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About Types of Life Insurance Policies

By Edited Sep 12, 2015 0 0

I think that one of the biggest hurdles in buying life insurance is actually learning about how these types of contracts work. Life insurance companies have marketing divisions which try to sell you a policy, but this doesn't really do much for you in terms of education. Some company's brochures really don't do much to tell you how the policies really work. Instead, they over-simplify the matter without providing much substance.

Fortunately, life insurance isn't really that difficult to understand. There are four basic contracts you'll encounter, one of which is hardly ever sold today.

Term Life

Term life insurance is possibly the simplest form of life insurance in existence. The contract provides death benefit protection in exchange for a premium payment. When you die during the term, your beneficiaries receive the death benefit you've purchased.

Annual renewable term

Annual renewable term, called  ART, is one year's worth of death benefit protection.  That's all you're paying for: one year. On your policy anniversary, you must renew the contract or it will expire and you'll be left with nothing. While people often say term life is the cheapest form of life insurance, that's really half true. You see, term life insurance gives you a low initial cost. That cost necessarily increases as you get older.

Each year when your policy anniversary forces you to make that "keep it" or "drop it" decision, you must choose: keep the policy and pay a slightly higher premium for the same amount of death benefit or drop the policy and hope I don't die before I can pay off all of my financial obligations.

Level term life

I think level term life insurance went a long way to kinda solve some of the dilemma of increasing premiums. The invention of level term insurance meant that the insurer would increase the premium over the one year term policy's premium, essentially inflating the cost of the death benefit. The excess premium collected would be invested. Since the insurer was collecting more than what was actually required to cover the cost of the death benefit, future premium payments could remain level. Level term insurance was the first attempt to build a cash reserve for a life insurance policy. You never saw the reserve account, but it was there.

Today, these policies provide the same basic protection that they've always provided. You buy them in 5, 10, 15 or or 30 year terms. Some companies still sell 20 term policies, but I think you'll eventually see that phased out in favor of either really short terms of 5 or 10 years or a long one, like 30.

At the end of the term, you must make the same choice as you do with an ART policy. Renew at a higher rate for the next term or pass and figure out what to do about your insurance needs if you have them.

Whole Life

Whole life insurance was invented because term policy holders hated the idea that they had to spend a bunch of money on term premiums for their entire life, and then when the probability of death was high, the insurance company's term premiums were unaffordable or they simply didn't qualify for coverage.

The insurance company, and their savvy actuaries (professional mathematicians), decided to follow the same line of thinking that they had with level term life. They raised the premium over the term policy premium and extended coverage out to age 100. The problem was the premium was now very high, but the coverage lasted much much longer than a term policy ever would or ever could.

Those early whole life policies were called "term to age 100". They were game changers. They provided a death benefit plus a cash reserve. In the early days of whole life, this cash reserve wasn't accessible during the lifetime of the policyholder. However, today, you can use this cash reserve during your lifetime for just about anything your little heart desires.

This cash reserve is called the cash value. It represents money which is earned by the insurance company that offsets the death benefit you purchase. It's not technically a separate account, and no actuary who builds a life insurance contract every refers to it as a savings separate from the death benefit.

It's more like a cash advance on the death benefit. In other words, the death benefit and cash value are indistinguishable and indivisible. What appears to change is the fact that you can borrow against the cash value--the portion of the death benefit earned by the insurer--and keep those loans open until your death.

Insurers also credit your cash value with interest which varies depending on the investments the insurance company uses to pay interest on the policy. Some insurers share profits of the company with policyholders in the form of dividend payments in addition to a basic level of interest credited to the cash value.

Universal Life

Universal life was invented in the 1980s. The policy is part term policy part investment account. Premiums par deposited directly into a cash value account. Interest is credited and money is deducted from the account to pay for the death benefit. The term policy is an ART policy. You cannot separate the two components, however, so if you remove all of the cash from the cash account, the policy terminates. Because of the nature of the contract, premiums are flexible. As long as there's money in the cash account to cover death benefit costs, the policy remains in force.

Life insurance companies allow you to invest the cash value in a fixed interest account, or choose a policy contract offering mutual funds as the investment. Finally, some insurers offer the option to track the upward movement of the S&P500, the Dow Jones or some other equity index. All losses in the stock market index are ignored. You don't earn dividends as you would with a direct investment in the stock market, but you don't lose money when the stock market crashes either. The insurer also normally caps earnings at a specific interest rate. This compensates them for taking all of the risk of loss in the contract.

Variable Life

Variable life is hardly ever sold today. It was created by Equitable Life Assurance Society. The contract was basically a one year term policy (ART) and the option to invest in mutual funds. As the policy design matured, it became more life whole life in the sense that premiums were not flexible and that at least some of the death benefit would be guaranteed, while some of it would not be.

Some variable life policies allow you to allocate a portion of your premium dollars to a fixed interest account, while sending some of your premiums to a mutual fund investment. I'm not a huge fan of these contracts since they don't have the flexibility of a universal life policy and they don't have the guarantees of a whole life. They're sort of a half-breed.

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