Summary
- The 5 types of insurance are term, whole life, universal life, indexed universal life, variable universal life.
- Term insurance is designed to expire while the others are designed to last your lifetime.
- Term insurance is the only type that does not have cash value.
- Cash value is like an investment account built inside your insurance policy.
- If permanent policies are not properly structured to fund the cash value, they run the risk of lapsing as you age.
Let’s talk about the basics of life insurance first. The purpose of life insurance is to pay a lump sum of money called the death benefit to your beneficiaries. This money is usually earmarked for specific purposes like income replacement, burial expenses, charitable donations, paying off debt including mortgage, funding college tuition, estate planning, etc. The person purchasing the life insurance is the owner of the policy. The person whose life you are insuring is called the insured. The owner and the insured are often the same person, but they don’t have to be. In fact, the owner doesn’t have to be a person. The owner can be an entity like a business or an organization. The beneficiaries are of course the recipients of the death benefit. Then there is the payee who is most often the owner but can be different, which is the person or entity that is paying for the policy. The money that you pay for the policy is called the premium. There is an approval process for applying. The 3 major ingredients that go into determining if you’ll get approved are medical history, age, and gender. If you’re young and healthy, you’ll typically get approved very easily and vice versa. When you get approved, you are issued a health rating which is the final factor in determining what the cost of your insurance will be. The healthiest ratings are usually called something like preferred elite or preferred best. The medium health rating is called standard. You can receive a rating below that, and those ratings are all called table ratings. They’re denoted by a letter such as table B, C, or D. That means there’s something about your health that will cause greater risk to the insurance company to issue a policy for you. You are still approved if you receive a table rating, however the premium will be significantly higher. Lastly, when you let an insurance policy lapse it generally means you didn’t make your premium payment.
Term Insurance. This is the most common type of life insurance because it’s the least expensive. Term refers to a fixed number of years that your policy will last. Typically, what you’ll see is policies that last for 10 – 30 years with increments of 5 years in between. There are so many insurance companies out there that all have varying lengths of terms, so it’s certainly not limited to that but that’s what you’ll commonly see. At the end of that term, if you still need life insurance, you’ll usually just buy another policy. A common misconception about term life insurance is that it expires at the end of that term. That is incorrect. Term is referring to the timeframe the policy’s premium is guaranteed to stay the same. It’s sometimes called “level term” because of this reason. At the term’s end, you can keep the policy if you continue to pay the premium. The premiums, however, will adjust annually to what your age is at the time of renewal meaning that it will be more expensive every year thereafter. There’s another type of term insurance policy that acts like a matured term policy right out of the gates. It’s called annual renewable term (ART). As I detailed how a term policy is paid yearly once the term ends, an ART works the same except it starts like that from day one.
Permanent Insurance. There are 4 types of these policies, and I’ll go over each of them in detail. There are additional terms I want to cover related to permanent policies. Permanent insurance will be more expensive compared to term however you’ll keep the same premium for life versus term where the cost will continually increase after maturity. That’s one major benefit to permanent insurance is that you can have level premiums for life. Another is what’s called cash value (CV). This is a feature inherently built into all permanent life insurance policies. CV is like an investment account built into the policy. It allows you to have accessible money inside the policy that can grow as if it were inside an investment account. In addition to that, there are significant tax benefits to this that has similar treatment to a Roth IRA. The money will grow tax-deferred and when you take the money out it’s “tax free.” I put that in quotes because this leads me to another feature of permanent life policies. You can borrow money from your policy’s CV. It’s taken as a loan to yourself like borrowing from your 401(k). Th difference is you don’t have to pay it back however you’ll typically want to unless you’re utilizing it for something like retirement income. As a loan, it does carry interest. It’s usually nominal but just be aware that it’s there. If you’re wondering how money gets into the CV, it comes from part of your premium payment. Your premium payment goes to paying for all costs of owning the life insurance policy and additional to go into the CV. There are rules and formulas that go into determining minimums and maximums that can go into life insurance CV. You can’t just fund it once or twice a year with minimal dollars nor can you put an infinite amount of money into it. It’s more important to know the rough outline of how it works than to know the exact calculations. One of the most important things to know about the CV is that it can never go to zero otherwise the policy will lapse. Unless you want the policy to lapse on purpose, you need to maintain an appropriate CV balance in your policy.
