it,” so something as simple as forgetting to pay a premium or not being able to afford it on time can mean you lose out of benefits due to a policy “lapsing”.
Basic Life Insurance Types
There are two primary types of life insurance: whole life insurance and term life insurance. Essentially, every life insurance product is a version of whole or term life insurance. So it’s important to understand these first.
- Whole life insurance (also known as permanent life insurance) includes a “tax-advantaged” investment fund that provides “cash value” and a fixed death benefit amount. It is a permanent policy that extends for your whole life or expires at a very old age. The longer you hold the policy, the more cash value it builds.
- Term life insurance doesn’t include an investment fund, and just provides a fixed death benefit. It is a renewable policy that extends over a certain period of time (typically 1 to 30 years). Term life insurance is usually “use-it-or-lose-it.”
Pros and Cons: Term Vs. Whole life
There is no right choice between term or whole life. The best choice for you will be based on your financial situation, wants, and needs. Here are some things to consider.
- Generally, term life insurance is paired with a mortgage or a child going to school and needing a college fund. On the other hand, whole life is an overarching policy that doubles as a tax-advantaged investment for helping with end of life costs and more.
- Renewing a term policy can become unaffordable since renewal fees are often based on age.
- Term life insurance is typically cheaper upfront, but it becomes more expensive based on risk factors like health and age.
- Term policies usually have a cheaper upfront premium. This is because they don’t “accumulate cash value” through investments and simply pay out a set “death benefit” amount.
- Whole life insurance can require higher premiums, but either doesn’t expire or expires at old age (example 100 years old).
- Whole life insurance includes fees to pay the life insurance company to manage an investment fund on your behalf.
- Term can be paired with individual investments to create an “ultimate” quasi-life insurance policy. However, this requires a person to be smart about manage investments – in practice, having the insurer invest for you may be more practical.
- Whole life insurance investment funds can have tax advantages, meaning the money isn’t taxed until it’s taken out of the fund.
Other Whole Life Insurance Types
Aside from traditional whole life insurance, there are two common versions of whole life to be aware of.
- Universal life insurance is a whole life insurance with adjustable premiums and benefits. It includes an investment fund. It provides “cash value” benefits based on current interest rates with a promise not to drop below a certain level.
- Variable life insurance is a whole life insurance with a more flexible investment fund. The policy holder derives all benefits from the fund, although there are minimum payouts.
Pros and Cons: Whole Vs Universal Vs Variable
- Whole life policies include consistent premiums with guaranteed payouts. A variable life insurance policy is a whole life policy with two investment accounts. One is for the policy holder and the other is for the insurer. Rates can vary, since it’s all based on investments. This is why it’s called “variable” life insurance.
- Universal policies include variable premiums and payouts. Universal life insurance is also sometimes called flexible premium or adjustable life insurance. This is because unlike regular whole life insurance, it has flexible premiums, benefits, and cash values.
- Variable polices are just like universal policies, except they allow the policy holder to manage their own investments. This means that variable policies can have a higher risk / reward than other policies.
Important Life Insurance Definitions
When shopping for life insurance you’ll hear terms life death benefit and cash value used frequently. You’ll need to understand the following before buying life coverage:
“Cash Value” — The money the you accumulate in your life insurance policies investment fund.
Death Benefit (Face Value) — The amount of money your beneficiaries receive upon death. Can vary depending upon what type of life insurance you have and can be adjusted mid-policy on other types.
Evidence of Insurability (EOI) — For life insurance, this is the application process to determine a policy holders health status, age, and other factors that are associated with risk.
Return-of-Premium Option — A return-of-premium option allows the policy holder to pay a higher price in exchange for the option of being refunded if the policy isn’t used. Essentially, the insurer holds your money like a bank, and invests your money for profit like a bank. Returns unused parts of premiums as dividends.
Cost of Insurance (COI) — The upfront cost you pay. This amount can be split between investment funds and paying premiums for death benefits.
Convertibility — Higher priced “term” policies can be renewed without paying a higher premium on convertible policies.
Annuities — A form of insurance or investment entitling the investor to a series of annual sums.
Living Benefits — Tax-free access to death benefits to pay for long-term end of life care.
Surrender — With many whole life policies you can “surrender” your policy for the “surrender value”, essentially you’ll accept a lower payout based upon the length the contract has been held, how much has been paid in, and other factors like early withdrawal penalties.
Life Insurance Sub-Types and Options
Aside Term, Whole, Universal, and Variable policies you’ll find combinations and subtypes of these four main groups with a number of different options for each type. The main differences between subtypes and options is how money is invested, how money is paid out, and the duration of the policy.
There are actually a good bit of “life insurance products,” ranging from burial insurance to variable universal life insurance, and each name has implications to how the policy works. Let’s cover the most common options:
Variable Universal Life Insurance — Combines universal and viable life insurance to allow the policy holder to adjust premiums, benefits, and investment choices. Given the flexibility, this is the most volatile type. However, insurers will often guarantee a minimum benefit. Due to the policy holder’s control over variable universal life insurance, the policies are actually considered securities and are subject to SEC regulations as well as oversight by the state insurance commissioner.
Index Universal life — While variable universal life allows flexibility in terms of what parts of the insurers portfolio you invest in, index life insurance allows you to invest money in popular indexes. Like other non-traditional life insurance types, you take a higher risk for higher reward. Money grows tax free. However, common life insurance stipulations of when you can take money out still apply, so know your plans limits and penalties.
Single Premium Whole Life — You pay one premium. Your investment fund is fully funded from the get-go allowing money to build more quickly.
Guaranteed Universal life — Guarantees that you are locked-in to larger death benefits for a specific duration of time, usually in exchange for a larger premium.
Burial Insurance — A low cost policy that provides minimal death benefits to help loved ones pay for funeral and burial costs.
Term subtypes — Term life insurance have a number of different subtypes which we will cover on our term life insurance page. Typically, these subtypes describe different ways in which premiums and benefits act. This includes policies that phase down over time. Some examples include Decreasing term, annual renewable term, and long-term level premium term.
Death Benefit Options — Some policies, typically universal and variable, allow you to change death benefits.
Life Insurance Riders — A number of different “riders” can be attached to policies to change the terms of the policy. These are usually found on universal and variable life insurance types, ie. flexible life insurance types.
Life Insurance Minimum Benefits
Generally, life insurance agrees to pay at least a minimum amount to beneficiaries. Minimum benefits can apply to death benefits or to cash value of investments.
Life Insurance Investment Funds and Interest Rates
The key to many life insurance products is understanding how investments work. With whole life policies you are letting the insurer invest your money for you. Although some policies promise not to let your cash value drop below a certain amount, your money is still tied to the market like a 401k.
Life Insurance Premiums
Life insurance premiums work differently depending upon the type. Some require annual payments, others have adjustable premiums, others have schedules for splitting premiums between death benefits and cash value, others simply require an upfront lump sum.
Like other insurance premiums, you pay a fee in exchange for the continuation of your policy. As long as you hold your policy, and other terms of the contract are met, your insurer pays on the event of death and cash value can be withdrawn (per the terms of the contract). It’s important to understand that it is your responsibility to pay your life insurance payment and in some types to allocate your premium payments properly.
If you don’t pay your premium, you could lose your entire policy and, with some life policy types, all of the money you put into it. Since you don’t use the death benefit portion of life insurance until you die, losing a policy can mean losing all value associated with a term policy. For whole life a policy holder may find themselves borrowing against the policy and losing cash value as well.
Life is different from other insurance types which can offer more tangible benefits throughout the duration of the policy.