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 with the difference between term insurance and other types 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 the 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.
For many American families, a properly placed life insurance policy can mean the difference between family security and family struggle. This is true in the event of the unexpected death of the main income earner.
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.
The Contract
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.
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 the 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 individual according to the terms of the 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.
The 5 Types of Life Insurance That We Cover Here:
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 is known as Indexed Universal life.
It is in your best interest to learn and understand them before you purchase insurance or as a reason to re-evaluate the life insurance you already have.
Term Life
This is the simplest form to understand and possibly 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. 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 cause 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 usually at a higher premium rate.
Graphically it works like this:
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 permanent life insurance because the maturity date is beyond the life expectancy of most individuals. 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 withdraw from it, and pay it back later. 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:
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 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 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:
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 policies. 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:
Indexed Universal Life
This last type of insurance is basically a hybrid between the Universal Life and 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.
With an indexed universal life policy, you can use life insurance as a death benefit and as leverage on income tax-free growth.
Graphically it looks like this:
Conclusion
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, other types of life insurance and due diligence.
Disclaimer: To the best of our knowledge the information here is accurate and reliable. However, we are not giving legal advice, Insurance advises, 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.
