Life insurance is a vehicle used to provide a death benefit for the policy’s beneficiaries. In exchange for a premium payment, the policyholder receives a death benefit that will be paid to the policy beneficiaries upon their death.
Life insurance can be used to provide a level of security to your family or others in the event of your death. Life insurance can be a key component of your estate planning efforts and has many other practical applications within the realm of financial planning.
You will pay a premium on a monthly, quarterly or annual basis to keep the coverage in force. Some types of policies provide a pure death benefit, others may have a cash value or savings component in addition to the death benefit.
Most life insurance policies require a medical exam as part of the application process. The results of this exam may determine whether or not the company will issue the policy and if so, the level of the premium that you will pay.
Here is a look at some of the most common types of life insurance policies available to you.
Term life insurance
Term life insurance offers a stated death benefit for a set period of time or term. Term policies provide a death benefit only, there is no cash value or investment component for the policy. Term life insurance can be a good fit in certain situations.
Premiums on a term policy will be cheaper than whole life and other types of permanent insurance policies for the same death benefit. For those who might need the death benefit for a certain number of years, a term policy can be an inexpensive way to obtain this coverage as compared to a permanent insurance product. This might include parents with young children who want to be sure to have a sufficient death benefit should they die while their children are still young.
However, if you know you are going to need the death benefit past the end of the policy term period, you may need to consider another type of policy.
Pros of a term life policy:
- A term policy can be a relatively inexpensive way to purchase life insurance coverage.
- You can generally purchase a higher death benefit with a term policy than with most other forms of life insurance for the cost of the term premium.
- You can invest the money saved on life insurance premiums elsewhere.
- Term insurance is pure life insurance coverage, there is no added cost to fund the cash value or an investment account.
- You can tailor the term period to your need for the coverage.
Cons of a term life policy:
- Coverage stops if you don’t continue to pay the premiums.
- Once the term of the policy ends, the premium amount will typically increase substantially if you wish to continue the coverage.
Whole life insurance
Whole life insurance is a form of permanent life insurance. The premiums are fixed for life as long as you keep paying them. Beside a life insurance death benefit, whole life also has a cash value component. Whole life serves the dual purpose of providing protection for your beneficiaries through the death benefit and providing a savings vehicle via the cash value component of the policy.
The cash value component of the policy builds up over time on a tax-deferred basis. A portion of each premium payment goes towards building the policy’s cash value. Additionally, the insurance company pays a predetermined amount of interest on the policy’s cash value as well.
As compared to a term policy, the premiums on a whole life policy will be more expensive.
Whole life can be a good option when you know that the coverage will be needed for a longer time period than might be available via a term policy. This might be connected to an estate planning strategy or perhaps you have beneficiaries to whom you want to provide a death benefit to regardless of when you were to die.
The cash value portion of the policy acts as a forced savings vehicle. It is there to be used while the policyholder is still living, the cash value is not paid out to the policy’s beneficiaries upon the policy holder’s death.
The cash value can be borrowed against if needed, however this will reduce the death benefit to the extent that there is any portion of a loan outstanding against the policy at the time of the policy holder’s death. Withdrawing the money will reduce the death benefit of the policy, to the extent that the amount of the withdrawal exceeds the total amount of premiums paid into the policy, some or all of the withdrawal amount could be taxable to you.
Another application of the cash value component is to use this money to pay some or all of the premiums in later years. This can reduce your cost as you get older while still allowing you to maintain the death benefit amount.
Pros of whole life insurance:
- The policy is permanent
- There is a cash value component which grows on a tax-deferred basis
- The premium cost will not increase
- In some cases the policy can be used as collateral against a loan
Cons of whole life insurance:
- Higher costs than term for the same death benefit
- Lack of control over the cash value in terms of how it is invested
Universal life insurance
Universal life insurance is another form of permanent life insurance, but with a bit of a twist. Like whole life, universal life has a cash value component. Your premiums go towards the death benefit and towards building the policy’s cash value. The twist is that you can change the premium payments and the death benefit of the policy without having to get a new policy.
The cash value element of the policy generally offers a number of options that are similar to mutual funds.
Universal life offers permanent life insurance with built in flexibility if needed. You can adjust the level of the death benefit and both the timing and the level of your premium payments.