Whole Life. This is the longest-standing type of permanent insurance that is still issued today. It’s also the most expensive type of permanent insurance you can purchase. There are more efficient options, but it has its place depending on your personal preferences. As we work through how each of these permanent policies work, you’ll find that the main difference between them is how the CV accumulates. With whole life, the way the CV accumulates here is through dividends. Just like a publicly traded company, the decision to issue dividends and how much to issue is decided on by their board of directors. The ability for the company to pay dividends is similar. It’s if they can afford to do so, i.e. the company is profitable and can afford to pay dividends. You typically won’t see dividends unpaid. The amount paid fluctuates year by year.
Universal Life. This type of insurance policy was the beginning of a new chain of permanent policies. It added the feature of flexible premiums payments. That doesn’t mean you can dictate how much you wanted to pay each month into your policy. There are minimums, however this is where the CV comes into play. The flexibility comes from having a balance in your CV. If you don’t make your monthly payment but you have enough in CV to cover that payment, the policy will automatically deduct the cost of insurance from the CV. It’s not the whole premium amount your monthly bill says, it’s only the amount the covers the cost of insurance and associate admin fees. A trouble spot for many people is when they need money for a purchase of some kind and borrow from their life insurance policy early in the policy’s lifespan. Often that money never finds its way back, and the policy lapses. When you get around to getting a new policy, you’re older and possibly less healthy so it will end up costing you more for a new policy. How does the CV build inside a Univeral Life policy? It grows based on current interest rates. In times of high rates like now when I’m writing this it’s earning quite a bit or conversely back in 2009 the rates were very low, so you weren’t earning much. There is no risk of loss and there’s a guaranteed minimum interest rate. Typically, you’ll find that minimum to be 1%. Overall, a very safe and practical form of permanent life insurance. If you’re looking for a basic, cost-effective, permanent life insurance policy, this would be where you should look.
Indexed Universal Life. This is a variation of the Universal Life explained above. The difference is the investment vehicle that allows the CV to grow inside this product is as advertised, an index. You’ll see the S&P 500 or at least a variation of an S&P index. Beyond that you’ll see other popular indices like the Dow Jones Industrial Average, NASDAQ, Russell 2000, or even an international index, but you get the idea. There is an index you can pick that will allow your CV to grow. It does provide another benefit that can be extremely attractive depending on your risk tolerance. There’s a guaranteed floor on your returns. Yes, you heard that right, there is a floor where your investment will not go below. You’ll be surprised to hear that it is 0%. Before you jump into deciding this is the insurance product for you, you must ask yourself “is this too good to be true?” The answer is no but there is a caveat… a ceiling. How can a company afford to guarantee you don’t negative returns on your investment? They cap how much you can earn. It’s going to depend on a few things in which I’ll provide a few examples here. Most commonly, how your return is calculated is a point-to-point measurement. An example of a 1-year point-to-point segment would be from Jan 1, 2024, to Jan 1, 2025. There are 3-year segments too. The return is measured from the day you invest into it until the same day a year or three down the road. 1-year segments will have lower caps, say 10%, whereas a 3-year could be 30%. These caps change regularly and can vary up or down depending on how the market is performing at the time. The insurance company deploys other methods of hedging against their downside risk as well. This is the most expensive of the Universal Life options. Great for the risk adverse, however you’ll pay a premium for it.
Variable Universal Life. Last but certainly not least, the variable option. This one allows you to invest your CV into a suite of mutual funds. It’s like an investment lineup in a 401(k) except you’ll have many more options. You will experience the full gains AND losses when you invest here. This is one where you’ll need to be extra careful when choosing a variable life insurance policy. All permanent life insurance policies stay in-force when they have CV as mentioned earlier. If you invest aggressively inside a variable policy and your CV drops to zero, the policy lapses and will terminate. This is common happenstance with all permanent policies because the CV provides flexibility of payments meaning if you don’t make your scheduled payment the CV will be deducted to make the payment for you. This gets compounded negatively when your CV is going down because of poor market conditions. However, this is generally the least expensive permanent insurance option.
When choosing what type of policy is best for you, consider how much you can afford, how long you’ll need it for, what you need it for, how much risk you’re comfortable with if choosing a permanent policy, and how much benefit do you need. Find a trusted insurance agent to have this discussion with.
