Life Insurance for Dummies
Although the title “Life Insurance for Dummies” is popular and easily catches attention, the better title would have been “Life Insurance for Beginners.” Learning about life insurance can be confusing, complicated, and boring, and most people roll their eyes when they even think of it.
Unfortunately, almost everyone needs life insurance because everyone will die sooner or later. When that happens, anyone who depends on you financially can be significantly impacted by the loss of your income stream. Others may be impacted by having to pay for your funeral and burial. Either way, you need to have life insurance unless you have a ton of cash that you can pass on to people that need it after you’re gone.
How Does Life Insurance Work?
First of all, life insurance is simply a contractual promise to pay in the event of your death. How much a company pays and who they pay it to will be specified in the insurance contract.
With life insurance, the insurance company agrees to accept an amount of money over time in exchange for a lump sum payout to your designated beneficiary in the event of your death. The premium that an insurer will charge is based on various aspects but primarily on your age, your health, and the amount of insurance you require (the death benefit). There are more aspects involved with the underwriting process but for the purpose of this article, we’ll keep it simple.
Why do I need Life Insurance?
It’s safe to say that most people need to own life insurance. Life insurance is used for many different reasons, but the most important is to protect you loved ones if you are not around to provide for them. Other uses for life insurance are:
- Pay off debts, such as a mortgage
- Income Replacement
- Business loans or buy outs
- Funeral Expenses
- Supplemental Retirement Income
- Fund a Special Needs Trust
How many Types of Life Insurance are There?
Although there are many different life insurance products available today, there are only two primary life insurance types: temporary life insurance (term insurance) and permanent life insurance (whole life and universal life). All of the other life insurance products available today are a hybrid of one of the two primary life insurance types that we just mentioned.
For example, term insurance comes in multiple hybrids like level term insurance and decreasing term insurance. Whole life and Universal Life also has many hybrid products that are based on these permanent products.
Term Life Insurance for Dummies
Term life insurance is considered “temporary insurance” because only lasts for a specified number of years, often referred to as the “Term” of the policy. Most insurance companies will offer terms of 5, 10, 15, 20, 25, or 30-years. With each of the policy terms, the premium is typically a locked-in amount until the end of the term.
If you die within the “term” of the policy, your insurer will pay your beneficiary the death benefit in a lump-sum tax-free benefit. If you die outside the term of your policy, the insurance company will not pay any death benefit.
There are main types of term life insurance:
- Level Term
- Annual Renewable Term
- Decreasing Term
Level Term Life Insurance
Level term life is the product sold most by agents. It’s pretty straight forward, the premium and death benefit are level for the term period chosen. The length of term periods range from 10-30 years depending on age of the consumer.
Annual Renewable Term Life Insurance
Annual Renewable Term (ART) is a term life insurance policy that cover most to age 90. Sounds great right. Yes, but these term policy’s renew on your anniversary date each year which comes along with a premium increase. These policies start out low, but usually become to expensive later in life.
Decreasing Term Life Insurance
Decreasing term life is designed just like it sounds. The death benefit decreases annually. The downside is premiums do not decrease, which means you will be paying the same for less. These types of policies are use to cover loans, such as a mortgage.
No. When the term is expired you no longer have insurance coverage. You can, however, renew your term policy when the insurance company offers a renewal. The renewal policy will be based on your attained age (age at renewal) so the premium will be much higher and the policy will typically be converted to an annual renewable term which means the premium will go up each year that you renew your policy.
Another option that may be available to you is called the “conversion privilege.” The conversion privilege allows the policyholder to convert a portion or all of their term insurance to permanent life policy like whole life or universal life insurance. Although your premium when you convert will increase to reflect your attained age and the permanent policy type, there are no medical underwriting requirements when you convert your policy.
Finally, and most important to most people, Term life insurance is priced considerably less than permanent insurance. The reason for this lower pricing will be discussed in a different article.
Permanent Life Insurance for Dummies
Permanent life insurance is designed to cover the policyholder for a lifetime and is available as whole life insurance and universal life insurance. There are several types of permanent whole life insurance and several types of permanent universal life insurance.
The biggest difference between permanent insurance and term insurance other than the premium is that whole life insurance and universal life insurance have a cash value account that earns tax differed interest over the life of the policy. This is accomplished by the insurance company placing a portion of your premium payment in a “cash value account” and the paying fixed or variable interest on your cash value.
As your cash value account accumulates over time, you can access this money by taking out a policy loan or taking withdrawals from the cash account. When you take a policy loan, you are not required to repay it however, your insurance company will deduct the outstanding loan from your death benefit when you die.