Pros of universal life insurance:
- The premium and death benefit flexibility are a major pro of universal life policies
- Guaranteed death benefit as long as the premiums are paid
- The death benefit can be increased or decreased while still maintaining coverage. A large increase in the death benefit might require a medical exam with some insurers.
- The cash value grows tax-deferred
- You can borrow from or take withdrawals from the policy’s cash value component.
Cons of universal life:
- It can be more complex than a whole life policy to manage and to understand.
- The cash balance can fluctuate with the performance of the stock market.
- The growth of the cash value is capped, regardless of how well the stock market performs.
- If too much is withdrawn from the cash value, the death benefit level could be impacted.
- Gains on the investments in the cash value component could be taxed upon withdrawal.
Variable universal life
Variable universal life is another form of permanent life insurance. Variable universal life combines many of the features of universal life insurance and variable life insurance. As with universal life insurance, your premiums and your death benefit can fluctuate based on your wishes and based on the performance of the policies cash value component.
Like a variable life policy, the cash value can be invested in a variety of investment accounts that are similar to mutual funds.
A variable universal life may be most appropriate for those who are looking for permanent coverage and who need another place to invest on a regular basis because they have maxed out other tax-deferred options.
If the investments in the cash value component of the policy do well, you may be able to reduce your premiums, or you may be able to increase the policy’s death benefit for the same premium payment.
Pros of variable universal life:
- For those who have maxed out other retirement accounts like IRAs and their 401(k) at work, variable universal life can offer another tax-deferred way to invest.
- Flexible premiums allow you to vary premium payments based on changes in your situation.
- The cash value component of the policy can be used to reduce premium payments, increase the death benefit or taken out of the policy as a loan or a distribution.
Cons of variable universal life:
- High cost. The fees and expenses associated with a variable universal life policy can be high.
- The policies can be complicated to manage.
- If the investment performance lags, this can result in higher premiums to maintain the same death benefit.
Indexed universal life insurance
Index universal life (IUL) has many of the characteristics of universal life, but the cash value component is distinctly different.
The cash value portion of the policy is tied to the performance of a popular market index like the S&P 500. Typically, the potential gains are capped at a percentage of the gain in the index. Most IUL policies offer a guaranteed minimum level of interest which is the minimum amount the cash value component of the policy will earn.
Like a universal life policy, the premium and the death benefit can be adjusted if needed. If the cash value component performs well, you may be able to use some of this money to pay the premiums.
IUL policies can be quite complex and there are often very high fees associated with these policies. There has been some debate over the years as to whether or not these policies are actually securities because of the index component.
Pros of indexed universal life insurance:
- It is a form of permanent life insurance for those who need coverage throughout their life.
- The premium payments and the death benefit can be adjusted if needed.
Cons of indexed universal life insurance:
- These policies can be quite expensive to own and they are very complex.
- The potential gains from the underlying index are capped, if the index gains more the policyholder doesn’t participate in those added gains.
Variable life insurance
Variable life insurance is another form of permanent life insurance that has an investment feature inside of the cash value component. These policies typically allow investment into a number of sub-accounts which are similar to mutual funds. These sub-accounts may include offerings from a variety of asset classes.
These investment options offer the potential for gains, but there is also the same downside risk that comes with any type of investment.
These policies are expensive compared to term insurance and some other policies. They are often used by people looking for an additional tax-deferred investing option if they have maxed out other options like an IRA or their 401(k).
Depending upon the terms of the particular policy that you are considering, the death benefit may be a level death benefit, or it may include some or all of the policy’s cash value in addition to the level death benefit. The latter version carries a higher cost.
Pros of variable life insurance:
- It provides a permanent death benefit.
- The investment component can help build the policy’s cash value.
Cons of variable life insurance:
- Premiums are generally higher than term and many other types of insurance for the same level of coverage.
- The investment options may be limited.
- The underlying fees and expenses inherent in this type of policy can be quite expensive.** **
Final expense insurance
Final expense insurance, also known as burial insurance, is designed to cover end of life expenses such as funeral costs and medical costs. This is another form of permanent insurance coverage.
As people age they may not need a full-blown life insurance policy, but they may want coverage that will relieve their loved ones from having to pay the cost of their funeral and other final expenses. This is where final expense insurance comes in.
These policies are relatively expensive compared to other forms of life insurance so they are most appropriate for those who cannot purchase a more traditional policy due to their age, health or other issues.
