The Different Types of Life Insurance

The life insurance landscape is confusing, to put it lightly. One can get lost in the different types of policies and terminologies, such as whole life, term life, cash value, variable life, and a lot more. If you want to purchase life insurance, you need to first understand the different types, how they work, their cost and which type is right for you and your lifestyle. They fall under four basic types: term, whole, universal and variable.

But how do you make sense of all the different types to ensure that you are picking the correct and best one? Here’s a quick breakdown of the four most common types of insurance policies.

Types of Life Insurance

There are two time-frames over which you can buy life insurance – a stated term or the rest of your life. Insurance that provides benefits over a stated term is known as term life. Permanent life policies provide benefits for the rest of your life (as long as you continue to make premium payments). There are three common types of permanent life insurance – whole life, universal life and variable life.

Term Life Insurance

Term life protects the insured for a pre-determined number of years which is usually any period from 10, 15, 20 or 30 years. The length of time the insurance is in effect is the “term” of the policy. When the term ends, the policy can be renewed on an annual basis as long as the premium is paid. Most insurance companies allow the policy owner to renew until the age of 95, after which point the probability of dying is so high as to make the cost of the insurance almost the same as the death benefit. The life insurance offered by employers is usually term life with a term of one year.

Term life is the most popular type of life insurance and the most affordable. Many financial advisors recommend that you buy term life insurance instead of whole life insurance and use the money you save to invest. But remember that this is a piece of general advice and not specific because you should first consider your own needs and personal situation. What product is most appropriate for you will depend on many things.

Here are the main strengths of term life insurance.

Flexibility

Life insurance will provide cash for your beneficiary so your family can deal with the negative financial consequences of your death. Term life insurance policies are very flexible in that they easily adjust to the policyholder’s needs.

Death Benefit

Beneficiaries do not pay income taxes on death benefits from life insurance. If the policy is properly owned, the death benefits can also be free from estate taxes.

Whole Life Insurance

When you buy traditional whole life insurance, the death benefit and the premium stay the same throughout the term of the policy. As indicated in the name, the term of a whole life is your entire life or until you stop paying the premium.

As you get older, the probability that the death benefit will be paid increases leading to increases in the amount of premium needed to pay for the death benefit (as would be seen in the premium increases you would pay if you bought a series of one-year term life insurance policies). You can imagine that the cost gets very high if you live to 80 years old or more. The insurance company could just assign a premium for term life insurance that goes up each year but it will come to a point that it will be very expensive for people at advanced ages.

Under a whole life policy, the insurance companies keep the premium level by charging a premium that is higher in the early years. This premium is more than what they need to pay claims when you are younger so they invest the money and use it to help pay the cost of insurance as you get older while keeping the premium level.

The main advantages of whole life insurance are as follows.

Lifetime Guaranteed Insurance

With whole life, the insurance company guarantees a premium amount that you have to pay. This means that this amount will stay the same for the rest of your life and will not increase. You can also rest assured that your loved ones/beneficiaries will receive a guaranteed, lump-sum payment at the time of your demise. You may also choose your business to be a beneficiary if you want.

Cash Value Accumulation

Aside from having life insurance for life, whole life also allows you to build a significant cash asset, as the insurance company sets aside a portion of the premium in an account. What’s more, your cash asset under a whole life policy is not going to be dependent on the ups and downs of the market at any time. You can also borrow against the cash value portion of your whole life policy. So, in case you need money for other things in the future such as payment for a home, college funding or a business loan, you’ll have a ready source of borrowing.

Tax Benefits

Whole life insurance carries with it numerous tax benefits, one of which is the tax-advantaged buildup of cash value. Also, many whole life policies provide dividends representing a portion of the insurance company’s profits that are paid to policyholders. Whole life insurance dividends may be guaranteed or non-guaranteed depending on the policy. The good thing is that even if you are accumulating dividends on the policy, you can defer paying the tax for them. This feature is one of the reasons that make whole life slightly more expensive than both term and universal policies. But take note that the policy is not flexible like the others.

Universal Life Insurance

Universal life falls under the umbrella of permanent life insurance options. It provides more flexibility than whole life.

There are three main components of universal life.

