All types of life insurance policies ultimately serve the same purpose: providing money for your survivors upon your death.
Three of the four types of life insurance policies arrive at the same end point — a set benefit for your beneficiaries — in different ways. The fourth type of life insurance, variable life, is a bit more complicated among life insurance policies.
The differences between each of these life insurance policies can affect the amount of your coverage, your cost, and how they grow cash value. The four types of insurance were each designed to meet certain needs, making none better than the others. Ultimately the best type of life insurance is the kind that satisfies your needs.
Group life insurance vs life insurance policies
The four types of life insurance policies discussed here are individual policies, meaning they’re paid for by you. Group life insurance on the other hand is usually provided by your employer, union or trade association as a part of your benefits package.
Unlike your individual insurance you won’t have much control over your group insurance beyond the amount (within limits) of coverage. It’s important to understand that because group life insurance is linked to your job, if your employment ends so does your insurance.
Here are four types of life insurance policies you have more control over because you buy them:
Term life
Term life insurance provides coverage for a specified period of time (term) and then it ends. The periods of time covered by term insurance can be from one to 20 years.
Term life insurance is sometimes referred to as pure insurance because it doesn’t accumulate cash value or provide benefits other than the death benefit. The cost of term life insurance is based on your age and your health making it is less expensive when you’re younger.
Pros
- You get the most insurance for the lowest cost.
- It can be used to provide protection for a period of heightened concern, such as while your children are young.
- You have the option to renew for an additional term without proof of insurability.
- You may have the option to convert it to permanent insurance without proof of insurability.
- Your death benefit is not taxable.
Cons
- Renewals and new policies increase in price as you get older.
- The cost of renewals may become too great when you are older making coverage unaffordable.
- It is not permanent and if you do not renew or convert your policy you lose your coverage.
- It does not grow any cash value.
Whole life
This is a permanent type of insurance providing coverage for your entire life. It remains in force as long as your premiums are paid. It can only be cancelled for non-payment or fraud and can not be cancelled if your health changes.
You decide the amount of the death benefit at the time you buy the insurance and that amount remains constant throughout your life. Whole life accumulates a cash value that you can borrow against, with any un-repaid loan balances at the time of your death subtracted from the death benefit.
Your cash value grows because only a portion of your premiums are used toward the cost of insurance and the remainder is cash and earns interest. Some insurance companies may also pay dividends which are also added to the cash value. Interest and dividends accumulate tax free.
Premium rates are based on your age and health at the time you apply for the insurance. While whole life premiums will be higher in your younger years than term they will not increase as you get older.
Pros
- Your premiums never change.
- Your cost will be lower when you are older.
- Protects you for your entire life without having to be renewed.
- Cash values grow at a guaranteed rate.
- Cash value interest and dividends are tax free until they are withdrawn.
- Your death benefit is not taxable.
Cons
- Your cost may be higher then term insurance when you are younger.
- Your dividend payments are not guaranteed.
- Your cash value will accumulate slowly in the first few years.
- Higher agent commission rate than term insurance.
- Requires a long term commitment.
Universal life
Like whole life this type of insurance combines permanent term insurance with a cash value component and that is where the similarity ends among life insurance policies.
When you make premium payments on a universal life policy they are placed in an insurance company managed investment fund. This is unlike whole life where only a portion of your premium goes toward cash value.
Each month, money is withdrawn from your account to pay your term insurance premium. The term insurance associated with this type of insurance is perpetually renewable so there is no need for you to reapply for coverage as long as there is enough money in your account to pay for your insurance.
Mutual fund administrative fees and insurance company overhead costs are also deducted from your account balance on a regular basis. Like all money market accounts these are subject to changes in the market. Rising interest rates will cause your cash value to grow faster while falling interest rates will cause it to grow more slowly or get smaller.
Universal life insurance policies are more flexible than whole or term life insurance policies because premium payments may be skipped as long as there is enough money in your account to cover the term insurance premium.
Pros
- Earnings on the investment fund component are tax-deferred.
- You may be able to skip payments or stop them permanently based on your policy’s cash value.
- You can vary the amount of your payments.
- You can borrow against the cash value.
- You can change the amount of the death benefit up or down.
- Your death benefit is not taxable.
Cons
- When interest rates go down your premium may increase.
- Your premium may go up as you get older because of the increased cost of term insurance.
- Administrative and management fees are front-loaded, causing your cash value to grow slowly in the first few years.
- The death benefit is decreased by the amount of your outstanding loans.
Variable life
This is a hybrid insurance and investment product and can only be sold by individuals who are both a licensed insurance agent and a registered broker, licensed by the National Association of Securities Dealers (NASD) to sell life insurance policies.
Unlike the three other types of life insurance policies, variable life does not always have a permanent, guaranteed amount of insurance coverage.
This hybrid product was developed to offer a way of having insurance protection keep pace with inflation. It works by having the amount of your life insurance tied to the value of your investments in your life insurance policies. If your investments increase in value so does your insurance and if they decrease in value your life insurance death benefit decreases.
When you buy a variable life policy you are generally given choices of what types of investments you want to participate in. Your options may include funds such as money market, and stock or bond funds. The volatility of these types of investments means there is always a risk that your cash value of your policy may go down to zero.
Pros
- You have control over how your cash value is invested.
- Earnings are tax deferred.
- If your investments do well, your cash value and death benefit can increase substantially.
- Your death benefit is not taxable.
Cons
- If your investments perform poorly your death benefit may go down.
- Administrative and management costs may be high and can lower the return on your investment.
- You can be very limited in how you can borrow against the cash value.
It’s important to realize the “cost” of insurance stays very stable throughout our lives. Notice I did not say the premium. Older people pay more premium because statistically they’re closer to death. Younger people pay a smaller premium but the company has their money longer and statistically they are further away from death. So waiting until your older really doesn’t matter as long as you still can qualify for the coverage at standard rates. If you are not a prodigious accumulator of wealth (and you know who you are) you may want a small whole life policy and the rest in term until you no longer need the term coverage. But if you spend or invest much of the money which gets into your hands, someone upon your death, would like that small policy to cover your final expenses and not have to liquidate investments in a hurry. No, perhaps it’s not the best or cheapest deal but it’s psychological and you’ll be doing “the right thing.”
All in all, pretty good. But there are a couple of points that I need to raise. 1) Term policies are not always guaranteed renewable. Some do, some don’t. It’s a company by company decision. 2) It’s the same with convertibility; some do and some don’t. To pick on an easy target…The term policy purchased while dealing with Primerica is not convertible. They are strictly “Buy term and invest the difference.” crowd. 3) You failed to note Variable Universal life and Indexed Universal life. While VUL does require a securities license to sell, Indexed Universal doesn’t. As to the benefits of these two, we will leave for another day.
Overall, I thought it was a well written article.
Very helpful summary! As we near retirement age after losing our shirts (and home) during this recession, we are without ny life insurance protection and need to address that next. We used to have an Annuity that seemed like a good replacement for providing monthly income. Time to find someone who specializes in investment tools that provide a reasonable income I think (which is, of course, not insurance, but achieves the same thing, don’t you think?