Family Finance Supplement
How to understand the types of life insurance policies
By Sue Frischie and Mary Ellen Rider McRee
How can a consumer feel confident in choosing the most appropriate life insurance policy when there are so many options available?
It is true there are many types of life insurance policies. However, all policies are either term, cash-value, a variation of one, or a combination of the two.
Term Insurance
Consumer educators recommend that most buyers choose term insurance in order to be able to afford adequate coverage. The recommendation assumes you will build financial assets as you grow older, thus lowering the need for life insurance. Term insurance provides the most protection for the money.
Term insurance is often called “pure protection” because it pays benefits only when the insured dies. It is similar to automobile, property and health insurance as it pays only if there is a loss. If the insured dies during the policy term, the beneficiary is paid the face value of the policy.
Coverage is provided for a specific time or term, usually 1 to 5 years, or as long as 10 to 20 years. Many policies can be renewed repeatedly, which means they potentially provide lifelong coverage. Some policies provide protection through age 100, others only to age 65 or 70. The policy must be renewed or repurchased to keep it in effect.
Premiums remain the same during the policy term. But, with each renewal, the premium will increase because the policy holder is older and has a greater chance of dying during the policy term. The higher cost is generally not a problem because the family income should be increasing, too. The amount of insurance needed usually decreases as the children grow up and as assets accumulate.
To continue coverage past the stated time period, the policyholder may have to apply for a new contract. He or she may also be required to have a medical examination. If a health condition is found, the insurance company may deny a new policy or issue a policy with a substantially higher premium because their risk is now greater.
Therefore, you may want to make sure your original term policy includes an option called guaranteed renewability. This means the policy can be renewed without having to prove insurability (such as undergoing a medical examination) after each coverage term expires. There may be a limit as to how many renewals can be made without proving insurability. Renewal could be limited to a maximum age. Once a guaranteed renewable policy is in force, the company cannot deny your right to renew it, regardless of changes in your health or occupation.
Another feature of term insurance is convertibility. Convertible term allows the insured to exchange a term policy for a cash-value policy without providing evidence of insurability. Usually, this conversion is an option only during the early years that a term policy is in force. Some term policies provide for an automatic conversion to cash-value after a specified number of years. As of the date of conversion, the cash-value policy would begin accumulating savings.
Decreasing term insurance offers constant premiums while the face amount of the policy gradually decreases. The premise of this type of insurance is that it can fit your changing insurance needs; usually as you grow older your life insurance needs decrease. It is important to determine the rate of reduction of the face amount and to consider that other factors, such as inflation, could actually cause your life insurance needs to increase rather than to decline. The premiums for a decreasing term policy are less than what you would pay for a comparable term policy with a fixed face amount.
Credit term life insurance is designed to pay the remaining balance of a loan if the insured dies before the debt has been repaid. Credit term is often sold by banks to cover home mortgages. Other lenders may require it as a condition of granting a loan. Credit term life insurance is usually a form of decreasing term insurance.
Level term policies provide a constant face amount and premiums during the time the policy is in effect. You actually pay an average rate, overpaying in the early years and underpaying in the later years. It mirrors cash-value insurance, in this respect, minus the savings feature. (See cash-value life insurance following). This level payment feature may be expensive, and not particularly beneficial, as most people don’t need the same death benefit throughout their lifetime.
Check to see if you can purchase term life insurance through a group. Group life insurance is typically purchased in full or part by an employer for a group of employees. No proof of insurability is required, and premium rates may be lower than premiums for individual policies. If you leave the group, you may be able to convert to an individual policy without proving insurability.
Cash-value Life Insurance
In addition to paying benefits upon the death of the insured, cash-value life insurance includes a savings feature. Other names for cash-value insurance include whole life, straight life and ordinary life. Cash-value life insurance costs more than term insurance providing the same amount of coverage because part of the premium is saved or invested for the policyholder by the company. Historically, the interest paid on whole life averages 2 to 3 percent, which is much lower than what other savings and investments typically earn. Interest on this savings is usually tax-deferred, and you may borrow against the savings.
Cash-value policies can be thought of as a kind of forced savings that accumulates over a lifetime. While the cash value accumulates, only the face amount of the policy will be paid upon the death of the insured. Prior to death, the insured can borrow all or part of the cash value of the policy, or cash in the policy for its accumulated value, thereby canceling the coverage.
The cash value that builds up over the life of the policy can be borrowed at an interest rate between 4 to 8 percent, generally less than that charged elsewhere for a loan. If you borrow against the policy, you must repay with interest. If you die before the debt is repaid, the amount owed will be deducted from the face amount.
