When you're learning about different types of life insurance, I think it's easy to get confused. Yet, life insurance is the most necessary component of financial planning for most people.
Unless you inherit a large amount of money, or you remain single your entire life, you're going to have to learn about different types of life insurance. You'll likely have a need for life insurance being that you're living in a civilized society.
Life insurance offers you several ways to do the same basic task. You buy a policy, and the insurance company insures you for a set number of years. The policy provides you with death benefit protection that ensures you have money to give to your heirs in the event that you die prior to paying off all of your financial obligations. When learning about different types of life insurance, there are several basic policy types you'll encounter in the marketplace. You should understand how these policies work and what they mean for you and your family.
Term insurance is simple. Dead simple. You pay the insurance company a premium (that represents the total cost of the policy, with fees and commissions paid to the insurance agent). The insurer then gives you a death benefit. When you stop paying the premium, the insurer stops providing the death benefit.
Annual renewable term
Annual renewable term is also called "ART". These policies renew every year. You're only paying for one year's worth of death benefit. When that year is up, you have to renew your policy. If you don't, then you lose your life insurance. The insurer guarantees the death benefit will be there for your family as long as all premiums are paid.
Level term life
Level term life insurance levels out the premium payment. The insurer collects more money than is needed to cover the cost of insurance. The excess premium is then invested and used to hold down the future costs of the death benefit as those cost start to rise. This is how the insurer can keep your life insurance premium level. It's called "level term funding".
When the term expires on your policy, you can choose to renew it or drop the policy. Level term policies normally allow you a choice of 5, 10, 15, 20 or 30 year terms. Like the ART, the death benefit is guaranteed as long as you pay your premiums.
Whole life insurance provides the same death benefit guarantee that term life provides. However, the premium is increased significantly. These policies were, at one time, called "term to age 100". They mature at your age 100. If you live that long, the insurer pays you the death benefit. If you die before then, your beneficiaries receive the money.
The insurance company doesn't keep the excess premium they collect, as they do with level term polices. Instead, they return it to you. A cash reserve, called a cash value is part of the policy. The cash value is money that is set aside to pay for the death benefit claim. In a technical sense, there's no distinguishing between the death benefit and the cash value. The cash value is essentially that portion of the death benefit which has been actually earned through the investments of the life insurance company.
This money is like equity in a home that you may borrow against. The difference here is that you don't need to repay the loan during your lifetime and the interest rates you are charged are far below what any bank would offer you.
Universal life insurance is an ART policy with a cash value account. You deposit money into the cash account. The life insurance company credits interest to the account. Then they deduct money to pay for the cost of insurance. As long as there's money in the account, you keep the policy. When the money's gone, so is your life insurance policy.
Universal life contracts offer investment options which include fixed interest, mutual fund investments and unique equity indexing options that pay you interest based only on the upward movement of the stock market, less dividends (it's not a direct investment in the stock market, so the insurer excludes dividend payments and caps earnings at a predefined interest rate).
Choosing A Policy
This is a lot easier than people make it out to be. You'll need money for burial and funeral costs, so decide what type of cash value/permanent policy you want (either whole life or universal life). Then, choose what type of life insurance policy you want during your lifetime.
This is largely driven by your investment experience and the amount of money you have to put towards a policy. If you're not very good at investing, a whole life or universal life is a suitable substitute for a fixed interest investment account. Some of the more complicated universal life contracts give you the ability to invest in the stock market through mutual funds.
I normally don't favor these options because I wouldn't want to lose my life insurance policy over a poor investment decision on my part. Guaranteed earnings are good in my book though.
If you are a decent investor, you may be more comfortable foregoing the whole life or universal life policy and buying term. Of course, you'll have to invest the money you save by not paying the higher premium payments. You'll also need to provide enough money to equal the death benefit at the age you plan on retiring since this is what you would have had with the insurance policy.
A final note: Take it slow. Take your time. Some of this stuff is complicated. That's OK. Just don't give up or get too discouraged when learning about different types of life insurance.