If you take withdrawals, you are actually reducing the death benefit of your policy in exchange for a certain amount of cash in your cash value account. Both whole life and universal life policies can also be surrendered to the insurance company in exchange for the entire cash that is available in your policy minus any surrender fees. It’s important to note, however, when you surrender your insurance policy it cannot be reinstated.
What is Whole Life Insurance?
Whole Life insurance, which is also referred to as permanent life or traditional life, is one of the oldest forms of life insurance in the marketplace. Although whole life is more expensive than term and universal life insurance, it remains a very popular form of life insurance because of several guaranteed benefits:
- Non-Cancelable Coverage – As long as you pay the required premium, your whole life policy will remain in force for a lifetime. Your insurance company cannot cancel your whole life policy for any reason other than non-payment.
- Level Premiums – After your whole life policy is issued, your premium will remain the same forever. Your insurer cannot raise your premium due to your age, health, or life expectancy, or any other reason for that matter.
- Cash Accumulation – Similar to the cash value account we spoke of for universal life insurance, your whole life insurance policy will build cash value over time. Your cash account is also credited with a minimum interest rate that is specified in your contract. And, if you have a participating policy, your insurer will pay dividends each year that can also go into your cash value account if you prefer. You can access your cash through policy loans, withdrawals, or by surrendering your policy.
Sample Rates for Whole Life Insurance
What is Universal Life Insurance?
Most of us in the industry consider Universal Life (UL) to be a hybrid of term insurance but with an investment component that builds cash value over the life of the policy. Universal Life is considered to be permanent life insurance because if it’s properly funded, it can last for the life of the policyholder. It doesn’t have to last forever unless you want it to. You can fund the policy for the time period of your choosing since the premium is flexible.
- Flexible Premium Payments – When you initially purchase a Universal Life policy, your premium is calculated according to the death benefit you select and how many years you want your policy to be in force. However, most people are not immune to life events that can affect your financial situation. With the UL policy, you have the flexibility to increase or decrease your premiums, or even skip a few payments as long as there is sufficient cash in your policy to keep it in force. You cannot make premium amount changes with Whole Life insurance.
- Flexible Death Benefit – Many individuals purchase life insurance with a death benefit sufficient to cover all of their debt. For most of us, debt is temporary. Vehicle loans are paid off, the mortgage gets paid off, and debts like credit cards and personal loans are reduced or paid off as well. When this happens, a policyholder can reduce their life insurance death benefit but only Universal Life is flexible enough to allow you to reduce or increase your death benefit.
Similar to the cash value available in whole life insurance, the UL policyholder can use their cash accumulation in a variety of ways:
- Policy Loans – After you have accumulated some cash in your life insurance policy, you can easily access that cash using a tax-free policy loan. The loan can be for any reason and you don’t even have to pay it back. If you died while a loan was outstanding, your insurer would simply deduct the outstanding loan amount from the death benefit.
- Policy Withdrawals (Partial Surrender) – Your universal life policy also provides the option to withdraw cash from your policy that is a withdrawal rather than a loan. The insurer will then reduce your death benefit based on the amount of your withdrawal and as long as you are not withdrawing interest; your withdrawal will be paid tax-free.
- Policy Surrender – Often times, individuals with multiple insurance policies may decide to cash an insurance policy in to retrieve their cash in the policy. This is known as surrendering your policy. You can do this with a Universal Life policy for any reason as long as you’re willing to give up the funds needed to pay surrender charges.
- Pay off your Policy – If your policy has been in force for a long period of time, you could reach a point when the cash in the policy coupled with future interest earnings will allow you to stop paying on your policy because your cash value is sufficient enough to cover all future payments. This is known as a Paid-up policy.
Sample Rates for Guaranteed Universal Life Insurance
Which Permanent Life Insurance Policy is the Best?
After discussing the nuts and bolts of Universal Life and Whole Life Insurance, determining which type of policy will work best for you will depend on your insurance needs. In other words, why do you need life insurance and what do you want it to do for you? Since we’ve already decided that you prefer not to purchase temporary insurance like Term, what’s left is the benefits that these policies can offer and what your premium budget might be.
Both policies will provide life insurance for a lifetime, both policies will build cash value that you’ll have access to, but only the Universal Life policy is flexible – if that’s important to you. And finally, Universal Life will typically cost less than whole life and build cash value quicker
The kind of life insurance you buy should be based on your need for life insurance. There are many reasons to buy life insurance other than pay for a funeral and your independent insurance professional can help you discover your “insurance needs” and recommend the best solution.
Here is a graphic showing which type of insurance best meets the need of the applicant:
Although we have been very brief in describing life insurance for this article, it is simply a starting point for beginners. Certainly, you’ll have many questions about life insurance and how it can be a solution for your everyday financial risks. If so, feel free to read other articles on our website, or just contact us now by calling our office during business hours, or contact us through our website. We’re always happy to speak with beginners.