Life Insurance has been around for at least a century now and it seems that it is still one of the most misunderstood financial products that people need. Yes, that is correct, this is one product that most people need but seldom understand.
When it comes to life insurance there always seems to be a misconception about it, possibly because of the industry’s own way of marketing. Most people get confused between the difference between term insurance and the other forms of life insurance.
The reality is that this is a vital and necessary product that most people should have and own.
Let’s start with the basic understanding that all types of life insurance have one common trait and that is a death benefit. Now the use of the death benefit can be anywhere from replacing the main income earners salary to the family in the event of a death, or key man insurance to replace a key employee or leverage the tax liability on an estate.
The purpose of the death benefit, other than an insurable interest, is up to the owner and the insured.
However, life insurance is more than that. It is actually a wealth creation and preservation tool when properly understood.Life Insurance professionals should know that by simply explaining what insurance is and what it does helps people overcome their concerns and to move forward doing the right thing for their lives.
Life insurance is nothing more than a contract between an individual and an insurance carrier. It is a mortality risk agreement. In this contract, there are certain terms that need to be understood. As we go through this, you will need to refer back to the glossary at the end of this article.
When you apply for life insurance, you are asking the insurance carrier to see if you are a good risk for the death benefit and at what cost. Various factors come into play such as your health, your age, your lifestyle activities and so forth.
If the insurance company agrees that you are a good risk, they will offer you a policy at standard premium rates for a given death benefit. If you are at a higher risk, they may still offer you a policy but will rate you at various ratings.
Just accept the fact that ratings are a way to say that you have to pay a higher premium to get the requested death benefit.
So basically a life insurance policy is a contract between the owner, the insured, the beneficiary and the insurance carrier. The insurer promises to pay the insured according to the terms of policy. It is a binding contract that all parties agree to and it involves mortality risk assessments.
Let’s look at each type of insurance as we go through this explanation on life insurance.
Types of Life Insurance
You will want to know about the five basic types of life insurance available and what they can and cannot do. This is for the purpose of creating financial intelligence toward wise decisions.
The five types that will be discussed here are Term Life Insurance, Whole Life Insurance, Universal life Insurance, Variable Universal Life Insurance and what is called a hybrid product known as Indexed Universal life.
It is in your best interest to understand them before you purchase insurance or as a reason to re-evaluate the life insurance you already have.
1. Term Life
This is the simplest form to understand and most likely the most profitable for the insurance carriers. It is also the cheapest of all insurance because it is based on the insurance companies’ ability to pay the death benefit and pay its expenses. There is no other obligation.
This type of insurance is the purest form of insurance in that it is the one that is the most profitable to the insurance. It is basically the pure cost of insurance.
The best way to look at the cost of insurance is to simply see it as the cost that any insurance carrier has to bear to provide death benefits, pay for expenses of running an insurance carrier company and basically keeping the lights on, so to speak. It also has embedded in it the profit margins needed for the carrier to stay in business.
It works like this. You will pay a premium, typically monthly. You will get a death benefit, well actually your beneficiary gets the death benefit if you happen to have an unexpected demise or even a natural causes demise. The death benefit is paid income tax-free to the beneficiary. There is no cash value build up inside a term policy.
The term is the amount of time you need to pay the premium to keep the death benefit in place. It is typically between 5 years to 30 years. The average policy is 20 years. Now you pay the premium for twenty years.
If you have had the good fortune of staying alive, then you can keep the policy but at a much higher premium rate. In fact, it is a ridiculously high rate at that point.
Graphically it works like this:
2. Whole Life
This is the first of the permanent life insurance policies. It does have a cash value build up based typically on the dividends of the life insurance carrier paid back into the cash value. In this type of policy, you pay a premium.
It is called a permanent life insurance because the maturity date is beyond the life expectancy of most individual. You get a death benefit. In addition part of the premium goes to the cost of insurance and part of the premium is where you start to build up cash value.
When we say cash value, think of it as something you could use to benefit you while you are still alive. You can draw from it, and pay it back.
The cash value is built up through the dividends paying ability of the insurance carrier.The dividends represent the profitability of the carrier.
