Over the years, the life insurance industry has grown significantly. With that growth has come the emergence of numerous types of life insurance policies. Some policies are used for pure insurance purposes – often on a temporary basis – while others are intended to be kept throughout an insured’s lifetime.
There are two primary classes on life insurance that are on the market today. These are term and permanent. Within each of these categories are a number of different policy creations, each with unique features and benefits that are designed to serve various coverage needs.
Because there are many reasons to purchase life insurance – both personal and business – it is important to understand the characteristics of the policy types as well as why each may or may not be a good fit for various purposes.
Life insurance provides many benefits, and it is an important part of a good solid overall financial plan. In the event of a person’s death, the proceeds from a life insurance policy can provide the needed funds for paying off debts, funding future expenses, or replacing the lost income of the insured in order to pay ongoing bills of the survivors.
In fact, having a life insurance policy can help to continue to standard of living for the insured’s loved ones so that they do not have to endure financial hardship during an already difficult time.
While many people have an individual life insurance policy that covers estimated financial needs and expenses if they should pass away, these policies have other uses as well. For example, when planning one’s estate, life insurance is oftentimes used to provide liquidity and wealth accumulation for heirs. It can also help to more easily and equally divide assets among survivors.
The proceeds from a life insurance plan can also provide funds for reducing or even eliminating estate taxes. Depending on the insured’s financial situation, this can help to preserve wealth for survivors as estate taxes can potentially take 50% or more of one’s total estate value.
Life insurance can also be used in business situations. It can help in transferring a company’s interests to partners or other interested parties, without disruption to the day-to-day business operations while a replacement is found or the business is sold.
Types of Life Insurance
The most basic type of life insurance is term life. When an insured purchases term life insurance, they pay a premium in return for an amount of death benefit that will be paid to his or her beneficiary in the event that the insured dies while the policy is in force. These types of life insurance policies offer the least expensive cost per $1,000 of death benefit purchased.
Term policies constitute one component of life insurance – the death benefit. And, although all life insurance plans have a death benefit, not all have a component that is used for savings or investment.
Permanent life insurance policies have two parts – (1) a death benefit and (2) a cash value portion. These types of policies offer an insurance component that pays a stated amount of proceeds upon the death of the insured. It also offers a cash value portion that accumulates cash that can be used by the policy holder to withdraw or borrow against.
Permanent Life Insurance Types
There are a number of different policy types that lie within the permanent life insurance category. These can range from basic plans that offer a death benefit and cash savings to much more complex types of policies that constitute a death benefit along with investments that follow an underlying market.
Whole Life Insurance
The most basic form of permanent life insurance is whole life. These policies offer a way to accumulate wealth as the premiums paid into the policy go towards funding the death benefit proceeds as well as towards growth in a savings type of account. In essence, a whole life insurance policy combines the benefits of a term policy with that of a savings account.
The cash value component of a whole life insurance policy typically will contain two separate elements. One of these is the actual cash value that grows on a pre-determined basis throughout the life of the policy. This portion of the cash value will “endow,” meaning that the amount of cash will equal the amount of the death benefit when the policy matures. This generally occurs when the insured reaches age 100.
In addition, there are some permanent life insurance policies that also have a type of cash value that is not guaranteed. This is made up in the form of policy dividends or excess interest. The combination of the general cash value portion when combined with the non-guaranteed cash build up can really enhance the value of the policy over time.
The cash value in a whole life insurance policy can usually be accessed at any time via withdrawals or policy loans. Payback of a policy loan is optional for the policy holder. However, any portion of a loan that has not been paid back at the time of the insured’s death will be subtracted from the death benefit that is received by the beneficiary.
During the early years of a whole life insurance policy, a smaller portion of the premium will go towards the cost of providing the death benefit. However, as the insured on the policy ages, the cost to provide life insurance rises. Therefore, as time goes on, more of the premium will go towards the cost of funding the death benefit, and a smaller amount will be placed into the cash value component.
There are several different types of whole life insurance policies. Some of these include:
Participating Whole Life Insurance – A participating whole life insurance policy will share the insurance company’s excess profits in the form of dividends that are received. These dividends are typically not taxable, as they are considered to be a return of a portion of the policy’s premium.
Non-Participating Whole Life Insurance – With non-participating whole life insurance, the insurance company will assume all risk of future performance. Therefore, if the cost of future claims has been underestimated by the insurance company’s actuaries, then the issuing insurance company must make up the difference. Conversely, if the cost of future claims has been overestimated, then the insurance company can keep the difference. Non-participating whole life insurance plans do not pay dividends.
Limited Pay Whole Life Insurance – Limited pay whole life insurance policies are similar to participating plans. However, rather than paying annual premiums throughout their lifetime, the insured will only pay a premium for a certain number of years. For example, premiums may only be due each year for 20 years, at which time the policy will be considered paid up.
Single Premium Whole Life Insurance – Single premium whole life insurance policies are a type of limited pay plan, however, the policy holder will only pay one large single premium and then the policy will be paid up. These types of policies typically have surrender fees if the policy holder decides to cash it in within the first few years.
