In this article we will give you a complete understanding of life insurance: how it works, why you need it, what kind of coverage options are available, and how to find the policy that best fits your needs.
This is a guide to life insurance and it can help you as you make contingency plans to care for your dependents after you have passed away.
General Life Insurance Categories: Term and Permanent
There are two main categories of life insurance: term and permanent.
The simplest explanation for these is that term insurance gives you life insurance coverage for a specific amount of time, for a certain period or term, and you are only covered and receive a death benefit if you die within that specific period of time.
Permanent life insurance, on the other hand, covers you until you die regardless of when you die, or in other words, for your whole life.
This is why permanent life insurance is often referred to as “whole life.”
Within each of these main categories there are a variety of life insurance options to choose from. Let’s dig a little deeper to understand each one.
Term Life Insurance
As the name suggests, this insurance plan covers you over a defined term.
If the insured’s death occurs during the predetermined term, the death benefit will go to the selected beneficiaries.
Terms generally range from 20-30 years, but the exact amount of time will vary from policy to policy.
If an insured outlives the term, he or she can renew or terminate the policy. After a term policy expires, some insurance companies will allow you to update it, change it, or even transform it into permanent life insurance. Keep in mind that because you are now 20-30 years older, the premiums on the renewal policy will be much higher and may be cost prohibitive.
Some people refer to term insurance as “pure insurance.” This means that you are not building any savings or cash value in the policy when you pay your premium. The insurance company simply takes the money and only pays you money if you die within the term. Term life insurance features no cash value component.
Term life is the least expensive life insurance policy because it covers you temporarily, not permanently. This makes term life insurance the most cost-effective way to get life insurance. Insurance companies can offer these policies at a low rate because the risk of dying at younger ages within the term is relatively low. They offset their risk with the large amount of people paying premiums in comparison to the amount of claims they end up paying.
Here’s an example to help you understand.
Let’s say you are a 25-year-old software engineer. You don’t smoke, you play basketball recreationally, you lead what would we call “a healthy lifestyle.” You have just started your family and they are dependent on your income to pay the mortgage and other bills, buy groceries and eventually to help pay for your children’s education.
Your family depends on your income and will continue to do so for a couple of decades, so you seek a term life insurance that will cover your family for 25 years in case something happens to you. If you die during the term, you know your family will be taken care of and have money to cover their financial needs.
So, you obtain a $300,000 death benefit policy for $30 a month. You decide that $30 a month isn’t that much to pay for peace of mind and a guarantee that your family will have income even in the event of your death. In your mind, it’s $30 well spent.
If you are an insurance company, you’ll gladly offer a term life insurance policy in this situation. Why? The chances that our software engineer will die in the next 25 years are low. In the meantime, you will collect premiums every month for 25 years. When the term has expired, you will no longer be under contract to pay the death benefit. You will keep the 25 years of premium ($9000) as profit.
$9000 isn’t much compared to $300,000 and if the software engineer dies during the term, the insurance company will take a loss of -$291,000. However, because insurance companies have term policies with lots of different people, they spread the risk of that loss over many policies. Since most term policies never have to be paid out, they end up making a profit and can offer you the term life insurance policy at this very low rate.
In comparison, if the software engineer chose a permanent life insurance policy instead of term, it would cost nearly ten times that amount, at $200-$300 a month.
Permanent Life Insurance
Permanent life insurance provides lifelong protection and a death benefit no matter when you die.
Permanent policies remain valid and in force for as long as you continue to pay your premiums.
People who choose a permanent life policy over a term one want coverage for their entire lives not just a selected period.
Some people may want coverage even after their kids are grown or the mortgage is paid.
It allows you to provide for your loved ones after you have passed away and pass money on to your children and grandchildren even if they don’t need it for daily living expenses.
Permanent life insurance policies also have the ability to accumulate cash value from a portion of the premiums you pay. In other words, part of your premium goes into a savings vehicle that can be obtained after a certain amount of time by surrendering the rights to the death benefit.
