Life insurance can be a complicated topic, and it doesn’t help that it’s not really fun to talk about. 😉
Today consumers can choose between not just term and whole life, but variable universal life (VUL), fixed universal life (UL) and even indexed universal life (IUL). Plus there are various hybrid policies such as modified endowment contracts, and return of premium term insurance.
Before you start determining what type of coverage you should purchase, you should decide how much insurance you need. Then use this guide to help navigate and understand all of the various options.
Guide to Understanding Life Insurance
There a few different variations of term insurance. However, term insurance can be thought of as temporary insurance. Term coverage provides protection for some time (the Term), and at the end of the Term, the insured will need to renew the policy. Typically, the cost for coverage will increase each time the policy is renewed, and eventually, the price for coverage will exceed the cost of permanent coverage.
Term insurance policies are comparably inexpensive to other forms of insurance. This is in part because it is highly unlikely that the insured will pass away during the term. The exact statistics are hard to find. However, it’s generally considered in the industry that less than 5% percent of term insurance policies will pay at out a death claim, and some experts think its less 2%.
Term insurance is not without risks. Many insureds purchase a term insurance policy thinking that they will only have a temporary need for coverage, then when the term renews, they find for one reason or another they need for coverage persists. Maybe they had a child later in life than expected, or perhaps due to some unforeseen reason, they were not able to pay down debt or the mortgage as rapidly as they were expecting.
Should the insured develop a health concern over the term, they may find it difficult to renew the existing term at favorable rates then. I have seen cases where people go to therapy for depression, and then find it challenging to purchase inexpensive insurance afterwords.
Note: This risk can be mitigated to some extent by purchasing guaranteed renewable term or purchasing term coverage that can be converted to permanent coverage.
Universal Life Insurance
Universal Life Insurance (UAL) is a permanent form of insurance and is considered more flexible than whole life. A UAL policy has a cost of insurance charge for the death benefit; when the insured pays into the policy more than the cost of insurance, the excess builds cash value in the policy. The cash value may earn a fixed interest rate; an indexed interest rate as in Indexed Universal Life, or can even be invested in various mutual funds as in a Variable Universal Life.
Once there is sufficient cash value in the policy, the earnings from the cash value could exceed the cost of insurance, and it may be possible to suspend or even discontinue making premium payments to the policies. Universal life policies are considered flexible because an insured could skip making payments as long as there is sufficient cash value to cover expenses. These policies work well for individuals whose cash flow may be unpredictable, but the insured still requires permanent coverage as a young family, a freelancer or small business owner.
The appeal to Universal Life Insurance is flexibility. Universal Life Insurance policies can be designed to do everything from providing relatively inexpensive permanent death benefits to producing retirement income. UAl policies are routinely purchased for their ability to build cash value, as the cash value in the policy grows tax-deferred. Since the policy offers permanent coverage, these policies are often used for business planning and estate planning, where temporary coverage would not be suitable.
These policies are not without drawbacks when compared to Whole Life policies. Universal Life policies typically have several “moving parts.” In a UL policy, the policy may have a guaranteed cost of coverage and a guaranteed minimum interest rate. If a policy is purchased under the assumption that the policy will earn more than the minimum interest, or less than the maximum amount of coverage is charged, and the insurer decides to lower interest rates or increase charges, than the insured may have to contribute more funds into the policy or risk the policy lapsing. To mitigate this, the insured can fund the policy assuming the worst-case scenario, or they can keep a keen eye on the policy and be prepared to contribute more money if necessary.
Some issuers offered a guarantee that if a specific minimum payment is made each year, the death benefit will remain in force regardless of the interest rates or changes to the cost of insurance. Anyone considering purchasing a UAL policy should familiarize themselves with the terms of any such guarantees to make sure they understand what is required to keep the coverage in force.
Whole Life Insurance
Whole life can be thought of as permanent insurance without the moving parts. Whole Life will provide a guaranteed minimum death benefit, assuming the insurance premiums are paid according to the terms of the policy. The minimum death benefit and the insurance premiums are fixed and will not change based on interest rates or the insurers’ changes to the cost of insurance.
Some whole life insurance policies are considered “participating.” For example, the insurer participates in a portion of the insurer’s profits. These policies earn a dividend based on the success of the company, and that can be used to offset some of the insurance premium, purchase additional insurance, or accumulate in a separate savings account. Over time, it is possible that the dividend could grow to exceed the yearly premium.
Whole life does not offer the flexibility to skip payments the way universal life does. However, in exchange, an insured will always know exactly what their minimum death benefit will be, and they will also understand what is required of them in the way of premiums. Depending on the policy, it is possible that they may be able to pay less in future years if they receive dividends. Keep in mind, while most insurers have a strong history of paying dividends, the dividend is not guaranteed.
Permanent death benefit protection could provide liquidity to pay inheritance taxes on an illiquid family farm or business. The cost of term insurance will exceed permanent coverages over time.
Question: Can you explain the investment or cash value component of whole-life insurance? What does it offer to the insured?
When an insurance premium is paid to an insurer, the insurer deducts the applicable costs and deposit the remainder into a cash-value account. Should the insured surrender the contract, the cash value would be paid to the insurer minus any applicable surrender charges. Some insurers allow the policyholders to borrow from the cash value under favorable terms. However, the insured should be cautious because if they do not pay the loan back, the policy could lapse.