Death Benefits

You can choose from 2 options when determining how you want the beneficiary to receive the death benefits:

• Type A Death Benefit or Level Death Benefit. It’s up to you to pick a level of the death benefit, one that starts off as a single amount and stays level or the same for the life of the policy, regardless of its cash value.

• Type B Death Benefit: The other option is a combination of a specific death benefit and then the insurance company adds the cash value accumulation feature that accumulates over the life of the policy.

The Cash Value Portion

The insurance company allocates a portion of your premiums to an interest-crediting strategy of your choosing. In the basic form of Universal Life, interest is credited at a fixed rate by the insurance company. Some policies, known as Variable Life as discussed below, allow people to invest in mutual funds.

Flexible Premiums

The owner of a universal life policy has the option to pay as much or as little premium above a stated minimum. Although this flexibility attracts many insurance customers, a good percentage find it confusing at the same time. In term life insurance, you pay a certain amount every month or every year and you already know what the death benefit will be. But here, the shifting balances of premiums and death benefits are more complicated than what the majority of people need. Plus, it comes with the same extra costs as other permanent policies.

Another major difference between universal life and whole life policies is that policyholders of universal life can pay the premiums as they desire. However, in order to remain active, the policy must have sufficient available cash value to pay for the cost of insurance.

This isn’t something that you can do with a whole life policy because you can’t change the premiums to suit your present economic situation.

Variable Life Insurance

Variable life is similar to whole life with a different treatment of the cash value component.

In whole life and universal life policies, the fund managers keep the cash value component in a savings account. Although the growth is small when compared to other investment options, there is an assurance of the minimum rate guaranteed by the insurer. The insurance company also makes dividend payments from time to time.

Investment of Cash Value

When it comes to variable life, you’d imagine that it is some type of investment vehicle. The funds are in a mutual fund-like sub-accounts where there is potential for bigger growth. But there’s also the possibility of losing money depending on how the market behaves. The insurance company places the cash value in the stock market. Unlike universal life insurance policies, the insurer of a variable life insurance policy does not guarantee that your cash value won’t decrease.

If you are seeking higher, tax-deferred growth, variable life insurance policies are better investment options than whole life policies because they are like a “super-IRA.” However, you can only invest in the sub-accounts that are available through your policy. You don’t have the option to choose from the wide variety of mutual funds that are on the open market.

While premiums for a variable life can be lower than whole life, it is riskier since the company invests in the stock market. Many people don’t know much about the stock market and don’t know how to properly manage the funds to adjust to the market conditions. An average person won’t have the necessary skills or experience to do it effectively. These features limit a variable life insurance policy as an investment option and as a life insurance choice. The limits on investment choices is common to all permanent policy types.

Cost Comparison

The premium for a term life insurance policy is less than the premium for a whole life policy in the first several years you own it.  As you get older, you are increasingly likely to die so the premium for term life insurance increases and eventually become more expensive than if you were paying for a whole life policy you started buying when you were younger.

Cost of Term Life Policies

You might think that it is a disadvantage to choosing term life. After all, you have to die first to receive money (which does not go to you at all). Every year you will have to keep paying insurance premiums so you can protect your family. The premiums are affordable so you won’t have problems making the payments. But here is where some people can’t reconcile the cost and the benefit: when the 20 years go by and the insured is still alive. The insurance company does not give back anything. The truth is, this is a fair deal because the low premium you are paying only accounts for the death benefit you will get in case you die during the term of the policy.

Cost of Permanent Policies

In contrast, if you had purchased a permanent policy, you could keep it forever. And if you opted to stop in 20 years, the insurance company would likely give you back a portion of the premiums you have paid. When you account for the dividends you’ve received, there is a chance that you’ll get back all your premiums at that point. There is no guarantee that the policy will pay dividends so the insurance companies will not include them in their projections.

In the early years, permanent policies are more expensive than term policies so you would have to consider how much you are able (or are willing) to pay when you choose your life insurance.

About Baruch Silvermann

Baruch Silvermann is a personal finance expert, investor for more than 15 years, digital marketer and founder of The Smart Investor. But above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

Top Ten Posts in Our First Year

Financial IQ by Susie Q celebrated its first birthday last week. In the first year, we published 52 posts on our site, two of which were guest posts from other authors, and published two posts on other blogs. In case you haven’t had time to keep up with reading the posts as they are published, we provide you with a list of our ten posts with the highest page views. (We note that there were two periods during which our site wasn’t “talking” to Google Analytics, so there might be a few posts that should have made the top ten, but didn’t.)

