If you remember, in part 1 of this series on Life Insurance Awareness, we talked about the value of having that protection in place, in case of the unexpected happening. I assume from the fact that you have decided to read part 2, that you actually see the importance and necessity of having yourself and your loved ones protected. Great news! However, now that you know that you need insurance, you may be thinking, “Yeah but how does it work? What are my options.” Life insurance may seem complicated on the surface, with many different moving parts, but when you dig deeper, it really is fairly simple at its core. This article is designed to provide you with a greater understanding of the basics on how it works, the different types of insurance you can choose from, and what makes each one a potentially good or bad option. By the end of this article, you will be well on your way to becoming comfortable with everything. Soon you will be ready to make the choice of what type of policy and coverage is best for you and what is the best way to protect yourself and your family, which is the ultimate goal. Protection first!
Key Terms and Elements of a Life Insurance Policy:
This section is designed to help you understand some of those moving parts and the terminology commonly found in most life insurance policies. You may hear a term or two referred to slightly differently depending on the person you talk to, but for the most part, these are all standard components you will find across the board.
Face Amount – This refers to the amount of death benefit coverage paid to your beneficiary when you pass away. Simply put, if you purchase a policy on yourself with a face amount of $500,000, this means that your beneficiary will receive $500,000 if you die, as long as you are still covered.
Premium – The premium is the amount of money that you agree to pay the insurance company for the coverage, very similar to an auto or homeowner’s policy. The annual premium is calculated by the insurance company and then you have the option of how you want to pay this amount over the course of a year. You can be billed annually, quarterly or the most popular and recommended, monthly. Most companies now a days have an automatic withdrawal set up, where the money can come directly out of your checking account every month on a particular day (15th, 30th etc).
Rating – Your rating is your classification for the amount of risk that you represent to the insurance company. In simpler terms, given your health, age, gender and other factors, how likely is it that you will die sooner rather than later. The greater a risk you are to the insurance company to die soon, the more expensive the coverage will be. Ratings vary depending on the company. The most common ones are standard and preferred. Standard represents the average, baseline for risk. If your health is above that standard, you may receive a rating of preferred, preferred plus, or even elite, depending on what that company calls it. A below average/higher risk will see ratings of substandard etc. Usually this information is collected via a paramedical evaluation, which is a series of medical questions about your history, conditions, and other factors designed to assess your level of risk to the insurance company. There may be a urine or blood test required as well, depending on the amount and type of coverage you are seeking.
Beneficiary – The beneficiary(s) on the policy is the person(s) you designate as entitled to be paid the face amount in the event of your death. You can choose primary beneficiaries and also contingent beneficiaries. The contingent beneficiaries will only be paid if the primary beneficiary is no longer living. In most cases you usually cannot designate a minor as a beneficiary.
Riders – A rider is an add-on option to your policy which allows you to further customize it and add additional benefits. These benefits can range from adding on more insurance in the future without having to go through underwriting again, to waiving the premiums for a certain period of time if you become disabled, to accessing a portion of your death benefit early if you become terminally ill. There is even a rider which can cover your child, allowing you money for help with final expenses, should the unthinkable happen and you lose a child. Some of these riders are free, but most carry a certain charge, which is usually no more than a few dollars per year.
Settlement Options – This is the manner in which the death benefit proceeds are paid to the beneficiary. In most cases, the beneficiary chooses the option after the death has occurred. The most common settlement option is a lump sum, however there are other choices, including those that cover a specific period of installments or interest payments, which may be more beneficial depending on the beneficiary’s financial situation at the time. No worries, a good advisor/agent will help them make the right choice that is best for them and the family.
Cash Value – Some policies, depending on the type of life insurance you purchase, allow you to accumulate cash value over time. In this case, the premiums that you pay, not only cover the cost of the insurance coverage, but also build up cash value over time, allowing you to earn some interest, and provide you with available cash that can be withdrawn or taken as a policy loan at your discretion, while you are LIVING. The cash value refers to how much money is available to you NOW, as opposed to the face amount, which refers to how much will be paid out when you die. We will cover this more when we get into the different types of policies you can purchase.
Different Types of Life Insurance Policies:
Understanding the various types of life insurance policies available helps you determine what is best for you. Your financial planner/advisor should be able to help you choose which option is optimal for you and your family, based on goals, needs and financial situation.
Term Insurance – This is, in most cases, the simplest and most affordable type of life insurance. Essentially you are paying for temporary life insurance coverage for a specific period of time (or term), and once this period is up, you are no longer covered. Terms can normally range anywhere from five years to as high as 30 years in some cases. The longer the term, the more expensive the coverage will be. This type of policy is used solely as life insurance coverage and does not accrue any cash value over time. The only time any money can be received or used from the policy is if the person insured passes away during the designated term, and the face amount is paid out to a beneficiary.
