Term and Permanent (Whole)
What Types of Life Insurance Are Available?
With all of the different life insurance types that are out there,
it's easy to become confused. Here is a simple way to categorize
the different types being offered.
Generally, life insurance products can be grouped into two expansive
categories:
- Term insurance
- Permanent insurance
As you consider different types of insurance policies, keep in mind they all deal with shifting risk. The different features focus on different pieces of the risk-shifting process. Are you shifting the risk of death for a year or a lifetime? Are you shifting the risk of insurability or are you retaining that risk by having to satisfy the insurance company that you are insurable on a regular basis?
Term Life Insurance
Term insurance illustrates simply how you can shift risk with life
insurance. For a specified premium payment, you can shift some
of the financial impact of your premature death to an insurance
company. Basic term insurance focuses solely on risk shifting.
Such policies include neither any form of savings nor a lot of
policy enhancements or features. The insured's death must occur
within the time specified in the policy for proceeds to be paid
to the beneficiary. At the end of the policy term, the coverage
and the risk shifting end.
Term policies do offer additional features with respect to premium
costs, renew ability, and the ability to change the policy into
other kinds of coverage. These features do not necessarily make
the policy better; they only allow you to better determine which
types of risk you want to shift to the insurance company.
- Level Term - fixed amount of insurance with fixed premiums for a certain number of years, generally up to 10 years.
- Annually Renewable - fixed amount of insurance with increasing premiums renewable on an annual basis.
- Increasing/Decreasing Term - amount of insurance increases or decreases over the term, but premiums remain the same.
- Group Term - usually purchased through an employer or professional association; sometimes easier for people to qualify for coverage.
Term insurance is relatively inexpensive in your younger years, but the cost increases as you grow older. The annual cost increases more quickly as you reach your 50's and 60's.
- You are younger and your need for insurance may be greatest because your financial goals are not well funded and resources available for making premium payments may be limited.
- The need for insurance will last for a relatively short period of time.
- The need for insurance will decrease over time.
Whole Life or Permanent Insurance
As the name implies, this product is designed for a longer term and
perhaps for your entire life. Premium payments purchase protection
against the risk of premature death and also allow you to build
a cash reserve -- the savings element.
In your younger years, the portion of your premium payment that
pays the cost of the death benefit is relatively small, and a larger
portion of the premium may be available to add to the savings element.
In later years when the premium you pay does not cover the full
cost of the insurance, a portion of the accumulated savings may
be needed to fund the actual insurance cost.
Generally, the face amount of the policy and the annual premium are
fixed and the cash value of your policy increases, so the amount
of pure risk protection decreases over time. You could look at a
whole life policy as a combination of decreasing term life insurance
and an increasing savings fund. Part of your premium goes for the
death benefit and the rest is like an addition to an investment account.
Unlike a savings account, the savings element of a life insurance
policy is usually not immediately available to you. You may have
to pay surrender charges if you withdraw funds early in the life
of the policy. You should carefully consider how much you are paying
for the "savings" part of the policy and how soon you might
need these funds.
Under current income tax laws, the earnings on the savings element
of a whole life insurance policy are not subject to income tax as
they accumulate over the life of the policy. This ability to have
a tax deferred savings element is an advantage for life insurance
savings over non tax-deferred savings accounts.
The portion of your premium that does not go into the savings element
pays for insurance risk of your death during the term of the policy,
as actuarially determined by the insurance company.
Insurance companies rely on mortality tables and theories of probability
to calculate their premiums. Actuaries statistically determine the
rate of death for men and women at each given age based on the insurance
company's past experience and incorporate this information into a
mortality table. With this information, the company can reasonably
estimate the number of claims and the amount it will have to pay.
It can then set the premiums to cover those claims and its administrative
and selling expenses and to make a reasonable profit.
There are various types of whole or permanent life insurance policies.
In recent years, some variations have grown in popularity. Many of
these variations have focused on giving you, the policyholder, more
flexibility with respect to the amount of insurance coverage and
the investment of your savings element. If you are considering a
permanent life insurance product, keep in mind the concept of risk
shifting and your reasons for buying life insurance in the first
place.
The benefits of flexibility may come with a cost -- the cost of retaining
some type of risk. For example, a policy that allows for flexible
premiums may not guarantee future premium rates.
- Traditional Whole Life. Provides level premiums and level insurance coverage. It generally costs more than term in the earlier years of the policy and less in later years. Nontaxable dividends may be paid on the policy.
- Universal Life. Combines term insurance with an investment fund that generally has a minimum earnings rate. Within limits you can vary the premium payments from year to year. You may even skip premium payments as long as the cash value is sufficient to cover all of the costs of the insurance. You can raise or lower the death benefit, although increases in death benefit may require proof of insurability.
- Variable Life. Is a whole life policy under which the policy owner "directs" the investment of cash values. This product has a guaranteed minimum face amount and fixed premiums similar to traditional whole life. However, there is no minimum guaranteed rate of investment return or cash value, and the death benefit is variable based on investment performance.
- Variable Universal Life - A combination of the flexibility of premium payments of the universal life policy, with the investment direction feature of the variable life policy.
- Survivor Life. Also called "second-to-die," survivorship life insurance pays a death benefit only after both of the insured individuals have died. Premiums are lower than for equivalent coverage in two separate policies. This product is often used to help pay estate taxes.
- Single Premium Life. Requires a single, large, front-end premium payment to keep the coverage in force for the life of the insured. Because of the high single premium, this type of policy provides the maximum allowable tax-free (or tax-deferred, depending on how proceeds are received) investment buildup permitted in a life insurance policy. The insurance portion must meet a minimum level so that the product continues to qualify as "insurance" (vs. an "investment" which would be subject to current tax). Before 1988, these policies were marketed as "tax shelters" because the cash values were invested on a tax-free basis and could be withdrawn tax-free after a certain period of time. However, in 1988, Congress significantly curbed the tax benefits for policies issued on or after June 21, 1988, by restricting the ability of insureds to receive distributions from these policies free of tax.
Similarly, a policy that allows you to earn more by making your own
investment decisions may not protect you from your poor investment
choices.
Some of the situations in which people purchase permanent or whole
life insurance policies include the time needed to shift the risk
is over 15 years.
For example, providing for the income security of a surviving spouse
could involve a time period of over 50 years.
In these situations, permanent insurance should be considered because
the cost of term coverage in later years can be prohibitively expensive.
- The amount of the need remains relatively constant or increases over time.
- The family wants or needs to take advantage of a forced savings program. (Some people correctly recognize that they do not have the financial discipline to save without being "forced" to do so.)