Types of insurance: An overview
Evolution in the insurance business means that you can now choose how often and how much you pay in premiums; whether you buy coverage for 1, 5, 10, 20 years or more; whether your policy builds cash value; and if so, whether it does so based on investment-grade bond returns or on stock market gains, and who assumes the risk of poor performance.
Term Insurance
The fact remains, however, that most people are better off with the simplest — and cheapest — insurance product: term life, which provides a death benefit only during the period covered by the contract, from one year to 30 years. If it’s an annual renewable policy (ART), you’re generally guaranteed the right to renew, but your premium will go up. In a guaranteed level-term policy, the premium stays the same, but to renew at a favorable rate you usually have to take another health exam. (Note: Some level-term policies don’t guarantee the premium for the entire term; check before you buy.) Premiums, expenses and commissions are lower for term than for whole life. No cash value builds up, but a convertible term contract allows you to convert to a cash-value policy later.
Intense competition has driven down term life premiums as savings banks, affinity groups and big insurance companies compete to offer deals. This trend may be ending, however, as states adopt regulations requiring insurers to keep larger cash reserves for 15 to 30-year guaranteed level-premium policies. Rates for some policies could rise 40%, industry sources say, or premium guarantees could be shortened.
Term is unquestionably the best choice for most young families. But after age 50, premiums can run into thousands of dollars a year, even if you’re in good health. By 60, premiums are often prohibitive. Even so, Glenn Daily, a fee-only insurance consultant, contends that convertible 10,15, or 20-year level-premium policies can meet most people’s needs.
Permanent or Cash-Value Insurance
Consumer advocates, in fact, are nearly unanimous in their criticism of cash-value insurance. So can these policies make sense for you? Perhaps — if you married or had kids late, have a much younger spouse, have maxed out on your tax-deferred savings, expect to incur federal estate taxes or are concerned about continuing a business.
Permanent policies provide a death benefit for as long as the premiums are paid, plus a savings or investment component that policyholders can borrow from or draw down as retirement income. Commissions and expenses slow the accumulation of cash value in the early years of the policy, so you should buy permanent life only if you’ll keep the policy for at least 20 years. And except for traditional whole life, permanent policies “have to be actively managed,” says Richard Weber, a Carlsbad, Calif. agent and professor of ethics at the American College.
Whole Life
This is the kind of policy your father or grandfather might have had. Premiums are fixed, and in the early years are higher than the cost of providing the protection; in later years they’re usually less. The insurance company invests the premiums in low-risk instruments as required by law, mostly bonds and mortgages. The policyholder has no say in how the company manages these funds; long-range returns are comparable to bond funds. In participating policies, a share of surplus mortality charges is returned to the policyholder as dividends, which may be used to reduce the premiums. Non-participating policies have no dividends.
The most attractive feature of any permanent life insurance is that earnings aren’t taxed until they’re withdrawn, and then only to the extent that they exceed the amount paid as premiums. The invention of tax-deferred retirement plans, like 401(k)s and IRAs, and the phenomenal growth of mutual funds have made traditional whole life less popular as a means of college or retirement saving.
Universal Life
Universal life lets you adjust the death benefit and the amount and timing of premiums, so long as you keep enough cash value to cover administrative expenses and mortality charges. The part of the premium not going toward the mortality charge is invested in a separate account of intermediate-term bonds.
The flexibility of universal life appeals to consumers who want to adjust their payments to an uneven cash flow.
Two caveats: Universal policies are very sensitive to interest rates. And cashing out, say, a whole life policy in order to buy a new universal (or variable) policy is not a good move.
Variable and Variable Universal Life
All variable policies allow policyholders to invest their premiums in a stock portfolio. The value of the death benefit — and the cash build-up — fluctuates depending on the performance of investments you choose from a limited menu of stock and bond funds in a separate account. If you invest wisely and the market is up when you die, your beneficiaries may realize a windfall; if the market is down, they may wind up with a smaller death benefit than expected, though most policies do guarantee a minimum. (Variable annuities are not discussed here because they are not primarily life insurance products.)
The hottest commodity in today’s life insurance market is variable universal. It combines the investing feature and the fluctuating cash value and death benefit of variable with the adjustable premiums of universal. (Variable life policies have a fixed premium.)
Both types of variable insurance carry mortality charges, expenses and commissions — often steep ones — that eat up returns. “So don’t buy variable life to play the market,” advises White Plains, N.Y. agent James Newhouse. “You buy life insurance to put the risk that you might die or get disabled on the insurance company, but [when you buy a variable product] you decide to take on that risk again.”