Term insurance is the most basic, and generally least expensive, form of life insurance for people under age 50. A term policy is written for a specific period of time, typically 1 to 10 years, and may be renewable at the end of each term. Also, the premiums increase at the end of each term and can become prohibitively expensive for older individuals. A level term policy locks in the annual premium for periods of up to 30 years.
Declining Balance Term insurance, a variation on this theme, is often used as mortgage insurance since it can be written to match the amortization of your mortgage principal. While the premium stays constant over the term, the face value steadily declines. Once the mortgage is paid off, the insurance is no longer needed and the policy expires. Unlike many other policies, term insurance has no cash value. In this sense, it is "pure" insurance without any investment options. Benefits are paid only if you die during the policy's term. After the term ends, your coverage expires unless you choose to renew the policy. When buying term insurance, you might look for a policy that is renewable up to age 70 and convertible to permanent insurance without a medical exam.
Whole Life combines permanent protection with a savings component. As long as you continue to pay the premiums, you are able to lock in coverage at a level premium rate. Part of that premium accrues as cash value. As the policy gains value, you may be able to borrow up to 90% of your policy's cash value tax-free.
Universal Life is similar to whole life with the added benefit of potentially higher earnings on the savings component. Universal life policies are also highly flexible in regard to premiums and face value. Premiums can be increased, decreased or deferred, and cash values can be withdrawn. You may also have the option to change face values. Universal life policies typically offer a guaranteed return on cash value, usually at least 4%. You'll receive an annual statement that details cash value, total protection, earnings, and fees.
Drawbacks to this type of insurance include higher fees and interest rate sensitivity. Universal policies include up-front fees as well as ongoing administrative fees totaling as high as 5% to 7% of your premiums. You may also find your premiums increasing when interest rates decline.
Variable Life generally offers fixed premiums and control over your policy's cash value. Your cash value is invested in your choice of stock, bond, or money market funding options. Cash values and death benefits can rise and fall based on the performance of your investment choices. Although death benefits usually have a floor, there is no guarantee on cash values. Fees for these policies may be higher than for universal life, and investment options can be volatile. On the plus side, capital gains and other investment earnings accrue tax deferred as long as the funds remain invested in the insurance contract.
Universal Variable Life insurance is the most aggressive type of policy. Like variable life, you control your investment in mutual funds. However, there are no guarantees on universal variable policies beyond the original face value death benefit. These policies are probably best suited to affluent buyers who can afford the risks involved.
Key Terms and Definitions
- Face Value -- The original death benefit amount.
- Convertibility -- Option to convert from one type of policy (term) to another (whole life), usually without a physical examination.
- Cash Value -- The savings portion of a policy that can be borrowed against or cashed in.
- Premiums -- Monthly, quarterly, or yearly payments required to maintain coverage.
- Beneficiary -- The individual(s) or entity (e.g., trust) that is designated as benefit recipient.
- Paid Up -- A policy requiring no further premium payments due to prepayment or earnings.
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