Life insurance helps make sure family members and/or other beneficiaries are financially supported if a person dies. This is especially important in households that rely heavily on one primary income earner. Many life insurance products exist, each with its own benefits and risks. This chapter covers:
Term life insurance provides coverage for a specific period of time (the term). It’s typically the simplest and least expensive type of life insurance. Common terms are 10, 15, or 20 years.
If the policyholder dies during the term, the insurer pays a death benefit to the beneficiaries. If the policyholder is still alive when the term ends, the coverage expires. The policy can often be renewed, but only up to a certain age; most insurers won’t renew after age 80.
To keep coverage in force, you pay premiums to the insurance company. With term life insurance, premiums are fixed (non-variable). Those premiums pay only for the death benefit - there are no additional benefits.
Premiums generally increase as a person gets older. This is especially noticeable at renewal. For example, suppose someone buys a 20-year term policy at age 30. When the term ends, they’re 50. Renewing at 50 can be much more expensive because the probability of death is higher at 50 than at 30.
Unlike every other type of life insurance discussed in this chapter, term life insurance has no cash value. Cash value is the “extra” amount paid above the cost of the death benefit. Term life insurance never accumulates cash value.
Let’s summarize the main test points related to term life insurance:
Whole life insurance is designed for people who want coverage for their entire lifetime. Coverage lasts for the “whole” life of the policyholder as long as premiums are paid. Like term life insurance, whole life uses fixed premium payments.
Unlike term life, whole life insurance builds cash value over time. Here’s a simple way to think about it:
For example, suppose a 30-year-old buys whole life insurance with a fixed $200 monthly premium. Early on, the cost of the death benefit might be $50 per month, so the remaining $150 would be cash value. As the policyholder ages, the cost of the death benefit typically rises, leaving less of the premium to contribute to cash value. At age 60, the death benefit cost might be $160 per month, leaving $40 for cash value.
Cash value is contributed to the insurance company’s general account. The policyholder owns the cash value, but the insurance company invests it and guarantees* a fixed rate of return. Cash value is usually invested in relatively safe securities like US government bonds or commercial paper.
From the policyholder’s perspective, the specific investments matter less than the guarantee. If the insurer credits a 4% fixed return, the cash value grows at 4% even if the insurer’s investments perform poorly. That means the insurance company bears the investment-related risks (e.g., market risk) because it must credit the promised growth regardless of market conditions.
*Due to the guaranteed return of the general account, whole life insurance is not considered a security.
Cash value can be used in several ways. In most cases, the policyholder can access cash value only while the insured person is alive. After the policy has been in force for a period of time (often 3 years), cash value may be withdrawn or borrowed.
For example, suppose an investor contributes $50,000 to cash value and it grows to $75,000. If the investor distributes $60,000, they generally owe ordinary income tax on the $10,000 of growth distributed, but not on the $50,000 basis.
If a policyholder wants to stop paying premiums, they are typically provided one of four potential options:
Keep death benefit for a shorter period
The policyholder can surrender the whole life policy and use the cash value to buy the equivalent of term life insurance. This option is typically only available to policyholders below age 80, since most insurers don’t offer term life to very elderly applicants.
Retain insurance with lower death benefit
The policyholder can stop paying premiums in exchange for a lower death benefit. Depending on the contract and agreement, the cash value may or may not be adjusted.
Surrender and receive cash value
The policyholder can surrender the policy and receive the cash value minus any applicable surrender fees. Surrender fees are charges paid to the insurance company when the policy is canceled. Many surrender fee schedules decline over time (higher in early years and lower in later years). Any gains above the basis (amount contributed) are taxable to the policyholder.
Perform a life (viatical) settlement
In some situations, the policyholder can sell the life insurance policy to a third party. This is called a life settlement or viatical settlement and is typically associated with a policyholder who is near death. People diagnosed with terminal illnesses commonly use these settlements.
If someone expects to die within a short period of time, they may sell the policy and use the proceeds for medical or end-of-life expenses. For example, a $500,000 policy might be sold for $300,000. The third party takes over premium payments and receives the full death benefit ($500,000 in this example) when the original policyholder dies.
Let’s summarize the main test points related to whole life insurance:
Variable life insurance shares several features with whole life insurance:
The key difference is how the cash value (and potentially the death benefit) can change over time.
Instead of placing cash value in the insurer’s general account, variable life insurance places it in a separate account. This works similarly to the separate account in variable annuities. The policyholder chooses how the funds are invested, often from options that include different asset classes such as common stock, preferred stocks, and bonds.
Separate accounts have two major consequences:
To offer variable life insurance, a professional must hold both securities and insurance licenses. This typically involves FINRA and NASAA licensing (e.g., Series 6, 7, 63, 65, and/or 66) plus a state insurance license.
Because the separate account’s value fluctuates, both the cash value and the death benefit can increase when investments perform well and decrease when investments perform poorly. Variable life insurance contracts typically provide a minimum guaranteed death benefit regardless of how far the separate account declines, but there is usually no minimum guaranteed cash value.
Let’s summarize the main test points related to variable life insurance:
Universal life insurance is similar to whole life insurance in several ways:
The main difference is premium flexibility.
The word “universal” is a good cue for flexibility. Universal life insurance premiums can change over time. The policyholder may:
If enough cash value accumulates, some policyholders pay premiums from the general account until the cash value is depleted. If cash value is exhausted and premiums aren’t paid, the policy will lapse (terminate).
This flexibility can be useful for people whose financial situation changes over time. For example, if income or family responsibilities increase, the policyholder can increase premiums rather than applying for a new policy to raise the death benefit.
Let’s summarize the main test points related to universal life insurance:
Universal variable life insurance combines features of universal life and variable life insurance. Like universal life insurance, it:
The main differences involve where cash value is invested and whether the product is a security.
Instead of investing cash value in the general account, universal variable life insurance places it in the separate account. As with variable life insurance, the policyholder controls the investments and bears the investment risk. Because both cash value and the death benefit can be affected by investment performance, there is no guarantee of growth. It’s even possible (though very unlikely) for cash value to fall to zero if the investments become worthless. However, many universal variable life insurance contracts provide a minimum guaranteed death benefit.
Universal variable life insurance is considered a security. As a practical test point, any insurance product with the word “variable” in its name can generally be treated as a security. This means the product is subject to registration, and the professionals who sell it must be properly registered with both securities regulators and insurance regulators.
Let’s summarize the main test points related to universal variable life insurance:
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