Life insurance helps make sure family members and/or other beneficiaries are financially supported if someone dies. It’s 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 usually the simplest and least expensive type of life insurance. Common terms are 10, 15, or 20 years.
If the insured person dies during the term, the insurer pays a death benefit to the beneficiaries. If the insured person survives the term, the policy expires and no benefit is paid. Many policies can be renewed, but only up to a certain age; most insurers won’t renew after age 80.
Term life insurance uses fixed (non-variable) premiums. Those premiums pay only for the death benefit - there’s no additional savings component.
Premiums generally increase with age. This becomes 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 other forms of life insurance, term life insurance never builds cash value. Cash value is the “extra” amount paid above the cost of the death benefit in policies that include a savings component.
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 lives. Coverage lasts for the insured person’s “whole” life as long as premiums are paid. Like term life insurance, whole life typically uses a fixed premium.
Unlike term, whole life insurance builds cash value over time. For example, assume a 30-year-old buys $250,000 of whole life insurance on themselves* with a fixed $200 monthly premium. Early on, the cost of the death benefit might be $50 per month. The remaining $150 would be credited as cash value. As the insured person gets older, the cost of the death benefit generally rises, so less of the premium goes toward cash value. At age 60, the death benefit cost might be $160 per month, leaving $40 per month for cash value.
*A person buying life insurance on themselves would be considered both the insured person and the policyholder.
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. The general account is typically invested in relatively conservative instruments such as US government bonds or commercial paper. From the policyholder’s perspective, the specific investments matter less than the guarantee: if the insurer credits 4%, the cash value grows at 4% even if the insurer’s investments perform poorly. That means the insurance company bears the investment risks (for example, market risk) because it must credit the guaranteed 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, but it’s generally accessible only while the insured person is alive. After the policy has been in force for a period of time (often 3 years), the policyholder may be able to withdraw or borrow against cash value. Any cash value withdrawn or borrowed and not repaid is generally subtracted from the death benefit.
Taxes also matter. Ordinary income taxes are generally due on distributed cash value above the policyholder’s contributions (basis). For example, assume a policyholder contributes $50,000 to cash value and it grows to $75,000. If the policyholder distributes $60,000, ordinary income taxes apply to the $10,000 of growth distributed, but not to 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 effectively surrender the whole life policy, then use the cash value to purchase the equivalent of term life insurance on the insured person. This option is typically only available if the insured person is below age 80, since most insurers don’t offer term life to very elderly applicants.
Retain insurance with a 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 the cash value
The policyholder can surrender the policy and receive the cash value minus any applicable surrender fees (fees charged by the insurer when the policy is canceled). Surrender fees often follow a sliding schedule: 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 or viatical settlement and is typically associated with an insured person who is near death. People diagnosed with terminal illnesses commonly use these settlements. If the insured person expects to die within a short period of time, the policyholder 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 then takes over premium payments and receives the full death benefit ($500,000 in this example) when the insured person dies.
Let’s summarize the main test points related to whole life insurance:
Variable life insurance shares several features with whole life insurance. Both provide coverage for the insured person’s lifetime, typically require fixed premium payments, and provide a minimum death benefit. The key difference is how the cash value (and potentially the death benefit) grows over time.
With variable life insurance, the portion of the premium allocated to cash value is not placed in the insurer’s general account. Instead, it goes into the separate account, similar to the separate account used in variable annuities. The policyholder chooses how to invest these funds, often across asset classes such as common stock, preferred stocks, and bonds.
Separate accounts have two major consequences:
Because variable life insurance is a security, the person selling it must have both insurance licensing and securities licensing. This typically involves FINRA and NASAA licensing (for example, Series 6, 7, 63, and/or 66) plus a state insurance license.
Investment performance in the separate account drives the growth of cash value and can also affect the death benefit. If the separate account performs well, both may increase. If it performs poorly, both may decline. Variable life insurance contracts typically provide a minimum guaranteed death benefit even if the separate account declines significantly, but there is usually no minimum guaranteed cash value.
Let’s summarize the main test points related to variable life insurance:
Universal life insurance has several similarities to whole life insurance. Both provide lifetime coverage, offer a death benefit, invest cash value in the insurer’s general account, and are not considered securities. The main difference is how premiums work.
Think of the word universal as meaning flexible. Universal life insurance premiums are flexible and can change over time. The policyholder can:
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).
Premium flexibility can be useful when a policyholder’s financial situation changes. If income or family needs increase, the policyholder can increase premiums rather than applying for a new policy to raise the death benefit (which may be necessary with non-universal policies).
Let’s summarize the main test points related to universal life insurance:
Universal variable life insurance combines features of universal life and variable life. Like universal life, it provides lifetime coverage, allows flexible premiums, and typically offers a flexible death benefit. The key differences are how cash value is invested and whether the product is a security.
Instead of investing cash value in the insurer’s 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 the cash value and (potentially) the death benefit depend on investment performance, there’s no guarantee of growth. It’s even possible (although 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-taking rule, any insurance product with the word variable in its name can be treated as a security. That means the product is subject to registration, and the professionals selling it must be 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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