Types of Life Insurance

Life insurance is one of the most important, if not always the most appreciated, tool in modern estate planning. It has a role to play in many phases of the economic life cycle of the typical family.

   Term Insurance — Term insurance is perhaps the simplest variety of life insurance. Premiums pay only for the death benefit, and only during the term of coverage—one, five, twenty or more years. If the insured does not die during the term, there is no benefit, although the policy may carry a right of renewal at the stated premium. (If it does not, the insured must satisfy the company’s insurability requirements anew.) However, term insurance may be convertible to “permanent” cash value insurance without additional evidence of insurability. Term insurance has no cash value. 

   Whole Life Insurance — Whole life insurance, which includes ordinary level-premium permanent life insurance, is so called because premiums are paid for the whole life of the insured. Like term insurance, whole life has level premiums. Because mortality costs are not level, but increase over the life of the policy, at first the premiums exceed the actuarial cost of the (fixed) death benefit, so that the policy can build up a cash reserve to prefund the mortality costs when they come to exceed the premiums. The surrender value grows slowly at first, partly because the reserve covers the costs of administering the policy (commissions, underwriting, and so on). In later years, the absence of these costs and the effect of compounding cause the surrender value to grow much faster. 

   Limited-Payment Whole Life — As its name implies, limited-payment whole life is whole life insurance that is paid up after a specified number of years rather than over the (actuarially determined) life span of the insured. Necessarily, the premiums are larger than with ordinary whole life, but once they are paid the policy is guaranteed to remain in force for the insured’s lifetime. The extreme case is single-premium whole life, which requires a single, very large, up-front premium.

   Participating Whole Life — Participating whole life is a variation on ordinary whole life in which death benefits and cash values are guaranteed, and profits resulting are distributed among the policyholders as dividends. If cash values plus dividends are high enough, it can even come about that no further premiums need to be paid, a state known as the vanishing point. Of course, if investment performance declines, the vanished premium may reappear to the policy owner’s chagrin.

   Variable Life — What’s “variable” about a variable life policy is the investment vehicles for the policy’s cash value. With an ordinary whole life policy, premiums are retained by the insurance company in a general account and invested. Cash values are guaranteed to the policy owner out of this general account. The insurer chooses the investments and bears the risk of loss. With variable life, premiums are held in a separate account, segregated from the insurer’s general portfolio. The policy owner can choose among various investments and bears the risk of loss. That risk is reflected in the fact that policy values are variable, tied to the investment performance of the particular separate account.

   Universal Life — Universal life is a variation on whole life that differs in a number of crucial respects. First, the premiums are flexible (hence the alternative name “flexible premium life”). Within limits, the policy owner can pay larger or smaller premiums, or even, if the cash value in the policy is sufficient, none at all. At the other end, the death benefit can also be increased or decreased by the policy owner. A further innovation is the choice offered the policy owner between two death benefit options. Policy owners choose an amount of insurance, referred to as the “specified amount,” and elect Option A or Option B. (Some policies refer to the plans as Option One and Option Two.) The specified amount is the amount of life insurance selected by the policy owner, which may include or be added to the cash value. The specified amount for Option A is paid when a policy owner dies, while Option B pays the cash value in addition to the specified amount.

   Variable Universal Life — Variable universal life (VUL), as its name implies, is a developmental step beyond universal life and variable life, combining features of both. As with universal life, premiums are flexible and can even be skipped if there is sufficient cash value in the policy; death benefits are also adjustable; policy withdrawals are possible if there is sufficient cash value; and policy expenses are frequently back-end loaded. As with variable life, premium investments are segregated in separate accounts and the policy owner has control of the investments. Consequently policy values are dependent on separate account investment performance.

   No Lapse Guarantee Universal Life — The hallmark of no lapse guarantee universal life ( a.k.a. Universal Life with a Secondary Guarantee) is low cost permanent death benefit guarantees and low cash value accumulations. The death benefits are designed to provide high internal rates of return at all ages of the insured (even beyond life expectancy). The product is designed to provide policy owners a guarantee of life insurance coverage, if all contractual conditions are met, even if the policy’s net cash value falls to zero. Thus, this policy type has become popular among affluent families seeking tax efficient inter-generational death time transfers of wealth typically through an irrevocable life insurance trust. The main advantage of this policy type is low premium rates for death benefits that are guaranteed, independent of investment performance or mortality experience. The main disadvantages of this policy type are low cash value accumulations and policy inflexibility. Policy inflexibility is underscored by the fact that, in certain policy forms, premiums must be paid no later than the due date in order to preserve policy guarantees. Depending on contract specifics policy loans may also impact the original guarantee.