When you think about life insurance, your first thought is most likely some variation of the definition. Life insurance is a promise from an insurance company to a policyholder. That promise is to pay a death benefit to an assigned beneficiary(ies) upon the death of an insured person, provided the policy hasn’t lapsed. The policyholder makes payments called premiums for the guarantee of this contract.
It is important to know the differences of life insurance options. The first difference is term vs. permanent. The main types of permanent life insurance are whole life, universal life, and variable universal life.
Regardless of which policy you have, a premium is required to be paid to keep the policy “in force”. How the premium is paid can be different for each policy. Familiarize yourself with these different options and be better equipped to financially protect your family.
Term life insurance is life insurance that you “rent” instead of own. It gives you coverage for a certain number of years (typically 10-30 years). Should you pass away within that period, your beneficiary will get the death benefit. However, if you live beyond the number of years agreed upon in the contract, the life insurance goes away. Due to this, term insurance premiums are significantly less than those of permanent life policies. When your term is up, depending on the policy you may restore the coverage for an additional term or transform the policy to a permanent policy. That new policy will be underwritten at your current age and be significantly more expensive. When thinking of term life, know that it gives you the most bang for your buck but generally if you don’t use it, you lose it.
Permanent life insurance is designed to cover you throughout your entire life. It is frequently used as a tool in retirement planning. Permanent life policies differ from term in two main ways. Premiums are higher due to the death benefit being guaranteed (with proper premium payment) and the ability to build cash value.
Your premium payment is typically split between two components, the cost of insurance and cash value. The cost of insurance includes operating costs and will vary based on insurability, age, and death benefit amount. Whatever is left over goes to the cash value. Cash values accumulate differently in the three main types of permanent life; whole life, universal life, and variable universal life.
Whole life is the most common of the permanent life options. In a whole life policy, the insurance company directs a portion of premiums right into a cash account. The premium you pay in a whole life policy is fixed. The return on the cash value is in accordance with a formula the insurance firm establishes when the contract is written. The contract you sign guarantees your coverage, assuming you continue to make the agreed upon premium payments.
Universal life (UL) policies differ from whole life due to the flexibility of premiums. You can pay more or less than the premium as long as the cost of insurance is being covered. The cost of insurance is lower in the beginning of your policy when you are younger. That is typically when you try and build up the cash value in your policy. The cash value grows based on market interest rates or the guaranteed minimum interest rate listed in the contract, whichever is greater. The goal with a UL policy is to eventually have the cash value be able to pay for the cost of insurance. As we age, the cost of insurance grows, which makes proper planning essential in a UL policy. If the cash value doesn’t accumulate like we had hoped, you may pay more for your UL than originally planned. However, if your cash value is sufficient the policy could end up paying for itself.
Variable universal life (VUL) policies differ slightly from UL policies. The main difference is the way the cash value is handled. Think of the cash value as a subaccount. This subaccount can be invested in mutual funds which give it a greater opportunity for growth. Obviously, it also has a greater potential to lose money. Since there are no guarantees with market performance the insured takes on the risk that the cost of insurance may not be met if the subaccount drops. If the subaccount falls and the cost of insurance rises a VUL could get expensive.
A few more things to keep in mind about permanent life insurance. When the insured dies the beneficiary only gets the death benefit, not the cash value. For instance, if a policy has a $200,000 death benefit and a $100,000 cash value and the insured dies, the insurance company pays out the $200,000 death benefit but keeps the $100,000 cash value. Each policy is unique but most times you can take loans from the accumulated cash value. You can even take withdrawals from the cash account, which is a common practice in retirement planning. You’ll need to get a better understanding of the tax implications pertaining to these options.
Which protection is right for you? The best way to start is to work with a competent insurance professional to audit your current insurance coverage and needs. This will help you determine the proper amount of coverage and utilize the correct policy to help protect your family.