Question: What personal factors (age, health, family, dependents, liquidity, current and projected wealth, financial goals) impact what life insurance product is right for you?
Term Insurance is best for individuals with good health and a genuinely temporary need for coverage. For example, you have dependent children at home, and they will move out in a few years or cover a loan.
Universal Life has so many variations that it can cover almost every situation. The key is that the policy is funded and designed correctly, but using too optimistic of assumptions in the level of funding could lead to trouble down the road.
Whole life can be better than UL in a few different scenarios; for older ages, entire life policies can be less expensive over time than UL. Also, whole life policies can often beat UL if the insured possibly has a few health issues that may impact health underwriting.
Question: What should consumers look at when comparing insurance providers?
Size and financial stability, insurance costs are determined mainly by the insurer’s risk pool. The more people and the more diverse the people in the risk pool, the lower the insurer’s costs will be. This is especially important if purchasing a participating policy where the insured may participate in some of the success of the company, or in policies where the company can adjust the cost.
Beyond the basics
Life Insurance can be a valuable tool in life to enhance retirement income, as long as the policy is correctly set up. Life insurance can be used to produce additional income or improve revenue in one or more ways.
- Whole life, if correctly set up, can produce tax-free dividends. Once the dividends for a whole life policy exceed the yearly premium, the excess dividends each year can be returned to the insured income tax-free. The dividend yield at some mutual life insurance can be extremely competitive with other investment options.
- Tax-free loans can be taken from the life insurance policy to supplement income. This strategy is sometimes sold as a “super Roth”; it can be beneficial. However, it is imperative the insured understand their policy and how to utilize this approach efficiently. Utilizing this approach, the insured would borrow money from the insurance policy each year to augment their retirement income. The insured would not pay these loans during their lifetime. Instead, the loans would reduce the death benefit. Loans from the insurance policy grow each year according to the terms of the policy.
- For this approach to be successful, the insured needs to be able to accurately anticipate the growth if the insurance policies cash value, project the loan interest and take into account any changes in internal costs to the policy. Should the loan balance exceed the cash value of the policy, the policy will lapse if the insured is unable to pay back the some of loans or add an additional premium. If the policy lapses not only will the income stops, it could trigger a taxable event as the gains in the policy would immediately become taxable.
- The cash value of a life insurance policy can be a one-time 1035 exchanged to an annuity. Also, many older insurance policies will allow the insured to annuitize their cash value. Once the insurance policy annuitizes, the death benefit is lost, and the policy becomes a series of systematic payments paid over a period of even a lifetime. The insured has multiple options for annutizing or also transferred to an annuity; however, going back to the life insurance can be difficult if not impossible. It is strongly suggested the insured does their research, speak with the insurer about their options, and consider discussing the options with a few different insurance professionals to get 2nd and 3rd opinions.
- Reverse Mortgage arbitrage. You have probably seen those commercials with Tom Selleck, claiming you can convert equity in your home into an income stream or even pay off particular debt. It’s true; the reverse mortgage does provide those benefits at a cost. The cost is the loan is negatively amortized, the loan balance grows, and when you pass away, you will end up owing much more on the mortgage than you originally borrowed. Life insurance can be used to pay the loan off cost-efficiently so that the home goes to the beneficiaries, or possibly the beneficiaries may choose to take the insurance instead rather than try to sell the house.
Life insurance is almost the inverse of a reverse mortgage, so they make an excellent pairing together. However, this approach is not for a DIY-er. If set up improperly, many things can go wrong. The insurance policy could lapse, or the homeowner could get upside down in the home while alive, making it difficult to sell the house to use the equity to move or downsize as the equity has now been allocated to the reverse mortgage.
Bonus tip: whenever a life insurance policy is being used for loan cancelation, income replacement or pension/social security maximization, I recommend my clients speak with an elder law attorney to establish the appropriate documents to protect the insurance from nursing home spend-down, probate, and frivolous lawsuits, if possible. If major decisions are being made on the presumption that an insurance policy is in place, then the policy needs to be protected.
Busting The Myth
Myth: It seems that whole-life insurance is increasingly unpopular with financial advisors. When can permanent life insurance be a viable part of a financial plan?
Most financial experts assume that market returns on an annual basis will exceed the internal rate of return on the cash value inside of whole life and universal life. So, the assumption is that the insured would benefit financially by purchasing term life insurance and investing the difference. This approach may be viable if the insurance coverage is only necessary for a limited number of years. Should the insured need permanent coverage, the costs of buying will exceed the costs of permanent coverage.
Myth: Should we buy term insurance and invest the difference in permanent coverage?
This debate has raged on for as long as I can remember and everyone has a relatively strong feeling that their personal beliefs are correct. Illustrations and examples can be drawn to show either method in a favorable light. The reality is life Insurance is purchased many times for not economic reasons, its a precaution against the worst happening, Death.
Every care can be seen as a cost or a waste of money until it is needed. Financial planning would be pretty straightforward if we all knew exactly what was going to happen. Don’t let someone jeopardize you or your families future by trying to trivialize non-economic decisions with math or questionable math.
The key to success is to find the tool and strategies that work for you and your families situation. If you have questions, I’m here to help.
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