Many of us do not start thinking about life insurance until we get our first full-time job and the company's human resources representative asks us if we want to enroll in the employer's group life insurance policy. Most people think “Why not?” and sign up, naming a family member as the beneficiary of their policy, and then never give it another thought. Although this may be a good start, too few of us spend any more time thinking about that life insurance policy.
What Is Life Insurance?
In it simplest form, life insurance is a contract between two parties, usually an individual and an insurance company. In this contract, the insurance company agrees to pay a specified sum of money (known as the death benefit) to the beneficiaries named in the policy upon the insured person's death. Generally, the intent is that the death benefit is to replace the economic loss that would otherwise be incurred by the beneficiaries because of the insured's death. In exchange for the death benefit, the individual who purchases the policy (the owner) agrees to pay premiums to the insurance company for a specified period of time, up to a specified amount, or both.
The right kind of life insurance, when properly understood and carefully coordinated with your estate planning, can provide significant economic benefits and peace of mind for you and your loved ones should you pass away sooner than expected. But there are numerous types of life insurance, and you should become familiar with the primary varieties and know when to use them.
Types of Life Insurance
Term insurance. Term insurance will pay the death benefit only if the insured dies within the specified period (term) spelled out in the insurance contract. For example, if the policy is for a 10-year term but the insured dies in year 11 (after the 10-year term has ended), no death benefit is payable to the beneficiaries. This type of insurance is generally more affordable than other types of policies and is designed primarily to protect the insured's beneficiaries should premature death create economic hardship within the specified term period.
Whole life insurance. Whole life insurance typically guarantees a consistent premium throughout the life of the contract, but the premiums are typically higher than term-life premiums because the insurance company maintains a reserve that helps keep the premiums level during the insured's life. This reserve is an accumulated cash value within the policy that the policy owner can borrow against or cash out if they choose to terminate the contract before they die. Different varieties of whole life insurance have unique features that can be customized for particular situations.
Universal life insurance. Universal life (UL) insurance policies are interest-sensitive policies that can result in higher death benefits and cash value over the life of the policy, depending on a variety of investment, expense, and mortality factors that are built into the contract. With the potential for greater gains in cash value, however, comes the potential for greater risk in the buildup of cash value. If the policy's underlying investment assets perform poorly and the cash value buildup is insufficient to cover the expense charges and mortality costs, the policy will terminate. However, compared to whole life policies, UL policies are generally significantly more flexible with regard to making premium payments from year to year and withdrawing cash value. Therefore, depending on your circumstances, the type of cash flow you anticipate, and the risks that you are insuring against, a UL policy may be appropriate. As with most insurance policies, you will find limitless varieties from insurer to insurer.
Variable life insurance. Variable life (VL) insurance policies are very similar to traditional whole life policies except that in VL policies, neither the death benefit nor the surrender value of the policy is guaranteed. In addition, either the death benefit or the surrender value, or both, can increase or decrease depending on the performance of the policy's underlying investments. However, each VL policy typically has a minimum death benefit so that, even with poor asset performance, the beneficiaries receive a payout at the insured's death. These policies are unique because of the control that the policy owner has over the types of investments underlying the policy. The policy's cash value can be invested in varying degrees in stocks, bonds, real estate, and money market portfolios. Policy premiums are typically fixed, but depending on the underlying assets' performance, the cash value can fluctuate from day to day. As with other life insurance products, the death benefits are income tax-exempt. The earnings on the assets and the accumulated cash value in the policy are income tax-deferred until after the policy has been surrendered. In addition, the policyholder can also borrow up to a certain percentage of the policy's cash value if they need cash for a period of time (although interest is charged while the loan is outstanding).
Variable universal life insurance. Variable universal life (VUL) insurance is, as the name indicates, a hybrid of variable life and universal life insurance, with many of the most desirable features of both types of insurance built into the contracts:
- flexible premiums,
- adjustable death benefits,
- control over the types of investments within the policy,
- the ability to borrow against the cash value, and/or
- partial withdrawal rights.
Both VUL and VL policies are subject to Securities and Exchange Commission (SEC) regulation because of the flexibility of their investment options.
Survivorship life insurance. Sometimes called “second-to-die” life insurance, survivorship policies can be used when the need for an infusion of cash (the death benefit) is necessary only at the death of the second of two individuals (such as a married couple). These policies can be term, whole, universal, or variable, depending on the policyholders' need. Survivorship policies are particularly useful when a married couple owns significant real property that they want to keep in the family after the second spouse dies, and the family would rather pay estate taxes from the life insurance proceeds than generate the cash to pay the taxes by selling the property.
First-to-die life insurance. First-to-die policies allow the death benefit to be paid upon the death of the first of two insured individuals. Insuring two individuals instead of one costs less than the total premiums for separate life insurance policies on the same two individuals. For example, these policies can provide a surviving business partner with the cash necessary to buy the deceased partner's share of the business from their spouse or family.
Single premium whole life insurance. Single premium whole life insurance allows an individual to purchase, with a single cash payment, a specific amount of insurance to cover the remainder of their life. As with typical whole life, the insured can borrow against the policy's cash value or surrender the policy. There may be income tax consequences for surrendering the policy, but as with most other life insurance policies, there can be significant income tax protection if the policy matures and pays out at the insured's death. Also, in some states, the cash value of life insurance can enjoy significant asset protection against future creditors' claims, thus making investing in life insurance more attractive than other types of investments.
Which Type of Insurance Is Best for You?
With all of the choices available in the life insurance world, considering what type of insurance is best for your situation can feel overwhelming. If you are a young couple just starting out and you do not have much spare income, it may be best to shop for some term insurance that will provide a cash payment that allows your surviving spouse to pay off the home and have sufficient income until they can provide for themselves on their own.
If you are a middle-aged working professional with a family, you may want to consider purchasing a much larger term life policy or even a whole life policy that has a guaranteed death benefit as long as you keep paying the premiums. This option can be important if there is a chance that you could develop a chronic illness, such as diabetes or cancer, that would disqualify you from obtaining a new term policy when your old term policy terminates.
If you have a large estate with significant assets that would be difficult to sell, such as a successful business or real estate, a second-to-die or first-to-die policy might be a better option for ensuring that there is sufficient cash upon the death of one or both of you and your spouse, or business partners, to pay taxes or to buy out a deceased partner's business interests.
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The bottom line is that life insurance policies come with a huge variety of options because families and individuals have an endless variety of circumstances. Ask your insurance professional, financial advisor, and estate planning attorney to help you identify the risks that you may be facing that could be reduced by using a carefully crafted insurance policy, coordinated with your estate planning, to meet your unique needs. Insurance can be complex, but you do not have to go it alone.