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Life Insurance

Life insurance is a policy in which the insurance company promises to pay a certain person or entity (the beneficiary) a certain sum of money (death benefit) upon the death of another individual (the insured).  There will be a policy owner (often the same as the insured, but not always) who pays a premium over the course of time (or occasionally in a lump sum) for this benefit.  The purpose of life insurance is to make up for some financial loss that would result from a person’s death, such as a debt or loss of income, or to pay for expenses that would result from a person’s death, such as funeral expenses or estate taxes.  Death benefit payouts from life insurance policies are not subject to federal income tax (as of 2012).

It seems simple enough.  Person A dies, person B gets a check.  While that is the general concept, there are several different types of life insurance, as well as some variables that need to be understood.  We will start with some of the most common types of life insurance.

Term life is by far the most commonly purchased type of life insurance.  It can also be the most misunderstood.  Term life is sometimes referred to as temporary life insurance.  What you are getting with term life is a policy with a fixed premium (payment), and a fixed death benefit, for a fixed period of time.  It is really only designed to cover you for a fixed period of time (say, the next 10 years) and not beyond that.  Term life is best suited for those who have the greatest need for life insurance death benefits at the lowest cost, and is often purchased by younger individuals just starting out.

Term insurance is most often sold in the form of 10-year, 20-year, or 30-year policies, with the shorter terms having the lower premiums.  If the insured passes away during the term period while the policy is in good standing (i.e. premiums are being paid), then the death benefit will be paid to the beneficiary.  If the insured outlives the term period, typically the policy ends and you are left with nothing (since term life has no cash value).  Actually, most policies will give you the option to keep the policy after the term period ends, but the premiums are no longer guaranteed at this point, and the rates go up substantially.

The biggest advantage with term life is that you can get the most coverage for the lowest cost when compared with permanent forms of life insurance such as whole life or universal life.  The premium on most term insurance policies will be fixed for the life of the term, so there are no surprise rate increases during the term period.  They are ideal for those who have a need for protection for a certain length of time (such as people with dependent children or a mortgage).

The main disadvantage is that it is a temporary form of life insurance.  Most of the time the insured will outlive the term, and no death benefit will ever be paid.  There is no cash value accumulation on a term life policy (except with a return of premium benefit), and there is little flexibility in premium payments.

Whole life is the second most commonly purchased type of life insurance.  Whole life is ideal for those who are looking for a long-term, permanent life insurance solution.  Whole life has a fixed premium, as well as a fixed death benefit.  However, since there is no term, the death benefit is guaranteed for lifetime, no matter how long you live (assuming premiums are paid on time and all other policy provisions are met).

Whole life also accumulates cash value over time, which can be borrowed against as a source of funds.  Within the policy these cash values grow tax-deferred.  Policy loans will decrease the cash value and death benefit of the policy.
While whole life tends to be richer in benefits compared to term life, the main disadvantage is cost.  Whole life is considerably more expensive than term.  Is the cost of whole life worth it for the extra benefits that it has?  That is for you and your agent to decide.

Universal life (UL) and variable universal life (VUL) are the least common and probably the most complex form of life insurance.  UL and VUL are permanent forms of life insurance, and one of the biggest advantages of them is that they offer flexible premiums.  You as the policy owner have the ability to vary, within certain limits, the amount of premium you are paying into the policy.  Paying higher premiums will allow the policy’s cash value to accumulate more rapidly, and possibly allow you to pay lower premiums or no premiums in future policy years.  Paying lower premiums (or simply paying the minimum required premium) may result in the policy becoming underfunded, with higher payments being due in the future to keep the policy in force.

This is the additional risk caused by the flexibility within a UL policy.  The cost of insurance within a UL policy increases as you age (meaning the older you are, the more expensive it is to insure you).  Therefore, once you start getting older, if you have only been paying the minimum premiums, they may no longer be enough to cover the cost of insurance.  At this point, if you not increase your premium payments, you will start to see your cash value start to diminish as the insurance company dips into it in order to cover the cost of insurance.  Once your cash value has been depleted, you will likely receive a letter from the company telling you that you have to pay more if you want to keep the policy.

The main difference between UL and VUL is how the cash value in the policy is allocated.  The cash value in a UL is not subject to investment risk, and usually grows based on some rate of return determined by the insurance company.  In a VUL, the policy owner has to option to allocate some or all of their cash value into separate accounts, which function similar to mutual funds.  In these policies the cash value is at risk and can increase or decrease based on the performance of the underlying investments.

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