At its core, a life insurance policy is a contract between the insurer and the policy owner. It spells out how much money the beneficiary or beneficiaries will receive upon the death of the insured, and how much money the policyholder must pay to keep the coverage in force.
In a narrow sense, the guarantee behind a life insurance policy is only as strong as the insurer that wrote the policy. However, life insurance companies are heavily regulated by the states where they’re licensed to do business. In addition, state associations of life insurance providers typically pool resources to backstop the obligations of failing member companies.
Also, if a life insurance company appears to be faltering, it’s typically sold to a stronger company that assumes its obligations. The last thing the life insurance industry needs is a loss of consumer confidence. Finally, rating agencies such as A.M. Best, Fitch Ratings, Moody’s and Standard & Poor’s issue assessments of insurers’ financial strength to help buyers gauge risk.
So what are the categories of life insurance? The primary distinction is between “term” and “permanent” (also called “whole life”) insurance. But even these have subcategories.
A typical term life policy, known as a “level” term, is the easiest to understand. It features a fixed death benefit and fixed premiums. The duration of the policy generally varies between 10 and 30 years. You might be able to renew the policy at the end of the term, but the premium will jump — possibly so high that it will become unaffordable. Therefore, if you expect to need life insurance coverage beyond the life of a particular term policy, you’ll need to make a plan for how you’ll extend your coverage.
The other, less common subcategory of term life insurance is called “decreasing term.” Here, the premiums remain constant, but the death benefit diminishes over time. This could make sense if you’re confident that your net worth will rise substantially over the policy term. This way, if you die closer to the end of the term, your beneficiaries will be protected by the build-up of your net worth.
Whether term or permanent, the younger and healthier you are when you initiate a life insurance policy, the cheaper it will be in an apples-to-apples comparison. This is because you’re less of a risk to the insurer. So, you’re usually better off buying a policy when you’re young and healthy because, if you wait too long, you’ll either face high premiums or, in a worst-case scenario, be unable to buy insurance at any price.
The key difference between term and permanent insurance is that permanent policies allow you to buy a death benefit that doesn’t decrease over time or expire. Consequentially, you’ll pay more in premiums than you would for a term policy. But this stream of higher premium payments ultimately gives the insurer enough of a financial cushion so that, eventually, it will declare the policy “paid up” and you’ll no longer need to pay premiums at all.
One purpose of a permanent policy is that, if you keep up with the premiums until you reach paid-up status, you’re effectively locking in an inheritance for someone. And basic life insurance death benefit payments are tax-free.
In the early years of whole life policies, some of the extra premium dollars create a “cash build-up.” These dollars are “extra” in the sense that they more than pay for the insurer’s initial financial risk of offering the policy. You can borrow from this reserve or potentially (depending on your policy) have it added to the death benefit. However, if you don’t repay a borrowed amount, it will lower the value of the policy’s death benefit.
Many years ago, it occurred to the life insurance industry that they could do more with that cash build-up than creating a loan pool. The result was “universal” (also called “adjustable”) life insurance. In a nutshell, these permanent policies give you the flexibility to suspend or reduce premium payments after you’ve built up a reserve and then fund your premium payments out of that reserve. If the reserve (cash value) is depleted, however, you’ll need to resume paying premiums to maintain the policy.
The cash value (also considered the “savings” component of a permanent life policy) can grow, based on a specified interest rate. But insurers later added a new twist for those who wanted to pay more attention to that savings component. With a “variable” life policy, the cash value component goes up (or potentially down) based on the performance of investment options chosen by the policyholder.
And for life insurance buyers seeking maximum flexibility, the features of universal and variable policies can be combined in a category suitably named “variable-universal” life.
To decide which category of life insurance works best for you, and how much you need, you’ll need to consider many details of your financial life. Plus, your needs may change over time, so it’s not a one-and-done proposition. Just don’t wait too long — especially if someone is depending on you to exercise financial wisdom.
Please contact Debora May for more information via our online contact form.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.