Types of Life Insurance Explained
It's natural to want to provide for your family after you're gone. Figuring out how to do it is the tricky part. In the event that you pass, life insurance can not only cover expenses for a mortgage, funeral costs and college tuition, but it can also help you build wealth during your lifetime.
In fact, life insurance is a versatile financial product that can help you meet a range of different goals. A big part of your decision when buying life insurance is to match your goals with the right type of life insurance policy.
This article will give you some background on the different types of life insurance that are available and what they can do for you.
The following topics will be covered:
Types of Life Insurance
When you start shopping for life insurance, you'll quickly find you have lots of types of policies to choose from. Some of the names you'll hear thrown around are:
If having so many choices seems a bit confusing, the best place to start is by understanding the difference between term and whole life insurance.
Term life insurance offers coverage for a specified number of years. Term life insurance only pays a benefit if you pass away during the term specified in your life insurance policy. The death benefit would go to a person of your choosing, known as a beneficiary.
Whole life insurance does not have a time limit. As the name suggests, it insures you for your whole life, as long as you keep paying the premiums.
In addition to paying a death benefit to your beneficiary when you die, whole life insurance often accumulates some cash value that you can leave to loved ones or tap into yourself during your lifetime.
Common Types of Life Insurance
Benefits Paid Within a Limited Term
Benefits Paid Whenever You Pass Away
Potential Cash Value in Addition to Death Benefit?
Lowest cost option?
Term Life Insurance
Whole Life Insurance
Universal Life Insurance
Guaranteed Universal Life Insurance
Variable Universal Life Insurance
Indexed Universal Life Insurance
Term Life Insurance
The most basic types of insurance are those where you pay a premium to protect your family from an unforeseen death. If you pass away while your policy is active, it pays a cash benefit.
If you live, you won't get anything in return for your premiums. You can renew your policy, however, usually at a higher rate and for a new set term.
Suppose you have a 20-year term life insurance policy. During that 20 years you will have to pay monthly premiums on the policy. If you die during the term, a death benefit will be paid to your chosen beneficiary. If not, you have the option to renew.
Advantages of term life insurance
The advantage of term life insurance is that because a payout isn't certain, the premiums are cheaper. You can also make sure you're covered for a set period of time, like while your children are still in school.
Disadvantages of term life insurance
The disadvantage is that if you do not die during the term, you won't get anything in return for all the money you've paid into your policy. There's no cash value to term life insurance and no death benefit after the term expires. It's also more expensive to renew because your likelihood of dying during the policy term are higher.
Who term life insurance may be right for
A term life insurance policy can make sense for a young working family. During the early years of your career, money may be tight so those cheaper premiums could be a budget-friendly way of getting life insurance.
The hope is that by the time the policy's term expires, you will have accumulated some wealth for your family to live on and your children are older, so a cash value on a life insurance policy is less important.
Whole Life Insurance
Whole life insurance is something you keep paying into for as long as you want to keep the policy active. So long as you keep paying into it, the policy will pay a benefit when you die.
Meanwhile, the policy will accumulate a cash value over time that you can tap into. This is in addition to the death benefit.
Advantages of whole life insurance
A good thing about whole life insurance is that it guarantees you'll get something out of it as long as you keep the policy active. If you keep paying your premiums there will be a death benefit when you die, no matter when that happens. For this reason, whole life is sometimes called permanent life insurance.
Also, as time goes on your policy may build up a cash value. You can borrow against this cash value or cash it in (this would mean no more death benefit).
Disadvantage of whole life insurance
The main disadvantage of whole life insurance is that it is typically more expensive than term life insurance. That's because the insurance company knows for sure it's going to have to pay a benefit eventually.
Also, while accumulating a cash value, a whole life insurance policy can function as a form of long-term savings account, but do note that you may be able to grow your money faster by investing it in other ways.
Who is whole life insurance right for?
Families with plenty of discretionary income should be able to better afford the higher premiums typical of whole life insurance.
Also, people with long-term dependents may find whole life insurance to be a good fit because the coverage does not expire after a set number of years.
Universal Life Insurance
Universal life insurance has some characteristics in common with whole life insurance, but with some added flexibility with regard to premiums, benefits and how the cash value is handled.
With universal life insurance, you can adjust the death benefit over time by raising and lowering the premiums you pay. This can be useful in helping a family tailor their insurance to their changing needs and circumstances over the years.
You can also apply some of the cash value the policy has built up towards those premiums, lowering your out-of-pocket costs.
Universal life policies also give you choices with respect to how the cash value of your policy grows. Some popular examples are described below.
Guaranteed universal life insurance
Guaranteed universal life insurance policies lock in the rate at which the cash value will grow.
That growth rate is determined by prevailing interest rates. In recent years, those rates have been quite low. So, this approach is for people who favor certainty over higher growth potential.
Indexed universal life insurance
If you are looking for more of a growth potential to the cash value of your life insurance policy, indexed universal life insurance may be an option to consider.
