Term, Permanent, Whole Life, Universal Life, Participating, Variable, Joint. There are so many variations of life insurance that it can become extremely confusing, very quickly.
To make things simple, there are essentially two types of insurance: term insurance and permanent insurance.
Term insurance is used to cover a temporary need – this could be 1 year, or it could be 40 years but the need will eventually go away. Term insurance is used to cover your Human Capital, so that if you die, your beneficiaries can cover debts and continue their standard of living without your income (or in-kind services like taking care of children). Term insurance will cover you for a specified period of time, i.e. the term of the policy. The most common term insurance policies are for 10 or 20 years. If you take out a 10-year policy, you’re covered and receive the death benefit if you pass away at any point within those 10 years. Once the 10 years have passed, the policy and coverage ends. At that point, you decide if you no longer need insurance, or take out a new policy for the future.
The premiums for term insurance policies are lower when you are young and higher as you age. This is because the younger you are, the lower probability of you dying. For most families, insurance needs are higher early on (when children are young, the mortgage balance is still high, retirement and education savings are relatively low), and decrease as time goes on, as mortgage payments are regularly made, and savings and investments accumulate. This makes term insurance the cheapest option for young families when their insurance needs are high. You’re covering your butt in case the worst happens, but not paying more for something that you won’t need longer-term.
On the other hand, permanent insurance is designed so that it’s in force for your whole life. This is why it is also referred to as whole life insurance. The death benefit works the same as a term policy. Your beneficiaries will receive the death benefit if you pass away while the policy is in force. If you keep the policy intact by paying the premiums, this death benefit will be paid at any age – if you die at age 35, or if you die at age 95. Premiums are level throughout the plan. Your premiums are higher than they would be for term insurance when you’re young, but lower than term insurance as you get older. A portion of your early premiums are set aside, which then grow over time to pay for what would have been higher premiums later on. These surplus premiums can be saved or invested and the cash value can be used by retirees to purchase an annuity, can be used to keep a policy in force if you don’t pay the premium, or you can borrow against the cash value if you need the money.
Participating insurance is a feature of a permanent insurance contract. Insurance companies use conservative estimates for premiums on permanent insurance to reduce their risk. Since permanent insurance policies are in effect for such a long time, it can be very difficult to estimate assumptions. Therefore, they charge higher premiums so they aren’t potentially stuck with huge death benefit payments and not enough cash if their assumptions are off. Participating policies will refund the premium surplus, if any, in the form of dividends. Premiums won’t go up, and death benefits won’t go down. The dividends can be used to reduce the out of pocket premiums you owe, taken out as cash, used to purchase more insurance, or can be left in the policy and accumulate interest.
Universal life is also a permanent insurance policy however, there is more flexibility to change plans as time goes on depending on how investments have done, actual mortality costs, expenses and other contingencies. The upside is that your premiums might decrease, or your death benefit might increase. However, while premiums might go down, the downside is that they may go up as well.
Variable insurance is a permanent whole life policy where the cash surrender value vary based on the performance of an investment fund or index, rather than simply accruing interest.
Finally, joint insurance is paid out on the last surviving spouse’s death. Therefore, this type of insurance is useless in providing the surviving spouse with replacement income when their spouse dies. It is used to cover estate needs like a desired inheritance or covering taxes owed upon death.
While there are many different features around permanent insurance, there are really only two types of basic insurance. Term and permanent. For the vast majority of people who are looking to cover the risk of maintaining their dependent’s lifestyle if they pass away, term insurance will be the cheapest and most effective way to do this.