Pros of Term Life: Obviously, the largest benefit to purchasing a term policy is the cost. For some families or individuals living on a very tight budget, this may be the only option for them. Also, in some cases, the temporary nature of the policy may fit their needs. It could be a situation where a family is just trying to add some coverage on top of existing coverage, just for a specific period of time, such as until the kids get older and move out of the house, or until the mortgage is paid off etc. Finally, the cost is fixed. The premium never changes over the course of the term.
Cons of Term Life: The biggest drawback to a term policy is the actual fact that it is temporary. You are essentially renting coverage from the insurance company for a specific period of time. If you are fairly healthy and do not experience a pre-mature death, the policy will most likely lapse before it pays out. This means that you are basically paying for something that you will never use. Some studies have estimated that as few as 2% of all term policies ever pay out, though those numbers vary by company and term length. However, there are riders available on some term policies that allow you to convert your term insurance to permanent insurance at a certain time. If you purchase a term policy, I would almost always recommend this rider. The other main negative is that there is no cash value build up to the policy. Essentially the money that you are putting into the policy provides no benefit or use to you other than a death benefit in case you die. Also, if you are older, less healthy or a smoker, term policies tend to be a bad value, since you are paying a much higher premium than you would want, when compared with your likelihood of actually having the policy pay out. Term insurance for older or unhealthy people tend to be a bad buy, particularly for smokers.
Permanent Life Insurance – This type of policy provides lifelong protection, as long as you pay your premiums. There is no term or temporary component to it. If you purchase permanent life insurance, and continue to pay your premiums, the policy will pay out upon death, no matter when it occurs. The policy remains in force until death. Some policies can be structured so that you only have to pay premiums to a certain age, like age 65, to have permanent coverage for the rest of your life. You will also accumulate cash value on a tax deferred basis, which can be used while you are still living. This is a key component that can make it a very attractive option for people looking for protection, and also a mid-long range savings vehicle that builds up over time.
Pros of Permanent Life: I tend to favor permanent insurance for two reasons. First, the coverage will last you for the rest of your life, as long as you pay your premiums. Keep in mind, this does not mean you have to pay premiums forever. There are ways to structure the policy which allows you to pay premiums only up until a certain age or time period. No one can predict the future or what will happen over the course of the next 20 years, so it is good to have a permanent policy in place now, while you are healthy and insurable. Second, the cash value that builds up in a permanent policy means that money that you are paying into it does not go to JUST insurance coverage. Your money is actually going into a savings vehicle which allows you to access it while you are still alive. Liquidity is a very important notion that I preach to all of my clients. To me, a term policy provides no value outside of the death benefit. The money you put into it gets locked into a gamble that you will die within a certain time period. The only way to ever touch this money again is if you die during the term. With permanent life insurance, the money you put into it does not just go away. It builds over time in sort of your own personal bank, allowing you to use it at some point in the future if you need it. I have seen clients use it for a variety reasons, including bills, college tuition, a down payment on a house, an investment property, a car, a vacation and even to start a business. The idea of letting the money work for you and earn even more is a concept we will get into in part 3.
Cons of Permanent Life: The main negative to permanent insurance is the cost. Obviously, if you are purchasing a permanent policy that is guaranteed to pay out (if you pay your premiums), the premium is going to be higher than that of a term policy. The insurance company knows at some point, they WILL be paying that face amount, whereas, with term life, the insurance company does not plan on ever paying most of the policies that are purchased. The saving grace to this drawback is that with a permanent policy, your money is not just going away. Rather it is accumulating and will be available for you to use at some point in the future. Yes you are paying a higher premium, but that extra money you are spending is going into building a cash account. You have both a death benefit AND living benefits of this policy. This is why these policies can be good mid to long range savings vehicles.
With that said, there are two main types of permanent life insurance policies, Whole life insurance and Universal life insurance. Whole life insurance locks in a set premium payment from day one of the policy, which never changes. The policy remains in force as long as you continue to pay that amount. Also, the cash value accumulates at a fixed, guaranteed rate. However, some insurance companies do pay dividends, which can be added into the cash value. Universal life insurance allows you the flexibility to alter your premium payments, death benefit coverage, and also cash value accumulations. Also, the cash value has potential to grow at a more rapid rate, based on certain factors. There is a minimum payment required to keep the policy in force. However, due to the risk/cost of insurance that increases as you get older in this type of policy, paying the minimum, or some other low amount, drastically alters how much cash value builds up in the policy. This makes them a riskier proposition. There are certain situations in which Universal life insurance is a better option, but for the most part, if you are looking for a consistent, predictable payment, and cash value accumulation, Whole life insurance tends to be the best bet. It all comes down to talking to your advisor/planner as to which one works best for you. Part 3 of this series will focus on the nuts and bolts of using a permanent policy as a savings strategy and how to benefit from its cash value while you are still living.
Peace and Wealth 