This type of policy invests a portion of your premiums in a market index. The S&P 500, which consists of stocks in large US companies, is a common example.
The better that investment index does, the faster the cash value of your policy will grow. This gives you more growth potential than a guaranteed universal life policy. Of course, market indexes don't always go up so there may be no growth at times.
An important aspect of this cash value growth component is that insurance companies often limit it in two ways:
Participation rate: this is a percentage of the market index increase that your cash value will get. For example, if your policy gives your cash value a 75% participation rate, you'd get only three-quarters of the market's rate of return.
Gains cap: Besides giving you only a portion of the market's increase, a life insurance policy may also put a ceiling on how much of a gain your cash value could have in any given year. So, if your policy had a cap of 12%, your cash value couldn't rise by more than than in any year regardless of how much the stock market went up.
Depending on the limitations, you may earn more by buying a policy with lower premium and investing the extra cash elsewhere.
Variable universal life insurance
Variable universal life insurance has growth characteristics in common with indexed insurance. Instead of investments being tied to a specified market index though, a variable policy allows you to choose from a range of different investment options.
Like an indexed policy, this kind of variable policy may be subject to a participation rate and gains cap that limit the growth of your cash value.
Also, your growth will depend on the success of the investment options you choose.
Types of Life Insurance by Underwriting
Underwriting is the process insurance companies go through to assess the risk of a given policy. The more an insurance company knows about the situation, the more accurately it can price its premiums.
The less information an insurance company has, the more inclined it will be to cover its risk by charging generally higher premiums.
When it comes to life insurance, the insurance company's risk has a lot to do with the policyholder's health. There are three different underwriting levels, based on how rigorously the insurance company will assess a person's health before issuing a policy:
Full underwriting involves a detailed medical exam plus questions about your habits and family medical history. If you're healthy, don't have any excessively unhealthy habits and come from a long-lived family, the insurance company will feel comfortable issuing you a policy at a lower premium. So, full underwriting can pay off if you are in good health.
Simplified issue substitutes a questionnaire about your health, habits and medical history for a full medical exam. In exchange for having less detailed information, insurance companies will generally charge more for a policy issued this way.
Guaranteed issue means the insurance company will give you a policy with no questions asked. The drawback is that if you're healthy, you'd probably pay less for a policy with full underwriting than for one which doesn't take your health into consideration.
Other Types of Life Insurance
Here are some brief descriptions of other types of policies you may hear about:
Burial insurance/final expense insurance. These are policies which pay relatively low benefits - perhaps enough to cover a funeral and any other final expenses.
Mortgage life insurance. This type of policy pays your mortgage company the balance you owe on your mortgage when you die so your family's house will be paid for.
Joint life insurance. This is a policy shared by a married couple. Benefits can go either to the surviving spouse after the first one dies, or to another beneficiary after the second spouse dies.
Group life insurance. These are policies offered as benefits by some employers. Because the risk is spread among the participating workforce, these policies are often more cost-effective than buying insurance individually. Plus, employers providing this benefit generally pay some or all of the premium.
Accidental death and dismemberment insurance. In addition to providing a death benefit if you are killed in an accident, this kind of policy could also pay out if you sustain catastrophic injuries in an accident.
Can I Have More Than One Life Insurance Policy?
Absolutely. You may want to add or subtract coverage over time as circumstances change. Also, if you're using insurance in part as a savings strategy, you may want to diversify your investment approach with policies that use different strategies to grow cash value.
Another reason to have more than one life insurance policy is if your employer offers group life insurance. You might want to take advantage of this benefit but also supplement this coverage with your own life insurance policy.
Whether it's through one policy or multiple policies, you may find there are limits in the total dollar amount of coverage you can get. This will be based on your age, income, net worth, health and other factors.
Life Insurance FAQs
When should I get life insurance?
Buy life insurance as you can afford it, especially if you have dependents. People who are young and healthy have a tendency to feel they don't need life insurance yet, but in many ways that's the best time to get life insurance. You have more future income to replace when you're young, and probably have only a small savings for your family to fall back on. Also, life insurance is usually cheaper at that stage of life.
How much life insurance do I need?
A good guide to this is the essential expenses of your household. At minimum, your goal should be to provide enough coverage for your family to make ends meet until your kids are grown up and/or your spouse reaches retirement age.
When should I think about changing my life insurance policy?
Any event that materially changes your finances should be a cue to reassess your life insurance coverage. This can include a raise, job change or having a child.
Shopping for Life Insurance
There are various types of life insurance coverage and costs vary too. Here's how to make the most of those choices:
Begin with the choice between term and permanent life insurance, and decide which best fits your budget and situation.
Then within those major categories, look at the specific coverage options to see how to tailor a policy to your needs.
Decide which type of underwriting best fits your likelihood of qualifying: full underwriting, simplified issue or guaranteed issue.
Consider whether you might also need insurance for a very specific purpose, like burial insurance or mortgage insurance.
Once you know exactly what you want, compare quotes to find the best deal on your choice of policy.
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