Types of Life Insurance Explained
B.A. Risk Management
Life Insurance Agent
Life insurance is undoubtedly one of the best ways to safeguard the financial interests of your loved ones in your absence. But with all of the different types of coverage, where do you begin?
Choosing a policy that can cover your family’s long-term financial needs is not an easy task, due to the sheer range of options available in the market today.
In this guide, we take an in-depth look at the different types of life insurance policies and discuss the benefits and drawbacks of each.
Term life insurance is the most basic form of coverage that you can buy. It is, as the name indicates, an agreement between you and your insurance provider for a specific term period.
If you pass away (either in an accident or due to a natural cause) while your policy is still in force, your spouse (or any other person whom you designated as your beneficiary) will receive the death benefit amount – usually in the form of a tax-free lump-sum payment.
Life insurance companies allow you to choose the policy term, which usually ranges from 10 to 30 years. You are required to pay the premium – on a monthly, quarterly, or annual basis – for the entirety of the term. Failing to pay the premiums will result in your policy lapsing.
Most term insurance is level term, meaning the premium amount is locked in at the start of the term and remains unchanged until the policy expires. However, there are other types of term policies like increasing and decreasing term life plans, annual renewable plans, and return of premium plans.
In this plan, the death benefit amount is set to increase steadily throughout the term. Along with it, the premium payments also increase proportionately. If you are in a situation where your financial liabilities are likely to increase as you age, this plan might be a good choice for you.
With a decreasing term policy, the death benefit amount is set to decrease steadily throughout the term. Along with it, the premium payments also decrease proportionately. It is also known as mortgage life insurance, as most people buy it to cover their mortgage debt.
The plan is designed in such a way that the death benefit amount reduces in tandem with your mortgage debt. It is set to expire by the time you pay off your mortgage.
Annual Renewable Term
This is a short-term policy which is meant to cover you only for a period of one year, after which you need to renew it again. In most cases, it functions as an extension of a traditional term life plan.
If you've ever wondered what happens to your term life insurance when it expires, most policies allow you to renew annually at a higher premium, without undergoing underwriting again.
For example, if your 20-year term life plan is about to expire and if you still need coverage for another year or two, you can choose to extend it on a yearly basis.
The biggest advantage of yearly renewals is that you do not have to undergo a medical exam. So, irrespective of your health condition, you can renew your plan on a yearly basis without worrying about getting rejected.
The downside is that the premium is generally higher compared to what a typical term life plan costs.
Return of Premium Term
Generally, if you outlive your term life policy, the insurance company does not pay you any money. The premiums paid by those who outlive their policies contribute to the death benefits paid out to the families of those who die prematurely. It is how the insurance industry works.
If you, however, outlive a return of premium policy, the insurance company refunds the total amount of premiums you paid throughout the policy’s term. The downside is that the premium payments are much higher compared to a regular term life policy.
Benefits of Term Life
- Term insurance is the most affordable form of coverage you can buy. For example, if you are a 30-year old non-smoker, a 20-year, $500,000 policy is likely to cost you only around $25 a month.
- You have the option of choosing the policy term, which means you only pay for the coverage that you need. If you need to be covered for 10 years, you can buy a 10-year policy. If you need to be covered for 12 years, you can buy a 10-year policy and then extend it annually for two more years, rather than buying a 15 or 20-year policy.
- A vast majority of insurance providers offer you the choice to convert your term policy into a whole life or universal life policy, if you wish to do so. If your insurance needs and financial needs change at any point, and if you need lifelong coverage as a result, you can have your existing term life plan converted into a permanent plan. The best part is that you are not required to undergo a medical exam in order to convert your policy.
Drawbacks of Term
- Term life policies, unlike permanent life policies, do not build cash value. You are not allowed to make a withdrawal or get a loan to meet your ongoing financial needs. The coverage amount is paid out to your family only in the event of your death.
- Term life plans are meant to provide you with coverage only for a limited period of time. In case you need coverage for a longer period of time, you can renew your existing policy on a yearly basis, convert it into a whole life or universal life policy, or apply for a new term life policy. No matter which option you choose, you can expect to pay a substantially higher premium, owing to your age.
It is a comprehensive form of life insurance which is meant to last your whole life. A permanent policy does not come with an expiration date. It stays in force as long as you keep paying the premiums.
The premiums you pay contribute to the death benefit (which is paid out to your beneficiary after your death) as well as a built-in cash value component (which you can access, if and when needed, to meet your financial needs).
The cash value part of your permanent life policy is designed to grow in value over time – either at a fixed rate (as determined by the insurance company) or at a variable rate (depending on market conditions).
Most permanent life policies have a minimum guaranteed rate of return, which is the interest rate guaranteed by the insurance company.
Regardless of how the company performs or how bad the market conditions are, the rate of return on your policy’s cash value component will never dip below the rate of interest guaranteed by the company.
If you buy a permanent life policy from a mutual insurance company, you might be paid dividends as well.
Mutual companies are structured in such a way that a person who buys a policy not only becomes a policyholder, but also becomes a part-owner. So, you are eligible to receive a share of the profits made by the company, which is usually paid in the form of yearly dividends.
There are many reasons why you might want to consider buying a permanent life policy.
- If you have a large estate, your family might have to pay a substantial tax bill – in the form of state and federal estate taxes – in the event of your death. By buying a permanent life policy, you can make sure that your family receives a lump-sum payment in the event of your death, which can be used to pay estate taxes as well as other liabilities.
- If there is a special needs child or a disabled person in your family who is financially dependent on you, the proceeds from your permanent life policy can be used to take care of their needs in your absence.