#1 Advice We Gave our Kids

This post had almost 1,000 page views in large part because it is the only post we’ve had featured on Money Mix. It provides a list of 7 themes about money that my kids heard frequently as they were growing up or as they were starting to make their own financial decisions. In addition, I added two other pieces of advice I wished I had given them.

#2 Should Chris Pre-Pay His Mortgage

This post was one of my favorite ones to write! Chris @MoneyStir published a post given a lot of detail about his financial situation. He asked others whether their opinion on whether he should pre-pay his mortgage. In my response, I showed Chris that, given his particular circumstances, he would be substantially better off after he fully re-paid his mortgage a large percentage of the time if he invested his extra cash instead of using it to pre-pay his mortgage. One of the broader takeaways from this post is the importance of isolating a single decision and not confusing your thinking by combining separate decisions into one process.

#3 Introduction to Budgeting

Introduction to Budgeting was our very first post. I’m not sure how high on the list it would have been had we published it later, as many of our friends viewed the post just to see what we were doing. I still think budgeting, whether done in great detail or at a high level, is a critical component of financial literacy, so hope that it is valuable to our regular followers and not just our curious friends.

#4 What to Do Once You have Savings

This post is the first in a series of three posts intended to provide a framework and guidance once you have some savings. The series talks about how much to put in emergency savings, how to save for big-ticket items, savings for retirement and deciding whether to pre-pay your student loans. For each type of savings, it provides suggestions for appropriate asset choices.

#5 Getting Started with Budgeting

This post is the first in a series of nine posts on how to create a detailed budget. The process starts with tracking your expenses to see how you are spending your money.  Subsequent posts talk about setting financial goals and figuring out how you want to spend your money.  The series finishes with monitoring your expenses to see how you are doing relative to your budget. This post includes a spreadsheet that allows you to track your expenses.

#6 New vs Used Cars

This post totals up all of the costs of owning a car to help you understand how much better off you might be by buying a used car rather than a new car.  For some cars, it is much less expensive to buy used, whereas for other cars it doesn’t cost much more to buy new especially if you plan to own it for a long time.

#7 Traditional vs Roth Retirement Plans

This post provides lots of information about Traditional and Roth IRAs and 401(k)s. It also explains in what situations a Roth is better than a Traditional plan and vice versa, including some examples. The biggest determinant of that decision is your expectations about your marginal tax rate at the time you save relative to your marginal tax rate at the time you make withdrawals. The post provides lots of information on taxes, too, to help you make that decision.

#8 New Cars: Cash, Lease or Borrow?

This post explains the costs related to buying a new car with cash, leasing a new car and borrowing to pay for a new car. It provides a detailed illustration for three different models.  The best choice among those three options depends on your ability to pay cash, how many miles you plan to drive, and the terms of each individual offer. For some cars and situations, leasing is less expensive than borrowing whereas, for others, borrowing is better. It also provides a spreadsheet that allows you to compare your offers.

#9 Car Insurance

I was surprised that this post made the top 10.  I spent my entire career in the insurance business so probably have forgotten how complicated car insurance is! This post describes all of the important terms and coverages you’ll find in a car insurance policy. It also provides some insights on how to decide what coverages, deductibles and limits to select.

#10 Health Insurance

On the other hand, it didn’t surprise me at all that this post made the top 10. In fact, I would have expected it to rate higher than it did. As with #9, this post explains all of the terms included in health insurance policies. Its companion post explains how to select the health insurance plan that best meets your needs and your budget.  That post includes a spreadsheet that follows along with the calculations. I recently had to select an individual health insurance plan as my COBRA benefits expired.  I used exactly the process described in this post to make my decision!

6 Tips About Homeowners and Renters Insurance

Homeowners, condo-owners and renters insurance policies cover you for loss or damage to your property and liability that emanates from your residence.  All three policies cover your belongings regardless of where they are as well as injuries to others that happen at your residence. In addition, a condo-owners policy protects you against damage to the part of your condo that you own (generally the walls in).  A homeowners policy protects you against damage to your home and any other structures. While that seems quite straightforward, there are some nuances that make the coverage more complicated. In this post, I’ll provide you six tips that will help you better understand your coverage.  In the rest of the post, I will use the term “homeowers” to include both condo-owners and renters.