All types of permanent insurance policies will have what is known as cash surrender value. This is the cost that the insurance carrier gets to keep if you surrender the policy too early in the cash value build-up phase. In most cases, the cash value and the surrender value will even out after the first 10 years of the policy.
At some point, the surrender value will be zero, which means you get to keep all the cash value as a money source within the policy.
Graphically it looks like this:
3. Universal Life
This type of insurance is based on the insurance company taking out their cost of insurance and you earning interest on the balance of the premium. The interest earned is based on a guaranteed interest rate or a current interest rate. These rates range typically from 1% to 6%. It is based on the interest rate environment.
Universal Life is also based on creating a cash value. However, in this policy, The investment cash value is built up by the issuance of interest payments against the cash value. So here you pay a premium, you get a death benefit and you get a cash value.
Again it takes the time to build up the cash value, as the interest payments are based on what the rate the insurance company is issuing. It is directly affected by the interest rate environment at any given time.
There is something known as the corridor of insurance. All this means is that the cash value can never exceed the death benefit value.If it does, it creates what is known as a modified endowment contract. This means that there are tax implications on the cash values upon withdrawal.
It is not a bad thing if you wanted to create an annuity-like product with life insurance and there are times to do that. Just keep that in mind.
Graphically it looks like this:
4. Variable Universal Life
In Variable Universal Life, the cash value build up is based on a separate account that the insurance carrier offers in which you create a diversified investment account into sub-accounts.
These are investment funds that are similar to mutual funds but cannot be stated as mutual funds. They are separate from the insurance carrier and have professional money management within these funds.
Think of it as an investment account with an insurance wrapper around it. This is a combination of variable and universal life insurance The investment portfolio is usually managed by the policy owner.
The carrier contracts with fund managers, and they manage the investment. In this case, the cash value build up is based on fund performance separate from the general ledger of the insurance carrier.
So you pay a premium, you get a death benefit, the insurance carrier takes out their cost of insurance and the rest is invested in your sub-account. The danger here is if the markets take a huge plunge, as we saw in 2008, your policy could run the risk of lapsing.
Graphically it looks like this:
5. Indexed Universal Life
This last type of insurance is basically a hybrid between the Universal life and the Variable Universal life. Basically, it is a compromise between Universal Life and Variable Universal Life.
It is probably less risky than the variable universal life and has a better chance of increasing the cash value over time than straight universal life.
In this policy you pay a premium, you get a death benefit and your cash value is invested indirectly into what is known as an index. It could be the S & P 500, the European Index, the Asian Index or any combination of the three. The most common is the S & P 500. This is 500 of the largest US companies.
We say indirectly because you do not technically invest in an index. The returns mirror the returns of the index and are credited to your cash value over certain terms periods.
The main thing to take away from all of this is that you can use life insurance as a death benefit and as a leverage on income tax-free growth.
Graphically it looks like this:
Uses for Life Insurance
So how can life insurance benefit your life and your family? We will discuss a few options below. It is important that you take the time to fully understand why it is that you have life insurance and why you carry these policies.
- Family Protection: The first reason is obviously to create a large death benefit that will take care of your loved ones in the event that you unexpectedly pass away. It is an act of love and caring to do this for them. The death benefit is income tax-free to the beneficiary and could mean the difference between maintaining their lifestyle or a serious downgrade.
- Your own bank source: As you build up your life insurance cash value over time, it is a source from which you can borrow money against. There are no questions asked, or credit check to go through. It is tax-free based on loans and withdrawal of principle.You are instructed to pay it back, but if you do not then it simply lowers the death benefit amount by the loan amount. The cash value continues to grow with the money still in the account.
- College Planning: Since life insurance policies are not considered as an asset in financial aid, they are not included in the Free Application For Student Aid or FAFSA. As such permanent cash value inside life insurance is an awesome tool to use to build up for college planning.
If you took out a permanent policy for your child when they are very young, that would give you 18 years to build up that policy. The cash value could be used to pay for college with no income tax obligations.
It is not part of the assets to disclose on the application it will not count against you in this regard.
