Life insurance

Life insurance is an important tool to ensure family members and/or beneficiaries are taken care of in the event of a person’s death. This is especially important for families with one “breadwinner” (money earner). A number of different life insurance products exist, all with their own benefits and risks. We’ll discuss the following in this chapter:

• Term life insurance
• Whole life insurance
• Variable life insurance
• Universal life insurance
• Universal variable life insurance

Term life insurance

Covering a specific period of time (a.k.a. term), term life insurance is a basic and cheap form of life insurance. Typically covering periods of 10, 15, or 20 years, a death benefit is received by beneficiaries if the insured person dies within the specified period of time. If the insured person survives the term, the life insurance expires and the policyholder paid premiums essentially for nothing. The policy can be renewed as long as the insured person is not too old; most insurance companies do not allow renewals after age 80.

Fixed (non-variable) premiums must be paid to the insurance company to gain coverage. Term life insurance premiums only pay for the death benefit, as no other benefits are associated with this type of insurance. The older a person is, the more expensive the premiums. This is especially noticeable when renewing term life insurance. For example, assume a person obtains 20-year term life insurance at age 30. At the end of the 20-year term, the person is 50 years old. The difference in premiums could be significant, as the chances of death are much higher for a 50-year-old as opposed to a 30-year-old.

With every other form of life insurance other than term, an element of cash value exists. Cash value is the “extra” paid above and beyond the cost of the death benefit. Term life insurance never gains cash value.

Let’s summarize the main test points related to term life insurance:

• Coverage for a specific term
• Fixed premiums
• Fixed, guaranteed death benefit
• No cash value
• Not considered a security

Whole life insurance

For those who need life insurance coverage their entire lives, whole life insurance can be a good fit. As the name suggests, coverage exists over the “whole” life of the insured person as long as premiums are paid. Like term life insurance, whole life requires a fixed premium to be paid.

Unlike term, whole life insurance builds cash value over time. For example, let’s assume a 30-year-old obtains $250,000 whole life insurance on themselves* with a fixed $200 monthly premium. In their younger years, the cost of the death benefit may be $50 per month. The “extra” $150 in this example would be considered cash value. The older the investor gets, the higher the death benefit cost and the lower the cash value contribution. At age 60, the death benefit could increase to $160 per month, allowing a reduced $40 monthly cash value contribution.

*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. While the policyholder owns the cash value, the insurance company invests it on their behalf and guarantees* a fixed rate of return. Most of the time, the cash value is invested in safe securities like US government bonds or commercial paper. The investment doesn’t matter much to the policyholder, though. If the insurance company promises a 4% fixed return, the cash value will grow at that rate no matter how poorly the investments perform. Therefore, the insurance company is subject to risks related to investing (e.g. market risk), as they are required to credit cash value with growth no matter the market situation.

*Due to the guaranteed return of the general account, whole life insurance is not considered a security.

Cash value can be used for several purposes. In most instances, cash value may only be accessed by the policyholder during their lifetime. It can be withdrawn or borrowed after the policy has been in place for some time (usually 3 years) as long as the insured person is still alive. Any cash value withdrawn or borrowed and not repaid is generally subtracted from the death benefit. Additionally, ordinary income taxes are due on any distributed cash value above the investor’s contributions (basis). For example, assume an investor contributes a total of $50,000 to their cash value, which grows to $75,000. If the investor distributes $60,000 of cash value, they will pay ordinary income taxes on the $10,000 of growth, but not 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
• Retain insurance with a lower death benefit
• Surrender and receive the cash value
• Perform a life (viatical) settlement

Keep death benefit for a shorter period
The policyholder can essentially surrender the whole life insurance, then take their cash value and purchase the equivalent of term life insurance on the insured person. This option is typically only available to insured persons below the age of 80, as most insurance companies do not offer term life to elderly persons.

Retain insurance with a lower death benefit
In exchange for a lower death benefit, the policyholder can stop paying premiums. Depending on the contract and agreement, the cash value may or may not be adjusted during this change.

Surrender and receive the cash value
The policyholder can completely surrender their policy, allowing them to keep the cash value minus any applicable surrender fees. These are fees paid to the insurance company upon cancellation of the policy. Many surrender fees are based on a sliding time scale, meaning the fees are higher if surrendered in early years, but lower if surrendered in later years. Any gains above and beyond the basis (amount contributed) are taxable to the policyholder.