1 – Read your homeowners policy

If you’ve read some of my previous posts (such as this one), tip #1 isn’t a surprise!  An insurance policy is a contract and, like any other contract, I recommend you read and understand it.  To be clear, I’m referring to the 30-or-so-page document with the details of your coverage, not your declaration page which is the 2-3-page summary of what you bought.  I get a paper copy of each of my insurance policies every year. If you don’t get one in the mail, you may need to ask for one or visit your insurer’s website to get a copy.

With insurance, it is a little less critical to read the policy before you buy it, as there isn’t anything you can do to change the policy wording itself.  The wording of personal insurance policies is approved by the state or provincial insurance regulators.  Nonetheless, you’ll want to read your policy to make sure you understand what is and isn’t covered. An insurance policy is actually fairly easy to read.  My recollection from when I took actuarial exams a gazillion years ago is that the policy must be readable at the sixth grade level. So, while it has a lot of pages, it shouldn’t take you more than a half hour to read the policy (maybe a little longer the first time).

2 – Carefully check your declaration page

Your declaration page lists all of the coverages you purchased, the dollar amount of limit you bought for each coverage, the locations that are insured and any endorsements you purchased.  You’ll want to check this document before you buy.   Here are several things to check:

Is the location right?

It probably is. However, I reviewed a relative’s policy one time and saw that his rental property was missing from the declaration page.  If there had been damage to the rental property, my relative would have had to first prove that the insurer or agent made a mistake by not including the rental property and then could have made a claim.  Fortunately, by reviewing the declaration page for him, I found that the rental property had been omitted before he had a claim.

Do the limits make sense?

  • If you own a home or condo, does the structure limit seem reasonable?  Remember it is the cost to re-build your house or condo. For many years, that amount was much higher than I paid for my house, as existing homes were much less expensive than building a new home.  In “hot” markets, the re-build cost could be lower. So, be sure to think about the re-build cost, not the market value.
  • Do you have any other structures, such as detached garages or workshops?  If not, you don’t need much limit for other structures. If so, make sure the limit is high enough to re-build those structures.
  • How much would it cost to replace all your “stuff,” known as personal property?  In most jurisdictions, the personal property limit on a homeowners policy is automatically set to 50% of the limit for the house.  That amount may be right on average, but isn’t necessarily right for each individual. When I lived in California, housing prices were very high.  As a young homeowner, my personal property was not worth anywhere near 50% of the replacement cost of my home. For places with a very low cost of housing, the opposite can be true.  You can’t change the personal property limit in some jurisdictions, but it doesn’t hurt to ask if this limit doesn’t look reasonable. If you have a condo-owners or renters policy, you get to select the limit.  (In Tip 5, I talk about creating an inventory with photos. It will be helpful for estimating your limit, too.)
  • Do the limits on specific items, such as jewelry, musical instruments and collector coins, need to be raised?  Not all policies have the same items with these types of limits, so be sure to check your declarations page if you own any individual items or collections that are particularly valuable.  Most insurers can add an endorsement (essentially a few extra paragraphs that change the terms of your policy) to increase these limits.

Are there coverages you don’t need?

There are a large number of other types of endorsements that either restrict or add coverage.  The names of the endorsements on your policy are listed on your declaration page and the wording should be attached to your policy form.  If not, ask for it! Take a look at these coverages to make sure that there aren’t any that you shouldn’t be buying. I had one relative who reviewed his declaration page and found that he was paying for sump pump failure coverage.  That endorsement covers repairs due to water seepage when a sump pump fails. His house didn’t have a sump pump, so the coverage was unnecessary. It is harder to figure out if there are endorsements you should have that you don’t. If you are insuring your first home or condo, you might want to talk to your agent or insurer to review the types of endorsements available to figure out which ones you might want to purchase.

3 – Make sure you understand what isn’t covered

A homeowners policy does not provide coverage against everything that can happen.  In fact, the policy includes a long list of causes of loss or perils that are not covered.  Many of them are not covered because they are under the control of the insured. That is, if the insured does something to cause a loss or neglects to do something that could have prevented a loss, it is considered intentional.  Intentional acts can’t be insured.

