Understanding Life Insurance

Life insurance is a contractual agreement in which an individual pays a lump sum or regular fee to a company in return for the company’s agreement to pay benefits to the policyholder’s beneficiaries in the event of the policyholder’s death or critical injury. The either regular or one-time fee paid to the company by the account holder is known as a "premium." The individuals who receive funds when a life insurance policy is paid are known as "beneficiaries." Life insurance is intended to provide financial security for one’s family in the event of one’s unexpected death. There are two basic types of life insurance policies: term insurance, which provides life insurance for a set period of time, and permanent or whole life insurance, which allows the policyholder to build cash value over the course of their life and provides payment to beneficiaries at the time of the policyholder’s death.

Background

A 2014 Wall Street Journal article cited statistics from insurance-assets company Conning pointing to a $15.8 trillion life insurance "gap" in the United States. This calculation was based on the number of potential beneficiaries that might be left financially vulnerable in the event of the death of a family’s primary earner. The largest gap in life insurance coverage occurred in families making between $38,000 and $100,000 annually because families in this general income range earn too much to take advantage of federal and state financial assistance but earn too little to have sufficient savings to protect the family’s financial future in the event of death. This gap continued in the subsequent decade. The 2024 Insurance Barometer Study conducted by the Life Insurance Marketing and Research Association found that 42 percent of American adults reported needing additional life insurance, many needing an additional $500,000 in coverage. Barriers to life insurance coverage disproportionately impact women, minority groups, and young adults.

The value of insurance also varies depending on the age and health of the person at the time the policy is first purchased. Individuals who purchase policies in their twenties to mid-thirties will typically pay low rates, depending on health issues and profession, for either term or whole life policies. Individuals in their mid-thirties to mid-fifties will pay higher premiums for any policy type based on lowered life expectancy and a greater probability of health issues. Individuals who smoke, are overweight, work in dangerous professions, and those who have pre-existing conditions like high blood pressure, diabetes, cancer, and asthma may pay higher premiums for coverage and may need to seek out specialized types of life insurance or disability coverage.

Overview

Term life insurance is a protection plan in which the customer pays a premium in return for the insurance provider’s promise to pay a certain amount if the insured dies within a specific period, ranging from one year to more than twenty years, depending on the policy. For instance, a customer might purchase a five-year policy with a $50,000 value. If the policyholder dies within five years and their account is in good standing, the life insurance provider will pay $50,000 to the policyholder’s beneficiaries.

With term insurance, the cost of premium payments is tied to the length of the term and factors related to life expectancy, including age, physical health, and occupation. In general, term life is the more affordable option for young consumers, as insurance companies offer low rates to young, healthy consumers. At the end of a term, coverage ends unless the policyholder chooses to purchase another term or enrolls in a renewable insurance policy.

Some companies also offer "adjustable premium" insurance, which generally starts with low rates but allows the company to adjust rates over the course of the term, up to a predetermined maximum amount. Sponsored insurance policies are another type of term insurance that are offered through an employer with the insured and the employer contributing jointly to the premiums. While sponsored insurance policies typically have lower premiums than other policies, the insured does not retain any insurance of value if they leave the job providing the sponsored policy. Some term insurance policies are "convertible," meaning that the company provides the policyholder with a "conversion period," during which time the policyholder can choose to convert their term insurance to a permanent insurance plan.

Permanent insurance, also known as "whole life," is a long-term investment typically lasting for the life of the insured or until the policy is canceled. Whole life plans offer a "face value," which is the guaranteed amount paid to beneficiaries upon the policyholder’s death. Some whole life policies also offer the potential to build "cash value" through investments and interest. Therefore, whole life policies can include an additional "savings element" that increases over time as the insured pays into the account. There are various types of whole life policies that differ according to how cash value is generated and utilized.

Non-participating whole life policies require the policyholder to pay a set premium, usually monthly, and promise to pay a "face value" upon the death of the policyholder. Such policies offer fixed costs and tend to have lower premiums but, in return, only pay the face value of the policy without the potential to earn revenue through investments or interest. By contrast, participating whole life policies tend to have high premiums but allow the customer’s account to grow through accrued interest and investments. These investments can generate dividends that can be paid to the policyholder or reinvested in the policy to increase cash value. Indeterminate premium whole life has a set payout amount, like the non-participating policy, but gives the company the right to raise and lower premiums (within a set maximum) based on the status of investment earnings.

Some companies offer policies that limit the amount of time that the insured must pay premiums to maintain coverage. These types of insurance may be viewed as a type of retirement investment. Single premium policies allow the policyholder to pay the entire premium amount in a single payment. After the payment is made, the policy guarantees a face-value payment if the policyholder dies at any time. Single premium policies typically include an interest and investment component, whereby the cash value of the policy can increase after payment is made. Policyholders can also borrow against the cash value of the policy; thus, the policy serves as a type of limited investment.

Limited payment is another type of whole life policy that spreads premium payments over a set period of time. Typically, limited payment policies offer premiums that last for ten, twenty, or thirty years. Premiums for limited payment policies tend to be high, as the value of the policy is divided over a relatively short payment period, but when the payment period is finished, the policyholder is guaranteed a certain face value without the need to make further premium payments. While some limited pay policies are considered "whole life" insurance, meaning that coverage lasts for the life of the policyholder, other limited pay policies have set payout schedules and will pay the dividends of the policy to the insured at a certain age, generally beginning at retirement age (between age sixty-five and seventy).

Universal life insurance is a type of whole-life coverage that provides more flexible premium payments based on interest rates. The higher the interest rates, the higher the value of the policy, though the value can also fall when interest rates decrease. The flexibility of universal coverage stems from the fact that universal life policies treat premium payments, cash value, and the face amount or "death benefit," as separate components that can be individually modified to suit the policyholder’s changing needs.

There are two basic types of universal life insurance. The policyholder can choose to have their policy pay a "level death benefit," meaning that the value of the death benefit does not change over time. Alternatively, the policyholder can choose a policy that pays the death benefit and cash value of the policy to beneficiaries. The cash value account will consist of savings built into the policy over time as the policyholder makes payments and gains interest. Premium payments are higher for policies that pay cash value, but cash value plans tend to offer higher payments to beneficiaries if the policy is maintained over twenty years or more.

Some universal-life policies allow policyholders to skip payments or reschedule payments without risking the cancelation of the policy. The value of the universal policy, however, varies according to market fluctuations; therefore, universal policyholders incur risk. Insurance specialists recommend universal life policies only for consumers who are willing and able to monitor and adjust their policy to maximize the value of their investment.

While term insurance coverage tends to be the most affordable type of coverage for those interested in protecting their beneficiaries over a specific period, over the long term, whole life provides the opportunity to gradually increase the benefits available to beneficiaries depending on the type of insurance and the length of time the policyholder pays into the policy. As life insurance can be complex—and the type of coverage depends on an individual’s health, employment status, life expectancy, and age—the best option for life insurance customers is to meet with insurance companies and financial advisers to learn about different options and create a long-term plan to protect their beneficiaries.

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