Cash value accumulates tax-deferred like money in a retirement account, but the money can be used for anything you want.
You can borrow from the cash value as well and lending rates are relatively low. Be aware that if you don’t repay the loan (with interest) the death benefit and the cash-surrender value will be reduced.
Additionally, you can also use cash value to pay your premiums for a time. If you stop paying your premiums altogether and surrender your policy, the guaranteed policy cash value is still yours.
It takes time to build up the cash value in your policy, so understand that if you surrender your policy in the early years, there may not be much money there.
It’s also important to know that the cash value is different than the “face amount” or death benefit. Cash value is only the amount you have saved inside the policy and not the amount that is paid out in the event of death.
The amount of actual cash value can also be affected by how the money is invested by your insurance company and other market influences.
Types of Permanent Life Insurance
There are many different variations of permanent life insurance.
We will go over the basic differences of many of these in this article, but even more specific information can be learned from a qualified life insurance agent.
Understand that there are lots of options for providing the death benefit and for the investment of the cash value and this creates the differences in the way these policies are set up.
Whole Life Insurance
Whole life insurance policies provide predictability.
These policies provide a guaranteed death benefit and a guaranteed rate of return on your cash value investment regardless of what the market does.
Additionally, the premium is level and never decreases or increases and does not change as you age.
Another valuable benefit of certain Whole Life policies is the chance to earn dividends.
Your policy has guarantees for a minimum death benefit and minimum cash value, but dividends offers you the opportunity to receive an enhanced death benefit and a greater cash value. Dividends are the way for the insurer to share its favorable earning with its policy holders.
If you purchase a whole life policy you can start earning dividends in the second year of the policy, but keep in mind that they are not guaranteed.
The downside to whole life policies is that the premiums can be high and because they are fixed, they can be hard for young families who are just starting out.
Variable Life insurance is a type of permanent life insurance that offers a death benefit and a cash value that varies with the performance of the portfolio and investments.
In other words, the death benefit and the cash value is not guaranteed but is dependent on the investment performance of the premiums.
With variable life, you pay a fixed premium and then allocate your premiums among a variety of investment options like stocks, bonds, mutual funds, etc.
As the investments grow or diminish, so does the death benefit and the cash value.
Good performance equals higher benefits; poor performance causes the benefit and cash value to drop.
These policies have a degree of risk involved and depending on your investment selection this risk can be higher or lower.
This type of insurance is perfect for people who are willing to assume investment risk to try to achieve greater returns.
When you purchase a variable life policy, you are shifting much of the investment risk from the insurance company to yourself.
Unlike Whole Life and Variable Life policies which have fixed premiums, Universal Life policies have adjustable premiums.
This allows you to have more flexibility when it comes to paying your premium.
You have the option to pay higher premiums when you have more money available and you can pay lower premiums when things are tight.
After you pay your first initial payment, Universal Life policies allow you to pay your premium at any time, and except for specified minimum and maximum amounts, you can pay any amount as well.
The only real requirement is that you meet your “cost of insurance” or COI.
Your premium is used to cover various expenses and your COI is the bare minimum amount to keep the policy running and active. And, as long as you are paying your COI, you are all set.
Universal Life policies also allow you to increase or decrease the death benefit over the life of the policy. In general, there is much more flexibility in this kind of permanent policy than others.
Universal Life will also provide a guaranteed rate of return on your cash values, but there are important limitations to this guarantee.
If you choose a Universal Life policy you will need to understand these in more detail and your insurance agent can help you navigate these contingencies.
Variable Universal Life
Variable Universal Life insurance is a combination of the last two types of policies we talked about.
These policies offer flexible premiums and the money is invested into a variety of investment accounts of your choosing.
Again, these investment options have a degree of risk and their performance will change the death benefit and cash value.
These policies are a good choice for people seeking maximum flexibility who do not mind a level of risk.
