Financial Planning 101 - Life Insurance
Updated: Jan 29, 2020
After a short hiatus exploring the pros and cons for having a financial advisor I am back to the Financial Planning 101 series. After completing the segment on financial fundamentals the focus will now shift to insurance and risk management. This post will specifically focus on trying to explain the different types of life insurance policies and their key traits. There are two primary categories of life insurance policies. The first is called term insurance while the other is referred to as permanent insurance.
What is the purpose of insurance?
Life insurance is a critical tool to help families safeguard their assets and provide financial stability in the case of death. If used properly, life insurance allows a family to not have to focus on financial worries when they have suffered the loss of a loved one. In most cases life insurance is generally thought of as a way to replace the income of someone or a way to help provide financial stability in the case of death.
Think of a family where one spouse is the primary wage earner. If that spouse dies, how would the family go about paying their bills and maintaining their lifestyle? Their income would be largely gone and they would still have a mortgage, car payments and all of life’s other obligations. Without life insurance they would quickly fall into financial distress. Even in the case of a family with two relatively even wage earners how would they go about continuing with their lifestyle on the remaining single salary? Insurance provides the funding for the survivors to continue their lives. It can be used to pay off major items such as a mortgage, auto loans and credit card debt or fund goals like college savings so that the ongoing monthly financial obligations of the family can be managed on a single salary. Additional insurance can then be used to fully or partially replace income so the remaining bills can be paid. It can allow a surviving spouse to possibly get a different job that allows them to better meet the family’s needs while not feeling the pressure to have a certain level of income.
It can also help provide a way to pay for final expenses such as funerals and estate settlement expenses. In other cases it can be used to fund trusts, or provide a way for business partners to buy out someone’s share.
Before getting started let’s make sure everyone understand some of the key terminology used in life insurance policies.
Death benefit – The amount of coverage provided by the policy and is paid to the beneficiaries in the event of death.
Cash value – The amount of value built up in a permanent policy available to the policy holder.
Surrender value – The amount that would actually be received if a permanent policy is terminated. This can be less than the cash value if the policy is terminated within the first ten years generally.
Policy owner – The person who took out the policy and is responsible for paying the premium. This does not have to be the same as the insured person. The policy owner is someone who just needs to have an interest in the insured person’s life.
Beneficiary – The person who will receive the proceeds from the death benefit.
Insured person – The person whose life is covered by the policy.
Premium – The amount paid each month for the policy.
This is the most basic type of life insurance. It provides a large death benefit for a relatively small price. The catch is that term insurance only provides this protection for a certain period of time or “term”. Term insurance is available for purchase usually in increments of five to ten years with 20 or 30 year coverage periods being the most common. Think of term insurance like your home or auto insurance. You pay a premium to protect against a catastrophic loss but there is a chance you will never receive any benefit from the policy.
Who is a good fit for term insurance? Generally term insurance is a good fit for younger people with families as it allows them to purchase a larger amount of coverage at a lower cost. In addition, term is a good fit for anyone who doesn’t think they will have a need for life insurance after a certain point. For example, if you and your spouse both retire at age 62, have adequate retirement savings and any children you have are grown you may not have a need for insurance past age 62.
In that case a 30 year term policy purchased at age 35 will cover you until age 65. In this instance if you have this policy and pass away at age 57 your survivors will receive the death benefit stated on the policy. If you don’t pass away until age 74 no death benefits will be received from this policy at it would have lapsed at age 65.
How much is term insurance? This is the most affordable type of life insurance. The amount you pay will depend on your age and the length of term of the policy. The older you are and the longer you want the policy in effect the more you will pay. In our above example, if you are a relatively healthy 35 year old you should be able to get a $500,000 policy for less than $75 per month. This premium won’t change during the term of the policy. The downside of term is if at the end of the policy you still felt the need for coverage it would be very expensive to get the same amount of coverage at age 65.
Permanent Life Insurance
As the name implies permanent life insurance is intended to be life insurance you carry for your entire life. There are multiple types of permanent life insurance and each has slightly different benefits.
Permanent insurance differs from term just in the length of the policy but also in that your premiums are used not just for insurance coverage but also for building cash value like an investment. Below is a recap of the primary types of permanent insurance. Generally, permanent life insurance is a good for people who feel they have a need to have coverage for their entire life or want the insurance to fund a specific purpose regardless of what age they pass away.
Whole life – This is the most basic of permanent life policies.
Premiums - You pay a fixed premium for life and a portion of that provides a death benefit and a portion is used to build a cash value.
Death benefit – The policy pays a stated death benefit. This amount does not fluctuate based on
Cash value - The cash value portion of the premium generally grows at a low fixed rate. The policy holder has no say in what the cash value is invested in. The insurance company assumes the risk as this policy offers a small but guaranteed return.
Taxes - The death benefit is tax free for the beneficiaries at the time of death. The cash value amount grows tax deferred. A policy holder will pay taxes on any withdrawals they make against the cash value of the policy.
Universal Life – This allows the policy holder a greater amount of flexibility. Universal policies allow the policy holder to have flexibility over both the premiums paid and the death benefit while still providing for the accumulation of cash value.
Premiums – To keep the policy in place the policy owner must pay at least an amount sufficient to cover the cost of the insurance. Excess premiums paid go to build the cash value. This feature allows the policy holder flexibility to pay more or less depending on what they can afford at a given time. This minimum amount usually increases over the life of the policy as the cost of insurance increases. Premiums will vary depending on how the death benefit is calculated.
