Life insurance is often perceived as a black box and our HNW clients often welcome a review of the fundamentals. Jay Judas review's the basic types of life insurance in the August edition of the Life Insurance Strategies Group Newsletter.
Tier One: The Basics - What Are the Types of Life Insurance
A majority of our consulting engagements are with affluent individuals and families who need to make decisions about complicated transactions involving life insurance. For those not part of the life insurance industry, trying to get a handle on the various types of policies is challenging, if not impossible. Therefore, a critical part of our engagements is educating our clients on the differing facets of the life insurance products available in the market so that they can be comfortable with their decision. Here is a brief, high-level overview of various products available to potential life insurance purchasers.
While our clients are typically using life insurance for wealth transfer or for investment purposes, a growing number are using policies to fund for business liabilities – from succession to executive benefits. As the policy type and underlying rationale become more complex, so do the funding strategies, which may involve split dollar, premium financing and gifting. These strategies work better with some policy types over others, and we will discuss those funding strategies in a future piece.
The categories of life insurance policies which meet most every need are Term Life and Whole Life. Within Whole Life contracts, there are subcategories: Whole Life (a.k.a. Ordinary Life), Universal Life, Variable Universal Life and Private Placement Variable Universal Life. We discuss each, in turn, below. Before we begin, here is an interesting stat: According to the American Council of Life Insurers (“ACLI”), in 2019, about 40% of policies purchased were Term Life and the other 60% were Whole Life.
Term Life is the most basic type of life insurance and is the type of policy most people think of when they think of “life insurance”. These policies are for a set period of time such as for 10, 20, 30 or more years and they only pay if the insured dies during the term of the policy. Term Life policies usually do not have other benefit provisions.
The Life Insurance Institute reports about 97% of Term Life policies purchased are ‘level term’ where the death benefit amount remains level, or the same, during the policy’s term. The less popular type of Term Life is ‘decreasing term’ where the death benefit drops, usually in one-year increments, over the course of the policy’s term.
Term Life is most suitable where there is a temporary need for coverage. For example, a young family may find that term coverage can provide for a family if the breadwinner dies. The need for coverage may go away after the children finish college and the mortgage is paid. We recommend when a young person purchases Term Life, that they consider a version of the policy which may be converted to permanent coverage in the form of a Whole Life policy. This can potentially save money and some underwriting procedures in the future.
Whole Life, or permanent insurance, pays a death benefit whenever you die, usually even if you live to be 100 and, in some cases, 120 and beyond. There are four major types of Whole Life or permanent life insurance: Traditional Whole Life, Universal Life, Variable Universal Life and Private Placement Variable Universal Life. And to make this all a little more complex, there are subcategories for each of these.
The basic design of most Whole Life policies is for the death benefit and the premium to stay the same, or level, throughout the life of the policy. As we explain in the next paragraph, this has the effect of creating an alternative benefit to the policyholder of cash value. This cash value can be used by the policyholder as a source of loans or as cash to make premium payments. As Whole Life is a more complex policy than Term Life, it tends to be more expensive.
How does cash value work? The cost per $1,000 of benefit increases as the insured person ages and becomes quite high when the insured lives to older ages. The life insurance company could charge a premium that increases each year, but that would make it difficult for most people to afford life insurance at advanced ages. As a result, carriers keep the premium level by charging a premium that, in the early years, is higher than what’s needed to pay claims, investing that money, and then using it to supplement the level premium to help pay the cost of life insurance for older people.
By law, when these excess payments reach a certain amount, they must be available to the policyholder as cash value if he or she decides not to continue with the original plan. The cash value is an alternative, not an additional, benefit under the policy.
Traditional Whole Life or Ordinary Life
This is the most common type of a permanent insurance policy. It offers a death benefit along with a savings account, called a cash value account. If you pick this type of life insurance policy, you are agreeing to pay a certain amount in premiums on a regular basis for a specific death benefit. The savings element would grow based on dividends the life insurance company pays to the policy.
These policies are suitable where there is a permanent or long-term need for coverage such as with estate planning or to fund a business buy-sell agreement. There is not a lot of flexibility for the client in terms of premium payment timing or amount, but the overall policy performance is fairly stable.
This type of policy offers you more flexibility than traditional Whole Life insurance. You may be able to increase the death benefit if you pass a medical examination or even lower the death benefit to reduce premiums. The savings vehicle, called a cash value account, generally earns a money market rate of interest which is established from time-to-time by the carrier and then guaranteed for a year.
After money has accumulated in your cash value account, you will also have the option of altering your premium payments, provided there is enough money in your account to cover the costs. This can be a useful feature if your financial situation has changed. However, you would need to keep in mind that if you stop or reduce your premiums and the saving accumulation in the cash value gets used up, the policy might lapse and your life insurance coverage will end.
Universal Life shifts some of the policy’s performance risk to the policyholder by providing some flexibility on when to pay premiums and in what amount. As with traditional Whole Life, Universal Life is chosen where there is a permanent need, such as estate planning, as well as for some business applications, but also where the flexibility discussed would be useful.
Variable Life & Variable Universal Life
This policy combines death protection with a cash value savings account consisting of insurance versions of mutual funds in which part of the premium is invested. The value of the policy may grow more quickly, but you also have more risk. If the investments do not perform well, the cash value and death benefit may decrease. Some policies guarantee that the death benefit will not fall below a minimum level.
If the ‘universal’ version of this variable policy is purchased, the policyholder receives the features of Variable and Universal Life policies. They have the investment risks and rewards characteristic of Variable Life insurance, coupled with the ability to adjust the premiums and death benefit like a Universal Life policy.
Variable Life policies are suitable where permanent coverage is sought but where the policyholder wants more control of how the premiums are invested, hopeful that the Variable Life contract will perform better than a Universal Life contract. Given that a portion of the premiums paid are allocated to an underlying investment fund, these types of polices are governed by securities laws and require a prospectus.
Private Placement Variable Universal Life
Private Placement Variable Universal Life (“PPVUL”) is a Variable Universal Life insurance contract that is not part of a general public offering and therefore not distributed by prospectus to the general public. Instead, it is a private offering, available only to qualified purchasers or accredited investors. These policyholders are people and institutions of substantial economic means and are presumed to have investment knowledge and expertise.
PPVUL is usually for investment applications where policyholders who might typically make long-term investments do so under a life insurance structure with a minimum amount of death benefit in order to obtain the benefits of life insurance. These benefits include tax-deferred growth of the cash value, the ability to take tax-free policy loans and the receipt of an income tax-free death benefit.
This is obviously a relatively basic overview of these types of policies and any potential purchaser of any of these policies should understand their comparative similarities and differences and all the nuance that we have not explained here. Navigating the various types of life insurance policies and their benefits and then educating our client is our speciality. We do not sell products, so our clients know they are receiving independent and unbiased advice.