Interest Sensitive Whole Life Insurance – These types of whole life insurance plans may also be referred to as “excess interest” or “current assumption” whole life. Interest sensitive whole life insurance policies are like a mixture of traditional whole life and universal life. However, rather than the insured receiving dividends when charges have been overstated, they instead will receive interest on their policy’s cash value that varies with current market conditions. Similar to other whole life policies, the death benefit on interest sensitive policies remains constant throughout the insured’s life. In addition, the premium on interest sensitive whole life plans may vary – however, it will not go higher than the guaranteed maximum premium that is stated in the policy.
Advantages of Whole Life Insurance
There are both advantages and disadvantages of whole life insurance. These are oftentimes dependent upon what an insured is looking for in a policy. One of the biggest benefits to these types of policy is that the premiums will typically remain level throughout the entire life of the policy. This can make it much easier to budget for over the long term.
In addition, whole life insurance offers a minimum guaranteed death benefit. Since those who are insured through a whole life policy never need to re-qualify, they can count on a certain set amount of death benefit for their survivors at a premium that will not change.
One other feature that makes whole life insurance attractive is the cash value component of the policy. The savings can allow the policy holder to build cash on a tax-deferred basis. And, should the policy holder decide to cancel or surrender the policy, they can receive the accumulated amount of cash.
Disadvantages of Whole Life Insurance
There are a few drawbacks to owning whole life insurance. One is that – although the premiums remain level – they will typically be higher in the early years than for a corresponding amount of death benefit on a term life policy.
In addition, the insured on a whole life plan will not usually be allowed to increase the amount of death benefit on the policy unless they purchase additional coverage. This will generally require an additional amount of premium as well as the need for the insured to prove insurability.
Universal Life Insurance
Universal life insurance is another form of permanent life insurance protection. These plans have been described as being similar to a term life policy with a cash value component. Here, a portion of the policy holder’s premium will go towards paying the cost of the death benefit, and another portion will go to a cash account that earns interest as a type of investment. Similar to the cash value in a whole life policy, these funds will accumulate on a tax-deferred basis.
With a universal life insurance policy, the policy holder is typically able to change – within limits – the death benefit, as well as the timing and the amount of the premium. For instance, should the policy holder decide to pay a lower amount of premium at a particular time, the cash in the policy will not build up as fast, yet the guaranteed amount of death benefit will still stay intact.
In addition, a universal life insurance policy holder will have a great deal of flexibility in that they can move their money in the plan between the death benefit component and the cash portion of the plan. For example, if the cash portion of the plan is not earning a good return at a particular time, the policy holder may use more of their premium to pay for the death benefit component rather than placing those funds into the cash portion. These additional premium dollars can then be used to purchase a higher amount of death benefit.
Advantages of Universal Life Insurance
One of the biggest advantages of universal life is that it allows the policy holder an added amount of flexibility over that which they can obtain with whole life. This allows an additional amount of choice to either increase or decrease the amount of death benefit as well.
In addition, depending upon how the interest is credited to the cash component of the policy, the rate of return can be higher on a universal life plan as versus a whole life insurance policy. With this tax-deferred growth, the policy holder has the probability of growing their funds exponentially.
In using the tax-deferred cash balance, the policy holder can pick from a variety of different options within their universal life plan, including:
Purchasing Paid Up Coverage – The policy holder on a universal life insurance plan can use their funds to lock in a fixed amount of paid up life insurance death benefit.
Borrow Funds – The policy holder may borrow funds from the cash account at any time in the form of a loan.
Create a Stream of Income – Once the policy holder has enough funds in their cash account, they can begin to receive a regular income payment in the form of annuity.
Disadvantages of Universal Life Insurance
Even though there are numerous benefits to owning universal life insurance, there are also a few disadvantages. One drawback is that falling interest rates could cause the policy premiums to increase – and the policy could even lapse if the interest is no longer enough to sustain paying a portion of the insurance cost. In addition, in some cases, the growth in a universal life policy’s cash value may be capped at a certain amount.
Variable Life Insurance
Variable life insurance is a type of permanent life insurance that offers a death benefit along with a unique investment aspect. With these policies, a portion of the policy’s premium goes into a variety of “sub-accounts.” These accounts can include different investment options and planning vehicles such as mutual funds, stocks, and bonds. Because of the investment feature, variable life insurance is considered to be a security.
Similar to with whole life and universal life policies, the funds in the investment portion of a variable life plan grow on a tax deferred basis. In addition, variable life insurance policy holders may allocate the interest that is earned from their sub-accounts towards paying down the cost of their premiums for the death benefit portion of the plan.
Advantages of Variable Life Insurance
Just like with other types of life insurance coverage, variable life has both pros and cons. Certainly one of the biggest advantages is that the policy holder has the potential to grow their cash a great deal, provided that the underlying investments perform well. Because the cash in the variable life sub-accounts grows on a tax-deferred basis, high market returns have an added advantage of potentially pushing the total account value even higher.
Disadvantages of Variable Life Insurance
The big advantage that is associated with variable life insurance can also become a disadvantage if market returns for the underlying investments are poor. In addition to the potential for negative investment returns, variable life insurance policies also have higher fees and expenses due to the underlying fund charges.
The Bottom Line
Given the many different forms of permanent life insurance, potential policy holders have a great deal of choice in terms of their policy structure as well as in the way in which their savings or investment portion of the policy will be set up.
In any case, it is a good idea to have a thorough understanding of exactly how a policy will work prior to purchasing. This will help to give the policy holder an expectation of how a particular plan may or may not best fit their needs.
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