In this post I will discuss the various reasons that a person may or may not want to purchase a life insurance policy, the different types of life insurance, and how they can be used in various situations.
Disclaimer: This is intended as an informational guide, nothing in this post should be construed as individualized advice. Life insurance can be quite complex depending on the product, therefore I recommend consulting with your financial professional prior to taking any action from this content. It should also be noted that every person has a unique situation and I do not endorse any insurance companies or products.
For those of you that are completely new to the concept of life insurance, here is a quick explanation on how it works: Life insurance is a contract between you and an insurance company. In exchange for your payment (aka premium), the company promises to pay an agreed upon amount in the event of your death (aka death benefit) to your named beneficiaries. Life insurance policies are issued in different ratings based upon the life expectancy of the applicant as determined by an actuary. People who are young and healthy tend to have the cheapest life insurance rates. Alternatively, those who are have health problems or are near the end of their anticipated life expectancy often have higher costs or trouble qualifying for life insurance at all. There are options available that are guaranteed issue regardless of health, however, they are often quite expensive in relation to the amount of insurance provided.
The question of whether a person needs life insurance is solely based on their individual situation. Some people will find that life insurance may not necessarily fit their needs, while others will find great value in life insurance. To start, let’s talk about some of the reasons a person may want to purchase a life insurance policy:
- Protecting loved ones: Making sure that the ones you care about are able to sustain themselves in the event of your passing.
- Business purposes: Often used when a company heavily relies on a key-employee and/or when a company needs to fund a buy-sell agreement in the event of a partner’s death.
- Leaving a legacy: Life insurance can instantaneously create an estate that passes to your heirs in a tax-advantaged way.
- Retirement income: Some types of policies allow a person to accumulate cash within the policy which can grow over time and be used to help fund their retirement.
- Planning for future needs: Sometimes there is no immediate need for life insurance, but people still find it valuable to purchase it at a time when their cost for insurance will be lower due to age or health.
Now let’s explain some of the most common life insurance options available today and how they can fit into these situations. Please note: This is not an all-inclusive list of every type of life insurance available. Some of the products that I will be discussing have different names depending upon the issuing company. If you are wanting clarification on a specific policy, I would speak with your financial professional or email me at deanbarda@appleandassociates.com.
1. Term Insurance: This is the most basic type of life insurance policy and the most similar to other traditional forms of insurance (auto, home, etc.). When you buy a term insurance policy, you are purchasing temporary coverage for a set period of time. Term can come in many different time-periods ranging from one year to as high as 35 years. Every year that you get older, the statistical likelihood of you dying increases and so does the cost of term insurance. When you purchase a 1-year term policy for example, your renewal cost for the following year will go up based on your new age. For longer terms, you usually pay a level premium over the entire period. This is because the company has averaged out your payment instead of increasing it every year.
Term insurance is often the cheapest life insurance that you can buy because it has an expiration date. If you live past the expiration date and then pass away, the insurance company no longer has an obligation to pay your death benefit. For example, let’s say a 25-year old purchased a 20-year term life insurance policy (expires at age 45). That person then passes away at age 46, that life insurance policy would not pay out any benefits as it had expired the year prior. This highlights that term insurance is temporary and should be used to cover temporary needs such as mortgages, cost of childcare, college savings for children, etc. Term insurance is often used to fund buy-sell agreements as well as key-employee insurance.
2. Universal Life Insurance: Can come in different variations, the most common examples are: Traditional Universal Life, Guaranteed Universal Life (GUL), Variable Universal Life (VUL), and Indexed Universal Life (IUL). First, I will give an overview of what Traditional Universal Life is and then I will discuss the differences between the various forms it can come in. Universal life is a hybrid life insurance policy that combines term insurance with a separate cash account.
The similarities of Universal Life and Term:
- Cost of insurance continues to increase as you age.
- Relatively cheap cost of insurance.
- Specified death benefit.
The primary differences between Universal Life and Term:
- UL is a permanent type of life insurance, meaning that it has no set expiration date.
- UL’s have a "cash-value" savings component where additional premiums (past the cost of insurance) are saved. Those savings then earn interest to grow the cash value.
- UL’s have a flexible premium option that allows the cost of insurance to be paid out of the accumulated cash value.
- UL’s can also have a flexible death benefit that may be changed by the policy owner.
Universal Life is permanent and therefore allows you to insure permanent needs such as the income of a spouse, final expenses, leaving a legacy to descendants, etc. It is important to note that while universal life does guarantee you a death benefit that will not expire. It also assumes that you will cover the increasing cost of insurance in your older age. If you only pay the minimum premiums without building up a sufficient cash-value in the policy, the rising insurance costs can begin to eat away at the cash-value in the latter years of your life (when you are really wanting to have the death benefit available). If the policy is unable to support itself, you can find yourself with a hefty insurance premium that will need to be paid for out-of-pocket. If you are unable to afford the premium, the policy will lapse. So long-story-short, if you don't properly fund a universal life policy, there is a chance that it will not be around when you need it.
Descriptions of the different UL policies:
- Guaranteed Universal Life - The most permanent type of UL available. The policy is guaranteed not to lapse so long as the specified premium payments have been made, even if there is no cash-value in the policy. Premiums are level throughout the life of the policy and do not increase with age.
- Variable Universal Life - Suited to someone with a more aggressive risk tolerance. These policies allow you to invest the cash-value in preset index funds. This can potentially grow the cash-value at a substantial rate. However, the money invested is subject to fluctuation of the investments and can lose value as well. This can have negative effects if the policy is not properly funded and could lead to a lapse in the policy. These policies tend to have high internal fees that can eat away at the cash-value.
- Indexed Universal Life - Similar to the VUL, the cash-value can grow based on the performance of underlying index funds. The primary difference is that the money is not actually invested by the policy-holder. The insurance company invests the money and then credits the policy's cash value based on the underlying index gains. The insurance company has control over the amount of return they pass on to the policy-holder. Those returns are controlled by the participation rate and caps on return. While this can lower your expected returns when compared to a VUL, the trade-off is that there is no potential for investment loss. Internal fees for these policies can be high as well.
3. Whole Life Insurance: Whole life policies are very similar to guaranteed universal life policies. They are guaranteed not to lapse so long as the specified premium is paid. They tend to be more expensive than a GUL, but they also tend to accumulate more cash value than a GUL would. The cash value grows from your premiums and the dividends of the issuing company. If the company does well, they will issue a dividend to your policy's cash value. If they have a rough year, they may choose not to issue a dividend. The dividend amount depends on the size of the insurance policy. The bigger the policy, the bigger the dividend. This is what is known as a Participating Whole Life Policy. Almost all whole life that you will find on the market today is participating.
Whole life is built on a completely different "chassis" than universal life. Due to this, they tend to have different options that are available within them. For example, you may see whole life policies that additionally offer long-term care benefits or policies that only require you to pay premiums for certain period of time. In general, whole life tends to be a much more conservative way to purchase permanent life insurance as it is the most guaranteed permanent policy you can buy.
When choosing a life insurance policy for yourself or a loved one, it is important to consider what the ultimate goal of the insurance is. If you find yourself unsure of what policy may be the best fit your situation, talk to a financial professional that you trust to help you in this decision.
If you have further questions regarding this blog or would like to discuss what type of life insurance would suit your needs, email me at deanbarda@appleandassociates.com.