Death Benefit – The death benefit of a universal policy can be calculated in several ways. Option one pays the stated death benefit of the policy but the insurance company keeps the built up cash value. This allows the premium to be lower as essentially the insurance company is using the cash value to pay part of the premium. Option two provides for a death benefit equal to the stated benefit plus the cash value. Premiums for this are more expensive as the policy holder must pay a premium that covers the cost of insurance.
Cash Value – Premiums paid in excess of the cost of insurance and other policy expenses go to build the cash value. The cash value on a Universal policy earns interest based on the current market returns or a minimum guaranteed rate, whichever is greater. This allows the policy holder the potential to gain a slightly higher return than a whole life policy.
Taxes – The death benefit is tax free for the beneficiaries at the time of death. The cash value amount grows tax deferred. A policy holder will pay taxes on any withdrawals they make against the cash value of the policy.
Variable Life – This type of policy allows for greater investment risk and both the death benefit and cash value can vary through the life of the policy
Premiums – Premiums for variable life insurance policies are fixed but a portion are dedicated to the investment portion. Unlike universal life policies the client doesn’t have the option to vary the amount of the premium they pay. Premiums for variable life tend to be higher than whole life. The cash value can be used to pay the premiums as well.
Death benefit – There is an initial stated face amount of the policy. This amount will not be decreased, like is possible on a universal policy because the premium stays the same is sufficient to always cover the cost of insurance.
Cash value – A portion of the premium is dedicated to building a cash value in the policy. The cash value portion may be invested in a variety of ways including mutual funds as compared to whole and universal policies which essentially earn no more than interest rate level returns. By having the ability to invest in mutual funds the variable policy has an increased amount of risk as well as potential for increased returns. This risk is fully taken on by the policy holder and can result in the cash value of the policy decreasing as a result of poor investment performance.
Taxes – The death benefit is tax free for the beneficiaries at the time of death. The cash value earnings grows tax deferred. A policy holder will pay taxes on any withdrawals they make against the cash value of the policy to the extent they are in excess of the total premiums paid on the policy.
Variable Universal Life – This type of policy combines some of the benefits of both the universal and variable policies including the ability to have flexible payments like a universal policy and the investment options of a variable policy.
Premiums – The premium for a variable universal life policy is similar to that of a universal life policy. A minimum amount needs to be paid in order to cover the cost of insurance or the excess cash value can be used to pay the premium. Any amount paid in excess of the minimum is invested to grow the cash value.
Death benefit – There are two options, one is a fixed death benefit while the second allows for the face value of the policy plus the cash value.
Cash Value – Premium amounts in excess of the cost of insurance. The cash value portion can be invested in a variety of investments similar to variable life policies. The risk of the investments also belongs to the policy holder.
Taxes - The death benefit is tax free for the beneficiaries at the time of death. The cash value earnings grows tax deferred. A policy holder will pay taxes on any withdrawals they make against the cash value of the policy to the extent they are in excess of the total premiums paid on the policy.
While each of the various types of permanent policies have different features there are some that are shared across the various types.
Ability to use the cash value. The excess cash value can be used for a number of purposes including the following:
Be used to increase the amount of the death policy by essentially using it to prepay premiums for additional insurance.
Use the cash value to make premium payments instead of the holder having to make payments. As long as cash value is sufficient to make the premium payments the policy stays in effect.
Take a loan against the cash value. Loans can be paid charging a low interest rate. Any unpaid loan at the time of death though reduces the death benefit by the unpaid amount. There are no tax consequences with a loan.
Make a withdrawl of some or all of the cash value. Depending on the policy type, cash may be withdrawn and be taxable at regular income rates, be non-taxable as long as the amount withdrawn is less than the total amount paid in premiums or might reduce the death benefit.
Surrender the policy. This is an option to let the policy lapse and withdraw all of the cash value. If this is done, there is no more death benefit and no further premiums are owed.
Surrender charges. While permanent policies build up cash value, not all of the cash is available to the policy holder right away. Policies have a surrender charge which is the amount of the cash value the holder sacrifices if they choose to surrender the policy. Surrender charges are usually in place for a period of up to 10 years although the amount does get smaller as the policy gets closer to year 10.
Capping of market returns. Depending on the policy the market rate of return might be capped by the insurance company though. For example the policy might be capped at 12% so in a year when the market return is 20% the policy will be limited to the 12% return.
Policy riders. Permanent policies are known to have a number of possible riders that the holder can elect to add to the policy. These riders generally provide the holder with extra options or levels of investment protection, performance or death benefit. Each of these riders will increase the premium amount.
Cash value at death could go back to the insurance company. Depending on the type of policy or riders on the policy it is possible for any remaining cash balance at the end of the policy to revert back to the insurance company. To prevent this the policy holder needs a rider to get the cash value in addition to the death benefit at time of death or use the cash value for one of the purposes listed above.
Cost of permanent insurance policies. Permanent policy premiums are significantly higher than a term policy in the same amount. In fact, you could expect to pay 5-10 times the premium for a permanent policy than a similar term policy.
In summary, there are many options available to someone looking for life insurance. To determine the best policy type and options speak to a fee only financial planner to get advice on what type of policy is the best fit for you and your specific situation.
Thank you for reading this latest blog entry. I hope you found this informational and can find something to use in your own life. The next blog topic will continue to focus on life insurance and explore how much life insurance you really need. As always, if you have any questions feel free to reach out to me at firstname.lastname@example.org.
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