Final expense coverage is generally offered as guaranteed issue or simplified issue. Guaranteed issue policies are available to virtually anyone regardless of their age or their health. In some cases the company may decline to issue coverage for those with certain terminal illnesses. Simplified issue policies tend to be a bit cheaper and are appropriate for those who may be considered to have a moderate risk profile.
Obtaining final expense coverage will typically not require a medical exam like most other forms of life insurance, but rather you will need to answer a series of questions about your health and other factors.
This type of life insurance is typically purchased by people who are older and don’t have another form of life insurance coverage. Sometimes these people have little or no outside assets that could be used to cover these costs.
Pros of final expense insurance:
- The policy is a way to cover your final expenses.
- The approval process is generally less complicated and faster than with other types of life insurance.
Cons of final expense insurance:
- These policies are costly, you get less death benefit for your premium dollars than with other types of coverage.
- The available death benefit is generally relatively small.
Group life insurance
Group life insurance is life insurance coverage offered by an employer, an association, a labor union or similar type of organization. In the case of an employer the coverage is usually offered to employees as part of their employee benefits package. The coverage may be free up to a certain amount. Employees may be offered some multiple of their annual salary at no cost. Additional coverage may be available for an added charge. Some employers offer spousal coverage or dependent life insurance, again usually with an added premium cost.
Professional associations may offer life group life coverage as a benefit of membership. Labor unions might offer this coverage as a benefit of being a member of the union, some employers may not offer their full benefit package to union members.
Premiums for group life insurance may be lower due to the size of the covered group. At least at the basic levels, there is often no medical underwriting involved. Employees and members of other groups may be required to satisfy a waiting period before qualifying for coverage.
Coverage will end when they leave their employer, union or other group offering the coverage. In some cases there may be an opportunity to continue this coverage after leaving the organization, but this will involve an ongoing premium cost.
Group coverage can be a nice perk, but many people will need to have another type of outside policy in addition to the group coverage to meet their life insurance needs.
Pros of group life insurance:
- Coverage is guaranteed to qualifying group members.
- There is usually no medical underwriting involved.
- Any premium payments are usually deducted for the employee’s paycheck.
Cons of group life insurance:
- The amount of the coverage is usually limited.
- The coverage may not be portable if you leave the organization.
- The employer or organizer of the group controls the policies and negotiates the terms of coverage with the insurance company. The coverage could change over time.
Other types of life insurance
There are several types of specialized life insurance policies that you might encounter as well.
Mortgage protection insurance
This is a policy that is designed to pay off your mortgage if you die during the mortgage term. The death benefit goes to the holder of the mortgage and not to your family or other beneficiaries. The death benefit decreases over time as the mortgage balance declines.
The major benefit of the policy is that it does ensure that the mortgage balance will be paid off in the event of your death. The biggest downside is that your heirs have no choice in how the death benefit proceeds are used. The money cannot be used to pay other bills, cover the cost of college for your kids or other purposes that may be more pressing for them.
Typically, if you qualify, a term policy might be a better choice than a mortgage protection plan.
Credit life insurance
Credit life insurance is a policy designed to pay off specific debts in the event that you before their debt(s) is retired. Like mortgage protection insurance, the death benefit goes to the creditor. As with mortgage protection insurance, there are often better options for life insurance coverage in many cases.
Accidental death and dismemberment insurance
Unlike Life Insurance AD&D policies typically only pay a death benefit if you are killed in an accident or other narrowly defined fashion. There is usually an injury payment if you suffer the loss of one or both eyes or a limb.
These policies may be available through an employer in some cases. Death from most other causes like an illness would not be covered.
If the policy is free or very low cost through your employer it might be worthwhile as a supplement to other life or disability policies. It may also make sense if you work in an occupation that is considered extremely high risk to these specific types of death or injury. The major con of AD&D policies are the narrow definitions of injury or death.
Which life insurance is best for you?
This is the ultimate question to ask when looking at obtaining new life insurance coverage. There is no one right answer as everyone’s situation is a bit different. Some questions to ask yourself might include:
- How large of a death benefit do I need?
- How long will I need the death benefit to be in force?
- How much can I afford to pay in premiums?
- Do I have any special health issues that might limit my ability to obtain coverage?
- Is the cash value or investment portion of a policy really important to me.
Overall life insurance is an important part of their financial planning for many people. Working with a trusted agent or financial advisor can be beneficial in many cases.