- A permanent life policy can be an additional source of income for your post retirement life, especially if you do not have a reliable income source to live off of.
Let us now take a look at the different types of permanent options.
It is the purest form of permanent life insurance coverage that you can buy. It has three key features.
- Guaranteed death benefit – It is the amount of money your family stands to receive from the insurance company in the event of your death.
- Level Premium – Right at the start of the policy’s term, the premium is determined by the insurer and locked in. It does not increase at any point for any reason.
- Living benefits – The policy builds cash value at a rate predetermined by the insurance company. The accumulated cash value can be accessed in the form of a withdrawal or a loan, as and when you need it.
One of the biggest advantages of buying a whole life plan is that you can be sure that the financial needs of your dependents will be taken care of in your absence, no matter when you pass away.
Moreover, whole life plans tend to build cash value on a tax-deferred basis, which means you are required to pay taxes only when you make a withdrawal.
In the absence of withdrawals or loans, the funds in your cash value account keep accruing interest and compound over time.
The downside of whole life is that it is far more expensive than term insurance. The premiums can be 5 to 20 times higher, depending on various factors. Not everyone can afford to pay these premiums for a lifetime.
Universal is a more flexible form of permanent life insurance. It offers lifelong coverage and a guaranteed death benefit, along with a cash value component which grows in value with every premium you pay.
The unique selling point of a universal policy is that you have the option of choosing the amount of premium that you want to pay.
The amount you pay, however, should not be less than the minimum limit set by the insurance provider.
The flexible premium option can benefit you in times of financial uncertainty. For instance, if you are unable to work for a month or two due to an illness or a short-term disability, you can keep your overall expenses in check by reducing your premium payments to the extent possible.
Another advantage of a universal life policy is that the accumulated cash value can be used to pay the premiums. If your policy has built up a substantial amount of cash value, you can stop paying premiums altogether and put the accrued interest to use.
You can also adjust your universal life policy’s death benefit depending on your financial needs. If at some point you decide that you no longer need as much coverage as you once did, you can decrease the death benefit amount. If and when you do, the premium also decreases proportionately.
If you, on the other hand, want to increase your death benefit, the insurance provider might ask you to undergo a medical exam in order to reassess your insurability.
An indexed universal life policy is similar to a regular universal life policy in terms of the coverage offered, death benefit, and the option to adjust your death benefit and premium payments.
The only difference is that the cash value portion of the policy is linked to a stock index. So, the rate at which your policy accumulates cash value is directly proportional to the performance of the stock index.
Indexed universal life policies usually have an upper and lower ceiling in terms of the returns on your investment. The lower ceiling works to your advantage, because even if the stock market crashes, you are assured of a minimum rate of return by the insurer.
The upper ceiling, on the other hand, is a downside as it restricts the returns on your investment. So, even if the stock index performs exceptionally well, your cash value account is unlikely to gain returns beyond a certain limit.
It is a permanent life policy whose cash value portion grows at a variable rate. Unlike a whole life policy, its rate of interest is not decided by the insurer.
Unlike an indexed universal life policy, its rate of return is not dependent on the growth of a stock index. Instead, you get to decide where the cash value portion of your premium is invested.
Insurance providers usually offer you a number of investment accounts to choose from. You can pick and choose the accounts in which your policy’s cash value component will be invested.
Since there is no cap on the returns on your investment, you can expect your policy’s cash value to grow substantially under favorable market conditions.
The downside is that the losses can be as substantial as the profits. If the market tanks, the cash value of your policy might diminish significantly.
It should be noted that variable policies require active management, since the cash value component is invested in the market. If the accounts you invest in perform poorly, you need reallocate your funds to make sure your policy’s cash value does not drop to dangerously low levels.
As the name indicates, variable universal life combines the features of universal life insurance as well as variable life insurance.
You can adjust your policy’s death benefit if and when your financial needs change. Similarly, you can choose the sub-accounts to invest your policy’s cash value.
The aforementioned caveat is also applicable here. A variable universal life policy requires active management. You need to keep track of your investment accounts and adjust your investing strategy if and when needed, depending on the market conditions.
The life insurance policies discussed above are generally best for healthy people who are willing to undergo medical exams to qualify for the lowest rates possible.
Simplified issue policies are not fully underwritten, which means you do not need to go through a medical test in order to qualify for it. Instead, you just need to fill out a form, which contains questions related to your health and lifestyle. The absence of a medical exam speeds up the overall process.
The biggest downside of simplified issue policies is that they are more expensive than fully underwritten policies.
If you are older and have serious health problems, even a simplified issue plan might be out of your reach. In such cases, a guaranteed issue policy might be your only option.
You are not required to fill out a questionnaire or go through a medical exam in order to qualify for a guaranteed issue life policy. If you can afford to pay the premium, you can get qualified, regardless of how old you are, where you reside, what you do, or how bad your health is.
The downside, as aforementioned, is that the premiums are usually substantially higher than what you can expect to pay for a fully underwritten policy.
Final Expense Insurance
Final expense insurance is meant to cover your burial and funeral costs. A funeral can cost anywhere from $8,000 to $12,000, which is more than what most middle and low income families can afford to spend. The payout usually ranges from $5,000 to $20,000, which should be sufficient to cover your funeral costs.
The cost of final expense insurance primarily depends on the policyholder’s age. The older you are, the higher will be the premium you have to pay. That’s because by insuring older individuals, the insurance company is taking on more risk in statistical terms.
Therefore, if you purchase final expense insurance when you are 40, you will have to pay less every month than if you postpone buying this policy until you are 70.