If your insurance needs change over time, Variable Universal Life usually provides the ability to increase or decrease the amount of your death benefit coverage.
You can also make lump-sum payments to increase the policy’s cash value.
Additionally, if you are short on cash, you may be able to skip a scheduled payment and let the accumulated cash value cover the policy’s expenses. Keep in mind that the cost of insurance and administrative expenses are still incurred. Over your lifetime and as your life insurance needs change, your investment goals and risk-tolerance will also change. With Variable Universal Life policies, you have lots of flexibility to move funds between investment vehicles, tax free.
Life Insurance Riders
As we already said, most insurers will allow you to fine-tailor your life insurance policy according to your needs. Instead of juggling between various plans, you can also supplement your coverage with a specific rider.
A rider is a provision of an insurance policy that changes or adds to the coverage or terms. Most riders add coverages for an additional cost. There are many kinds of riders that you can learn about through your agent, but we will talk about a few of them here.
Accidental Death Benefit
An Accidental Death Benefit Rider provides an additional payment if your death happens because of an accident.
This additional payment can be as much a double the original death benefit.
If you work in a dangerous environment or have a long commute, an accidental death benefit rider might be a good rider to consider adding to your policy.
Accidental death benefits do have limitations and are not paid for those who die in military combat, from self-inflicted injuries, or from “hazardous hobbies” (such as skydiving, deep sea diving, motorsports, mountaineering, etc.), among other reasons.
Disability Income Rider
This rider allows the insured to stop paying premiums in the event that he or she is disabled for at least six months.
Some disability income riders also provide monthly income payments at the rate of 1-2% of the full value of the policy.
For example, if you have a life insurance policy for $500,000, the disability income rider would provide from $5000-$10,000 of income every month.
The benefit of a disability income rider is that it allows a person with a life insurance policy to continue to receive coverage even if they can no longer pay the premiums because they have suffered a disability.
This means that even though the premiums could no longer be paid, the beneficiary would still receive a death benefit, and for qualifying policies, cash value would continue to grow, and dividends would still be paid out.
Waiver of Premium Rider
Waiver of premium rider is a broader version of the disability income raider.
This rider waives premium payments in the event the policyholder becomes critically ill, seriously injured, or disabled.
Again, even though the premium is no longer able to be paid, this rider allows the death benefit and cash value to still be available for the beneficiaries.
Benefits of Riders
Not everyone that gets life insurance needs to add riders to their policies.
But each rider that is available serves a unique purpose and adds to your death benefit. You can discuss your particular insurance needs with an insurance agent or a broker.
They can help you determine exactly which riders make the most sense for your situation.
What Is the Best Life Insurance Policy for Me?
If you have dependents who rely on you for income, you need a life insurance policy.
The question is, which one?
This answer depends on a number of factors including what you are going to use the insurance for. If your goal is to provide a death benefit while your children are young and get it at an inexpensive rate then you probably just need a term policy.
If you want the security of being able to pass money on to your children or grandchildren no matter when you die, then you will likely select a permanent policy.
From there, your selection will depend on the amount you want to pay on premiums, on your risk-tolerance, on your need for flexibility in your policy, as well as other factors.
Again, a knowledgeable agent can help you assess your needs and your situation so that you can arrange the right coverage at the right price, so the benefit is there when and if your family needs it.
Life insurance is not for those who die; it is those who are still living.
As you think about your personal situation and those who rely and depend on you, consider what they would do if you weren’t here.
Plan ahead and protect them from financial difficulty.
Talk to an agent today.
You can set up a straightforward term life insurance policy for a very small monthly premium and get peace of mind knowing that they are provided for.
Life is uncertain and has no guarantees, but having life insurance does provide a financial safety net.
At Insurance Professionals of Arizona we are happy to answer your questions and provide any information that can help you as you look for the right life insurance policy for you.
Call us or reach out to us today and we will be happy to guide you through the process.