You can maximize your financial aid need, then use the cash value to help pay for college. In addition, if you choose, once the student graduates from college, you can give him ownership of this policy and they will then be both the owner and the insured.
- Tax-Free retirement Source: Lastly, if you are about 20 years away from retirement, you could use permanent life insurance as a tax-free retirement source.
Basically, you will set up the policy with the minimum amount of death benefit while maximizing the cash value without creating a modified endowment contract.When you do this, you create the ability for the cash value to grow quickly as the risk to the insurance company has been minimized.
During retirement, you can make monthly withdrawals based on loans and distribution of principle that are income tax-free.In many ways, this creates a much better account than any retirement account, as those type of accounts is taxed upon distribution. This would be a great use for a permanent life insurance policy.
These are just a few of the options available to you when you fully understand life insurance and its uses. These can be complicated products and our discussion here is the bare essentials of what you as a consumer need to know and understand.
We encourage you to have an in-depth discussion with your insurance agent for more education and due diligence.During retirement, you can make monthly withdrawals based on loans and distribution of principle that are income tax-free.In many ways, this creates a much better account than any retirement account, as those type of accounts is taxed upon distribution.
This would be a great use for a permanent life insurance policy.These are just a few of the options available to you when you fully understand life insurance and its uses.
These can be complicated products and our discussion here is the bare essentials of what you as a consumer need to know and understand.We encourage you to have an in-depth discussion with your insurance agent for more education and due diligence.
Hybrid Long Term Care
The longer a person lives, the higher the chances are that they will need long-term care insurance. That is just the unintended consequence of our mortality rates increasing. The longer we live, the higher the probability that we will keep living longer.
So the need for long-term care insurance is high. The two biggest complaints about this are that it is expensive and if you just happen to die or pass on after a short illness you lose the benefit of nursing care from the policy. There is no death benefit in the standard long-term care policy to leave for your loved ones.
A solution to this is not just a rider on the life insurance policy. The solution is a hybrid product that has a universal life policy under the umbrella of a true long-term care policy. Typically, you would pay a premium which will create a death benefit that creates a long-term care policy that is about twice the value of the death benefit.
So in this arrangement, let’s say your death benefit was $200,000, your total long-term care benefit would be about $400,000. This is a simplistic explanation but these types of policies are in the marketplace and are another use for life insurance.
Terminology is what we need to know first.
- Death Benefit – The amount of money that the insurance company agrees to pay upon the death of the insured during the term period to the beneficiary(s).
- Owner – The person who owns the insurance contract with the insurance company. Could be the same as the insured or not.
- Insured – The person whose life is being insured against in case of death. Could be the owner or not.
- Beneficiary – The person or persons who receive the proceeds from the death benefit, typically income tax-free. Could be the owner, but never the insured.
- Premiums – The amount of money paid by the owner to the insurance company on the life of the insured during the term period.
- Term – The length of time that the policy is in effect as long as the premiums are paid. After the term period, the insurance benefit is done, extended at a higher premium or may be converted to a permanent policy. The term period is typically 10, 15, 20, 25 or 30 years.
- Age- Important as to what the insurance company will allow for a death benefit based on mortality rates. Read this as the older a person is, the higher the premium is.
- The cost of Insurance – This is what the insurance company needs to charge to maintain their viability to keep their business running, pay their employees, cover death benefit claims and make a profit. In term policies, the premium is pure insurance cost or the actual cost of insurance to the insurance company.
- Table ratings- Creates higher cost of premiums based on health, lifestyle choices and activities.
- Cash Value – Amount of money that is built up in an insurance policy from interest or investment that is available to the policy owner for use during their lifetime. There is no cash build up in a term policy. It is pure insurance.
- Corridor of Insurance – The difference between the death benefit and the cash value. By law, the cash value can never exceed the death benefit without becoming a modified endowment contract that loses its tax benefits upon the distribution of the cash value.
- To the best of our knowledge, the information here is accurate and reliable. However, we are not giving legal advice, Insurance advice, tax advice or estate planning advice. We encourage you to take this information as a beginning point to seek professional advice from a qualified attorney, tax professional, and financial advisor.