Wednesday, May 12, 2010

Types of Life Insurance

In the previous article I suggested most of us have the wrong amount of life insurance. That said, many of us may have the wrong kind as well. Currently you can buy four major types of life insurance: Term Life, Whole Life, Universal Life and Variable Life. They are not totally separate species so they interbreed and produce subspecies like Universal Variable Life.

Term Life     This is the pure insurance form. For a specific number of years (the term) you pay a specific dollar amount to purchase a specific face amount of life insurance. If you pay your premiums and you die during the period, the insurance company pays the full face amount. Terms can be as short as one year and as long as twenty. During the term period the life insurance company can’t cancel the policy or raise their rates, even if you are on death’s door. Each year we age, life insurance becomes more expensive because more people in our age-cohort are expected to die. Consequently, whenever the term is greater than one year, the rate you pay is an average rate to cover the whole term. You pay a bit too much in the early years and are getting a break in later years. On average the insurance company is still making money.

Whole Life     Think of this as term insurance that lasts your “whole life.” AS with term insurance, for whole life policies the insurance company can’t cancel the policy as long as you continue to pay premiums on time, it pays off whenever you die and your premium remains constant.

Because the premium will last your whole life (usually they stop when you reach a defined age, like 100) the amount you pay in the early years far exceeds the cost of pure insurance. To make that attractive, the policy calls for investment of the “excess” premium in a Cash Value Account. The cash value account grows, often based on arcane formulae related to the insurance company’s investment earnings and typically has a low minimum guaranteed interest rate. Over time, the policy may pay dividends that you can apply to reduce the premium or (preferably from the insurance company’s standpoint) increase the amount of life insurance.

Starting to get confusing right? Whole Life is a combination of Term Life and an investment product. Depending on interest rates, tax policy, and a host of other characteristics it can be a good investment or a bad investment, but it is important to realize it is an investment. Life insurance companies understand this and they pay their brokers a lot more commission to sell you a Whole Life policy than a Term Life Policy.

Universal Life     Think of Universal Life as a life insurance policy with the extra advantage that you can make additional contributions to the Cash Value Account, which will earn market interest rates based on the insurance company’s investments in bonds and (often) mortgages. You can apply returns on the Cash Value Account to reducing future premiums, building up extra cash values or purchasing additional insurance.

As you can see, this product moves farther away from pure insurance and more toward an investment. Under current law, tax advantages are available, but periodically as Congress looks for ways to cut deficits, these tax “loopholes” come under fire.

Variable Life     For the first three types of life insurance, the amount of insurance remained fixed, unless you use policy dividends to purchase additional insurance. Variable life changes that dynamic. You pay premiums that are invested in investment vehicles you choose from a selection that includes stocks and bonds. Your Cash Value Account can decrease as well as increase and the amount of life insurance you have in effect depends on the value of the account. This product is mostly an investment tail wagging the life insurance dog.

What else?

Oh gosh, I haven’t touched on the ability to borrow from your Cash Value Account and the myriad ways that affects your death benefit, or future premiums, or how some policies allow you to automatically increase coverage at certain periods in time and … There is nothing simple about life insurance products once you move away from Term Life. That’s how insurance companies try to differentiate themselves and brokers justify their commissions. If everything were transparent insurance companies would have to cut their profits to compete on costs and service. Well, that’s a rant for another day.

From the previous post we saw that our insurance needs do not remain constant over our lifetimes. Only by great luck will one policy be a good fit all of your life. Many people end up cancelling their Whole Life or Universal Life or Variable Life policy because they don’t meet their needs. This is an expensive proposition because you’ve paid your insurance broker much of his commission from the first years’ premiums.

If you need life insurance, buy term. If you want investments, choose the best one. Sometimes, because of tax advantages, an insurance product may be the best investment vehicle. Sometimes. My money is mostly sitting in mutual fund companies.

As you can guess, your local insurance broker isn't sponsoring this blog.

~ Jim

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