Life insurance is one of the most important components of any financial plan. It can protect your family in the event of a premature death. It can create a meaningful legacy for descendants and communities. It can even be used as a tax-advantaged cash-accumulation vehicle. It’s therefore striking that only 57% of American adults have life insurance coverage, 32% of whom are only covered by employer-provided plans, which tend to be inadequate.[1]
When consumers are asked why they avoid or defer conversations about life insurance they offer a range of answers, but we often hear that it’s because they find the topic of insurance confusing and intimidating.
Our goal has always been to help our clients understand the industry and the marketplace so that they are empowered to make informed decisions about how best to protect themselves, their families and their businesses. In that spirit, this post is meant to serve as a general introduction to life insurance.
The Two Main Categories
As you began your life insurance search you may have heard that you have to choose between term insurance and whole life insurance. That was the case – until 1979 with the introduction of universal life insurance (more on that later). Nowadays, it’s more accurate to talk about the distinction between term insurance and permanent insurance.
Term Life Insurance
Term insurance is a form of life insurance coverage, which is intended to last for a predetermined term of years (hence the name). In its most basic form, a policy will consist of a level death benefit and a fixed annual premium, which will guarantee the continuation of the death benefit for the term. This is called level term insurance. The most common level term options are 10, 15, 20, and 30 years.
The other common form of term coverage is annually renewable term. Whereas level term averages the cost of insurance across the term period to calculate a level premium, the annually renewable term premium is linked to the actual cost of insurance (i.e. the risk of insuring the client) in each year, which increases as the client becomes older and, therefore, a greater risk.
Term insurance holds by far the greatest market share of individually-owned life insurance policies,[2] and because 99 percent of term contracts never pay out,[3] term insurance is much less expensive than permanent insurance.
That said, term insurance has its limitations. Because the vast majority of term policies don’t pay claims, the overwhelming likelihood is that a policyholder will pay premiums without there being a return on the investment. Term insurance also does not provide living benefits like permanent insurance can.[4]
Term insurance is often likened to renting an apartment. Your initial costs are lower, and as long as you pay your premiums you have the security of knowing that the coverage is there. However, the coverage is all you get and only for a limited period of time, and when that time expires there isn’t anything to show for it.
Permanent Life Insurance
Permanent insurance is just that, permanent. It is designed to last through the end of the insured’s life. Because the insurer has every expectation that the policy will pay a claim the premiums are usually considerably higher than for term insurance. However, unlike term insurance, you, as the policyholder, can have confidence that there will be a return on your investment.
The other key distinction between term and permanent insurance is that permanent insurance typically builds cash value. Cash value is an accumulation of funds that grows within a permanent insurance contract. This potential growth represents your investment in the contract, and it can also be disbursed from the policy in the form of loans or withdrawals.[5]
Whereas term insurance is likened to renting, permanent insurance can be equated to purchasing a home. You own an asset designed to be there for the rest of your life. As time goes by, you may build equity (in the form of cash value), and when you pass away, you’ll leave an asset to your beneficiaries.
There are different types of permanent insurance. They have certain characteristics in common – for example, their permanent nature and the fact that they can build cash value – but they have different structures, functions and risk profiles, which should be understood prior to making a purchase. Below is a brief summary of each form of permanent insurance:
- Whole Life is the traditional form of permanent insurance. It offers guaranteed premiums, cash value and death benefit. In addition, it credits the policy with dividends each year to enhance its cash value and death benefit growth. This is a high-premium, high-cash-value form of coverage.
- Current Assumption Universal Life was the first permanent insurance alternative to whole life. It is more flexible and (usually) less expensive than whole life. Its cash value grows based on a fixed (but not guaranteed) rate of interest determined by the offering insurer. The higher the rate, the potentially better the cash value growth.
- Variable Universal Life operates on the same chassis as current assumption universal life, but values are allocated by the policyholder among separate investment sub-accounts within the policy. The sub-accounts are invested in the stock and bond markets. The cash value will rise and fall with fluctuations in the markets. As a result, this type of coverage is subject to greater risk.
- Indexed Universal Life is similar to variable universal life in that its cash value is invested in the equity markets, but it does not directly mirror market performance. Policies provide for a floor, generally 0%, below which investment losses won’t be debited against the policy, while simultaneously imposing a ceiling above which returns won’t be credited. This limits downside risk, but also restricts upside potential.
- Guaranteed Universal Life is permanent insurance without the frills. It rarely builds cash value, but as long as premiums are paid in a timely manner, the coverage is guaranteed to remain in place. Think of it as permanent term insurance.
What Should My Plan Look Like?
We are frequently asked what the best type of life insurance is. Our answer is that there is no such thing. It all comes down to each client’s unique needs, goals and philosophies. However, there are certain rules of thumb that can help guide you.
Term insurance is generally ideal for people who have a significant insurance need, who may not have the ability to pay higher premiums, and/or who may not have a permanent need. We think of term insurance as “If I die” insurance, since the clients for whom term coverage is appropriate tend to frame their goals in those terms. For example, “if I die…
- I want my spouse to be able to pay off the mortgage.”
- I want to make sure that my kids can go to college.”
- I don’t want my family to have to worry about money.”
- I want to know that my business will be able to survive.”
In contrast, permanent insurance is “When I die” coverage, because it is generally used to make provision for your end-of-life goals. For example, “when I die…
- I want to ensure my spouse’s standard of living in retirement.”
- I want to leave something of significance to each of my children.”
- I want to leave money to a charity that has been meaningful to me.”
- I don’t want my family to have to worry about taxes.”
Remember that there is no one-size-fits-all life insurance solution. Decisions about product and coverage amount should only be made after you’ve crystallized your personal goals. We understand what products are available, which companies are competitive, and how to represent you in the marketplace, but we cannot tell you what’s important to you. And protecting what’s important to you is the whole purpose behind life insurance.
Life insurance is subject to underwriting wherein individual health, business/personal activities, and other factors are considered prior to policy issue. All recommendations for life insurance policy types and face amounts must be suitable and appropriate for the client and must be based on a thorough fact finding and understanding of the client’s unique financial situation and life insurance needs. Variable life insurance products are offered by prospectus only. Your financial professional can provide a prospectus, which contains more complete information regarding charges, risks, expenses and investment objectives. You should read the prospectus carefully before you invest or send money.
[1] Scanlon, James et al, “2019 Insurance Barometer,” LL Global, Inc. and LIFE Happens, 2019, 25.
[2] Of new individual life policies purchased in 2018, 40 percent were term contracts, representing 72 percent of the total face amount issued, per Melnyk, Andrew et al, “Life Insurers Fact Book 2019,” American Council of Life Insurers, 2019, 64.
[3] Yellen, Pamela, “Is This the Worst Financial Advice Ever?” Entrepreneur, March 22, 2018.
https://www.entrepreneur.com/article/310731
[4] The one exception to this is the accelerated death benefit provision, which allows for the death benefit to be accessed if the insured is diagnosed with a terminal illness. Generally, the insured must not be expected to live beyond six months.
[5] Loans and withdrawals reduce the policy’s cash value and death benefit and increase the chance that the policy may lapse. If a policy lapses, matures, is surrendered or becomes a modified endowment, the loan balance at such time would generally be viewed as distributed and taxable under the general rules for distributions of policy cash values.