Perform a life (viatical) settlement
In some circumstances, the policyholder can sell their life insurance to a third party. Known as a life or viatical settlement, this type of transaction is typically tied to an insured person near death. In particular, people diagnosed with terminal illnesses routinely utilize these types of settlements. If the insured person knows they’ll die within a short period of time, the policyholder can sell their life insurance to a third party and potentially use the funds for medical or end-of-life expenses. For example, a $500,000 life insurance policy might be sold for $300,000. The third party takes over the responsibility of paying premiums and will receive the total death benefit ($500,000 in our example) upon the death of the insured person.

Let’s summarize the main test points related to whole life insurance:

• Coverage for the “whole” life of the policyholder
• Fixed premiums
• Guaranteed death benefit
• Cash value invested in general account
• Cash value grows at a guaranteed fixed rate
• Insurance company subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with the death benefit
• Not considered a security

Variable life insurance

There are several similarities between whole and variable life insurance. Both offer coverage throughout the life of the insured person, involve fixed premium payments, and provide a minimum death benefit. The primary difference relates to the growth of the death benefit and the cash value over time.

Instead of portions of the premium being contributed to the insurance company’s general account, these funds are placed in the separate account. This is similar to the separate account in variable annuities. The policyholder maintains control over how these funds are invested, allowing them access to a variety of different asset classes like common stock, preferred stocks, and bonds.

There are a few prominent consequences related to separate accounts. First, the policyholder accepts the risks related to investing (e.g. market risk), as opposed to the insurance company accepting this risk with whole life insurance. Second, insurance products with variable features are considered securities. This makes the product subject to registration and securities regulations. In order to offer variable life insurance, a person must attain both securities and insurance licensing. This typically involves FINRA and NASAA licensing (e.g. Series 6, 7, 63, and/or 66) plus a state insurance license.

The separate account provides for the growth of both the death benefit and the cash value over time. In the event the separate account performs well, both will grow. However, both the death benefit and cash value may decline if the separate account declines in value. Variable life insurance contracts typically provide for a minimum guaranteed death benefit, no matter how far the separate account declines, although there usually is no minimum guaranteed cash value.

Let’s summarize the main test points related to variable life insurance:

• Coverage for the entire life of the insured person
• Fixed premiums
• Guaranteed minimum death benefit
• No minimum guaranteed cash value
• Cash value invested in the separate account
• Cash value grows based on investment performance
• Policyholder subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with the death benefit
• Considered a security

Universal life insurance

There are several similarities between whole and universal life insurance. Both offer coverage through the life of the insured person, provide a death benefit, invest cash value in the insurance company’s general account, and neither are considered securities. The primary difference relates to premium payments.

The term ‘universal’ should be associated with flexibility. In particular, universal life insurance premiums are flexible and may change over time. The policyholder can increase their premium payments in order to attain a larger death benefit. Conversely, they can also decrease or skip their premium payments, as a trade-off for a lower death benefit or a deduction from the cash value. Once a large amount of cash value is accumulated, some policyholders make all their premium payments from the general account until their cash value runs out. If the cash value is exhausted and premium payments are not made, the policy will lapse (terminate).

The premium flexibility is most beneficial to those with changing financial situations. If the policyholder’s family or income grows over time, they can simply begin contributing more in premiums. Otherwise, they would be required to obtain a new policy to increase their death benefit, which is sometimes necessary for those utilizing non-universal forms of life insurance.

Let’s summarize the main test points related to universal life insurance:

• Coverage for the entire life of the insured person
• Flexible premiums
• Flexible death benefit (some maintain minimums)
• Cash value invested in general account
• Cash value grows at a guaranteed fixed rate
• Insurance company subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with the death benefit
• Not considered a security

Universal variable life insurance

There are several similarities between universal and universal variable life insurance. Both offer coverage through the life of the insured person, provide a flexible death benefit, and allow variable premium payments to be made. The primary differences relate to the cash value and its security status.

Instead of portions of the premium being invested in the general account, it’s placed into the separate account. This is similar to the difference between whole and variable life insurance. The policyholder retains control of investing and is subject to investment risk. Because the death benefit and cash value are subject to investment risk, there is no guarantee to either’s growth potential. In fact, it’s possible (although very unlikely) for the cash value to fall to zero if the investments become worthless. However, many universal variable life insurance contracts provide for a minimum guaranteed death benefit.

Similar to variable life insurance, universal variable life insurance is considered a security. In fact, any insurance product with the term ‘variable’ in its name can be safely assumed to be a security. This makes the product subject to registration, plus the professionals selling this type of product are subject to registration with both securities regulators and insurance regulators.

Let’s summarize the main test points related to universal variable life insurance:

• Coverage for the entire life of the insured person
• Flexible premiums
• Flexible death benefit (some maintain minimums)
• No minimum guaranteed cash value
• Cash value invested in the separate account
• Cash value grows based on investment performance
• Policyholder subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with the death benefit
• Considered a security