Coverage lasts a lifetime as long as the premiums are paid. The cash value grows slowly in the early years, then more rapidly as the policy reaches maturity. Once a cash-value policy is purchased, it never needs to be renewed, nor must insurability be proven again.
Universal life insurance
This type of insurance was introduced in 1979 to satisfy consumer demands for payment of higher rates of interest on the savings portion of the policy than were previously available from traditional cash-value policies. The insurance companies share more of their investment yield with their policy holders than they do with traditional cash-value policies.
In addition to a potentially better return, universal life also offers greater flexibility. Many companies allow the policy holder to vary the premium and the amount of the death benefits as family financial needs change.
Universal life is actually a combination of term insurance and a tax-deferred savings plan. The savings part generally grows at a faster, higher rate than with whole life, but it may take 5 to 10 years before the interest earned approaches that earned in other forms of tax-deferred savings. The overall cost is less than whole life but more than term insurance.
Variable life insurance
This insurance is similar to universal, except that the policy holder controls the investments of the premiums in funds of varying risk. While the face amount of the policy is guaranteed as long as premiums are paid, the cash value of the policy may increase or decrease depending on the rates of return on the invested funds. Premiums may be fixed or flexible. The death benefit and cash value very depend upon the performance of funds invested.
Again, similar to universal, flexibility allows the policyholder to change coverage as family needs change, but this requires the insured to be more involved. You can probably get this same flexibility at a lower cost by combining renewable term insurance and a regular savings account in a money market instrument.
Variable policies are recommended only for experienced investors.
Advantages and disvantages
Each type of insurance has advantages and disadvantages. Remember that your life insurance needs will change over your lifetime, and insurance policies and provisions will change, too.
Consider these suggestions:
• Determine your family’s insurance needs. Decide who should be insured and how much you can afford now to have insurance protection in the future.
• Decide whether you want pure protection or protection plus a savings program. However, remember that the primary purpose of life insurance is to protect your family from financial loss if you should die. You can receive a higher return on investments from other financial tools.
• Select an insurance agent who is qualified to provide professional and personal service in helping you make important financial decisions.
• Review your insurance needs at least annually and more often when there are major family changes, such as marriage, birth, etc.
• Select a policy you can understand.
Policy provisions and settlement options
Most individual life insurance policies include provisions to pay benefits to the insured prior to death. These include the following:
Cash dividends—Surplus earnings of the insurance company are the difference between the premium charged and the company’s cost of providing insurance. In participating policies, these earnings are returned to policy holders as dividends. Policies that do not pay dividends are called non-participating policies. Both stock and mutual insurance companies distribute dividends to their policy holders.
Policy holders of participating policies may select how they receive the dividend. Options include a cash payment at the end of the year; leaving the dividend with the insurance company to earn interest until retirement, when the funds can be used to buy an annuity; or using the fund to buy small amounts of paid-up life insurance.
Grace period—By law, insurance companies are required to provide a grace period, usually 31 days after each premium due date, in which an overdue premium can be paid without a lapse in the policy. All provisions of the policy remain in effect during the grace period.
Nonforfeiture values—A cash surrender value accumulates in a cash-value policy after premiums have been paid for several years. The policy holder can receive this amount if the policy is canceled. Nonforfeiture values protect the insured from losing the accumulated cash value if the policy is cashed in or lapses.
Settlement options are the choices the beneficiary or the insured has regarding the form of payment of the death benefit of a life insurance policy. The insured may choose the form, or the beneficiary makes the choice after the insured’s death.
If a lump sum is chosen, the insurance company pays the funds, usually within two weeks, upon receipt of the death certificate.
The other four options—interest income, income for a specific period, income for life or income for a specific amount—allow the funds to be left on deposit with the insurance company. The funds earn interest and are paid to the beneficiary according to the terms of the option chosen.
Interest income—The beneficiary receives the annual interest earned from the death benefit. The death benefit remains on deposit with the insurance company until the death of the beneficiary, when it becomes part of his or her estate.
Income for a specific period—This option requires the insurance company to divide the death benefit into an equal amount of income for a specific number of years, exhausting the fund and interest at the end of the specified time.
Income for life—The beneficiary receives an income as long as he/she lives. The insurance company calculates equal annual payments so the funds should be exhausted by the expected date of the beneficiary’s death, based on average life expectancy. Income payments continue if the beneficiary lives longer than expected.
Income of a specific amount—The beneficiary receives a specific amount of income from the fund each year until the death benefit and interest are spent.
Choosing the right type of policy and understanding its provisions can help assure you are not over- or under-protected with insurance.
(This article was produced by Purdue Extension, part of Purdue University in West Lafayette, Ind.) †