Why Life Insurance

The answer lies in one word — risk. The purpose of life insurance, as with all forms of insurance, is to provide protection from loss by transferring the risk associated with that loss to someone else, i.e. the insurance company. With life insurance, the loss we are generally trying to protect ourselves from is the loss of income in the event of the death of a family provider. In addition to income replacement, life insurance is often purchased to pay expenses including home mortgages and estate taxes that may exist after the insured dies, as well as funeral costs.

Many people may think that during tough economic times, life insurance is something that can be cut. However, life insurance is more important than ever in a bad economy since most plans offer guaranteed coverage amounts that are not dependent on the economy for performance. It is also important to note that death benefits from life insurance are not taxable under current law

TYPES OF LIFE INSURANCE

The insurance industry offers an array of products, each designed to satisfy a particular requirement in the marketplace. In fact, the variety of products coupled with the unique jargon associated with the insurance industry can make the task of simply understanding insurance options a bit daunting. We will try to keep our discussion simple and straightforward.

The three most popular types of insurance sold are term, whole life, and universal life. We will focus on these first, and then we will examine some of the other types of life insurance including variable, group, and multiple life policies.

Term Life Insurance

Term life insurance offers protection for a stipulated period or term. The policy may be renewable annually, or it may be issued for a fixed period, say 5, 10, or 20 years. The face amount of the policy is payable only if death occurs within the period that the insurance is in force.

Most term policies are sold with a renewability clause which allows the policyholder to successively extend the insurance coverage up to a specified termination point which is usually 65 or 70 years of age. Also, many term policies have a convertibility feature that allows the holder to exchange the term policy for another type of life insurance program. The renewability and convertibility features associated with term insurance can generally be implemented “without evidence of insurability.” This means that if an individual takes out term insurance when he or she is healthy and then becomes terminally ill, the renewal or conversion of the insurance cannot be denied based upon the current adverse medical condition. Term policies issued for a fixed period of time may not have conversion options available at the end of that time. If they do have conversion options, it will be at an increased cost.

Term policies may be either decreasing or level. These words refer to the death benefit provided. Decreasing term policies provide a reduced amount of coverage for the same premium cost at each renewal period. For example, let’s say you bought a $100,000 policy at age 35 for $200 a year. By the time you are 50 years of age, you will continue to pay $200 a year but the insurance coverage will have decreased to approximately $50,000. Decreasing term policies were once very common but have become rare as level term has become more competitive.

With level term policies, the amount of insurance coverage remains the same over a period of time, however the cost of the insurance increases as you get older. Some policies have renewal periods in which the premiums change at each specified period. The premiums start very low at age 25 or 30 and increase at five-year intervals for the life of the policy. A more popular version of level term insurance is one in which the amount of coverage and the premiums are fixed over a period of 10, 15, 20, or 30 years. This type of insurance is referred to as “fixed level term” and enables the individual to buy term insurance to fulfill their needs over an extended period. These programs usually are available in three rate classes: preferred, standard, and smoker. Preferred rates are the lowest and offered to those with the more healthy lifestyles while smoker rates are the highest for all age categories. Rate categories may vary from company to company and include additional categories of preferred like super-preferred, as well as ratings for certain occupations or hobbies.

So what is the bottom line on term insurance? Generally, for a younger person term insurance is the least expensive form of insurance coverage. It is designed to furnish basic protection against the risk of death and is comparatively inexpensive when purchased at a point in life when the probability of death is low. Term policies do not include additional characteristics such as the accrual of cash value. While cash value is a useful feature contained in many types of policies, it can significantly increase the premium charge.

Whole Life Insurance

Unlike term insurance, which is intended to provide protection for a specified period of time, the purpose of whole life insurance is to provide protection for the duration of an individual’s life. It is called permanent insurance because the amount of insurance coverage and the premium charged generally remain constant over the life of the insured. In addition to providing death protection, whole life policies contain a savings feature called cash value. The idea behind cash value is to provide the insured with some type of tangible benefit while they are alive in return for the insurance premium charges they are paying. The benefit is in the form of a savings program which generally carries a guaranteed minimum level of interest return. Consequently, the cash value of a policy will build up over time. Since the actual cost of insurance increases with age, the buildup of cash value is also used to fund these increased charges later in the life of the insured.
Based upon the duration of the premium payments, there are three types of whole life insurance — ordinary, limited payment, and single payment.

Ordinary Life

Under ordinary life (also called straight life) policies, level premium payments are made on a periodic basis over the life of the insured. The earlier in life the policy is started, the lower the periodic payments will be. However, all things being equal, the earlier you start the coverage the greater will be the total payments that you make into the policy. Of the various types of whole life policies available, ordinary life offers the most death protection and the least savings buildup. Consequently, most insurance advisors agree that when death protection is the principal objective, the ordinary life policy represents the best choice for families who are filling their permanent insurance needs.

Limited-payment Whole Life

Limited-payment whole life also provides insurance coverage over the life of the insured. However, it schedules level premium payments for a specified period, generally 20 or 30 years. These are called 20 payment or 30 payment whole life policies. One advantage of limited-payment policies is a faster buildup of the policy’s cash value feature. A disadvantage is higher premium costs. In fact, because of their higher premium costs, limited-payment policies are not well suited for those who want permanent insurance and whose personal circumstances require a high level of protection at a time when their income level is relatively low. The insurance needs of people in this category are better served through an ordinary life or term insurance program. Limited-payment whole life is designed for those individuals who already have enough insurance in force to protect against income loss, but who are seeking additional insurance that will also provide a supplement to their personal savings or retirement plan.

Single-payment Whole Life

Another type of whole life policy is called single-payment whole life. With this type of policy, insurance is purchased through a one time cash payment made at the beginning of the insurance contract. This is different from ordinary life and limited pay life which provide for the payment of premiums on an installment basis over an extended period of time. An advantage of a single-payment whole life program is the immediate availability of substantial cash and loan values. Since the single premium cost is relatively expensive, these programs are generally of limited usefulness in the life insurance plans of most families. However, the investment attributes of these programs may make them useful for those individuals who are looking for a tax sheltered investment vehicle which simultaneously provides a degree of insurance protection.

So what is the bottom line on whole life? The biggest advantage of whole life is that these policies provide protection and allow the accumulation of an estate regardless of how long the insured lives. If he or she dies prematurely, the value of the policy will be paid to the beneficiaries. If the insured lives a long life, the buildup of cash value provides a source of funds which can be accessed through borrowing, policy cancellation, and fund withdrawal or conversion to a paid-up policy. Another benefit of whole life is that it allows individuals who need a lifetime of insurance to budget their payments over a relatively long period, thereby eliminating potential problems of uninsurability and the high cost associated with term policies in the later years.

Universal Life Insurance

Universal life is similar to whole life in that it provides both death protection and a cash value savings feature. With whole life policies these features are merged and the allocation of premiums between these benefits is not distinguishable to the policyholder. In universal life policies, the cost of death protection and the investment in the cash savings feature are separated.

Universal life is available with either a level death benefit or an increasing death benefit. With a level death benefit you have a fixed amount of protection, i.e. $100,000, which is the face amount of the policy. The increasing death benefit combines the face amount of the policy and the cash value for a total death benefit.

The cost of insurance protection provided by universal life policies is similar to term insurance — that is, the cost will increase as the policyholder gets older. The cash savings component earns tax-deferred interest at market rates and generally includes a guaranteed return. If all the cash value remains in the policy until the death benefit is paid, the interest earned is not taxed since the death proceeds of a life insurance policy are not considered taxable income of the beneficiary.