Other perils, floods in particular, are not covered because the potential losses are considered (at least by the government) to be so widespread as to be too big for the insurance industry.  If you live in a flood zone, you can buy flood insurance from the National Flood Insurance Program.

Some perils, such as earthquakes, are not covered because they are so expensive that insurers require you to purchase them separate from the rest of the policy.  By separating the very expensive coverage, the rest of the coverage becomes more affordable. When I lived in California, the cost of earthquake coverage was more than the cost of the rest of my homeowners policy.  In addition, the earthquake coverage had a 10% deductible. I chose to not buy the earthquake coverage because it didn’t fit in my budget. Fortunately, we didn’t have any earthquake damage.

There are several sections of a homeowners policy that identify exactly what is and isn’t covered, so be sure to look for all of them.

4 – Be aware of little extras that are covered

You may be surprised by some of the costs that are insured under a homeowners policy.  You’ll want to make sure you are aware of them so you can recover the full amount you are due from your insurer.   One example is additional living expense coverage.

Additional living expense coverage pays for the increase in your living expenses so you can maintain your normal standard of living if your residence is uninhabitable due to an insured peril.  It also provides coverage if you are required to evacuate due to an emergency. That is, if you need to rent an apartment for several months or stay in a motel for a while, it will be reimbursed by your insurer.  Any reimbursement will be reduced by the portion of your deductible that wasn’t used by the damage itself.

As an example, there was a fire in a transformer in my mother’s condo building.  The building was declared uninhabitable for a little over a week. In addition, the smoke was bad enough that her walls, ceilings and all of her belongings had to be cleaned.  It turned out the ceiling had asbestos that had to be removed. The building insurance covered the asbestos abatement and cleaning, but she was responsible for the rest of her costs so submitted them to her insurer.  Her insurer not only paid to replace her belongings that were damaged by the smoke (such as her TV and computer), but also the cost of her plane ticket to my house for her initial evacuation period and the cost of a residential hotel for a month while her condo was cleaned and abated.

There are several other such extras, including financial loss if someone forges your signature and worldwide coverage for loss or damage to your personal property (not just when it is in your home).  You can find out more about these coverages when you read your policy. (Hint, hint.)

5 – Be ready if you have a claim

A homeowners insurance policy has a list of duties for the insured in the event of a claim.  These duties include promptly notifying your insurer or agent, notifying the police if there is a crime and protecting the property from further damage.  When you have a loss, the insurer may send someone fairly quickly to help you prevent further damage, such as drying carpet and furniture to try to avoid having to replace it or tarping or boarding up windows or roof damage.

Keeping an inventory of your belongings is one of the most important things you can do (and one that I have been remiss in doing).  If part or all of your residence is destroyed, such as in a fire, you’ll need to provide the insurer with a list of what was lost, including the quantity, replacement cost and age.  Obviously, it is impossible to keep a list of every item you own! The most important things to put on the list are those that are valuable – electronics, cameras, furniture, jewelry and watches, collectibles and the like.  It is particularly helpful, especially for unique items, if you take pictures of the items and the receipts and store them outside your residence (e.g., on the Cloud). If you have a loss, you will be able to access that information as documentation for the insurer.

6 – As always, buy the highest deductible and highest liability limits you can afford

A deductible is the amount that you pay on each claim before the insurer starts reimbursing you for your loss.  On a homeowners policy, the deductible applies only to the property coverages, not liability. When an insurer sets the premium for a policy, it has certain expenses and often a profit margin that are essentially percentages of the losses it pays to or on behalf of insureds.  So, if you buy a lower deductible, the losses paid by the insurer will go up. Your premium, though, will go up by the insurer’s estimate of the average amount of insured losses it will cover under the deductible plus the insurer’s additional expenses and profit margin. The additional premium could be 125% to 150% or more of the additional losses.  If you can afford to pay more on each claim through a higher deductible, you won’t have to pay the additional expenses and profit.

If someone gets injured or dies due to a condition that exists at your residence, you may be legally responsible for their medical expenses, lost wages and other costs.  If those costs are more than your liability limit (including the limit on any umbrella insurance you buy), you will become legally responsible for those costs. A higher liability limit can reduce your chance of becoming liable for these types of costs.  Of course, a higher limit also increases your premium, so you’ll need to evaluate both your deductible and the premium for a higher limit in the context of your budget.