Types of Life Insurance
Definition of Life Insurance
Insurance is the practice of substituting cost for risk. An individual who buys life insurance is paying the insurance company to assume certain risks, particularly the loss of income associated with unexpected death. Upon the death of the insured, the company pays a death benefit to the beneficiaries named by the policyowner. This sum compensates for income the insured would otherwise have provided.
The premiums paid for the insurance policy are invested by the company. Actuaries calculate a life expectancy for each insured, allowing the company to estimate its likely payouts. Given a sufficiently large number of policies sold, premature deaths will be counterbalanced by insureds who exceed their life expectancy. This large-scale transfer and pooling of mortality risks is more effective than individual risk-bearing.
Term Life Insurance
Term is the original form of life insurance. Term life insurance is pure protection; it carries no cash value. Its premiums cover only the cost of insurance, based on life expectancy. Hence, term life premiums are lower per-dollar of death benefit received than premiums for other types of life insurance.
Basic life insurance need arises when an individual’s wealth (or assets) is insufficient to compensate dependents for his or her unexpected death. This insurance need is strongest for the young, who have not yet accumulated substantial wealth but who may well have spouses and children dependent on their income. On average, young people enjoy better health and a lower likelihood of death, which allows them to pay lower mortality charges. In other words, term insurance premiums are lower for young people at the time of life when insurance protection is most needed. Young people benefit most from term life insurance.
With increasing age, wealth increases and the number of dependents decreases. At retirement, income replacement ceases to be an issue since there is no longer any income to replace, and basic insurance needs may vanish completely. Term life insurance is ideal for younger individuals with temporary insurance needs that can be timed accurately, and who are not interested in using life insurance as an investment vehicle.
Whole Life Insurance
This is permanent insurance designed to last for the full life of the insured. In addition to its death benefit, it offers level lifetime premiums and generates a cash value that may be redeemed or serve as loan collateral. The cash value increases over time until the policyowner attains age 95 or 100, at which point the cash value is equal to the death benefit and the policy matures.
A whole life insurance premium is allocated between two accounts. One account covers the cost of insurance, computed using the same actuarial tables used for term life. The second account is the “cash value” or “cash surrender” account, which is equivalent to a savings account. Its rate of return flows from the company’s general account of conservative loan investments. The insurance company’s ability to pay out cash value and death benefits depends on its financial strength. Four major ratings agencies rate the financial strength of life insurance companies and their evaluations are available to the public.
Whole life and term life are the two basic types of life insurance. Whole life premiums are necessarily much higher than term life premiums, at least until the insured reaches an advanced age. Even though whole life insurance provides a cash value, the policyowner may accumulate more wealth by buying term insurance instead and investing the premium difference. Certain specialized insurance needs, however, may require permanent insurance. Examples include insurance for burial or final expenses, business succession, estate planning and key persons.
Universal Life Insurance
In this form of permanent life insurance, premiums may be paid out of the policy’s cash value. This gives the policyowner the option of paying little or no premium in a given month. The premium flexibility makes this variant popular with young consumers whose low incomes might otherwise prevent them from obtaining full coverage of their insurance need. As with whole life insurance, the cash value is funded by conservative investments controlled by the insurance company.
Variable Life Insurance
This is permanent life insurance in which the cash value of the policy fluctuates with the market value of investments chosen by the policyowner. Part of the premium is placed in separate accounts, functionally equivalent to mutual funds, which invest in equities, bonds or money-market funds. Unlike allocations to the cash value account of a whole life policy, investments in separate funds are controlled by the policyowner. They offer more potential for wealth accumulation (and more risk) than do the conservative cash-value accounts of whole life or universal insurance. As a security, variable life insurance is subject to federal regulation as well as the state insurance regulation common to all forms of life insurance.
Variable Universal Life Insurance
This hybrid form of permanent insurance embodies the features of both variable and universal life insurance. As in universal life insurance, premiums may be paid out of the cash value of the policy, allowing for considerable flexibility in premium payments by the policyowner. As in variable life insurance, the cash value is determined by the investment performance of the separate accounts (analogous to mutual funds) chosen by the policyholder. Candidates for VU life should have a high tolerance for market risk.
Mortgage Life Insurance
This term-insurance policy is designed to insure a mortgage against the death of the mortgagee. At issue, the policy’s death benefit equals the outstanding value of the mortgage. The policy term is exactly the same as the term of the mortgage. Over time, the insurance company calculates how much to reduce the death benefit (and the premium) to exactly cover the remaining money at risk. Should the mortgagee die, the death benefit is used to liquidate the mortgage.
Return of Premium Life Insurance
This is a variant of term life insurance that returns all premiums paid in a lump sum at maturity if the coverage is not used. A 30-year term life insurance policy on which $25,000 was paid in premiums will return $25,000 to the policyholder if the insured is still alive when the policy expires. The tradeoff for this benefit is premiums that are 25-50% higher than for a standard term life insurance policy. An alternative is for the policyowner to buy ordinary term insurance, invest the premium difference between ordinary term insurance and return of premium insurance. The effectiveness of this strategy depends on market and interest rate performance. Return of premium insurance is suitable for the same classes of people as ordinary term insurance.