Types Of Life Insurance Summary
Quick Summary:
There are many type of life insurance products and you will learn the basic differentiators of each
Additionally there are different ways policies get underwritten that will impact the price you pay
Part 1 went over the basics of life insurance. Part 2 will cover the various types of insurance available.
Main Types of Life Insurance
There are many type of life insurance. They can be broken down into 3 main groups (term, group, and permanent insurance). Permanent insurance can be further broken down into whole life, variable life and universal life insurance. But first, just defining some commonly used terms
Common Terminology For Life Insurance
Premium = what you pay to the insurance company
Face Amount = The amount of insurance stated in the contract and the death benefit at the point of sale
Death Benefit = The amount your beneficiary gets paid upon your death. Death benefit is the same as face amount at point of sale
Beneficiary = Who gets your death benefit upon your death. You need to declare a beneficiary when you purchase the policy.
Account Value or Cash Value = Some insurance products have an investment account within them. The premiums you pay at the start of the contract are more than the cost of the insurance to the insurance company. Some of that extra premium goes into the investment account and grows over time.
Loan = If the insurance product has an account value, many insurance products offer the option to take loans against the account value rather than taking withdrawals. Withdrawals may be taxable event, while loans are not taxed which allows you to access your money.
Term Insurance
The most basic type of life insurance. You are paying for coverage over a pre-determined period of time, typically 10, 15, 20, or 30 years. If you are still alive after the term is over, you get nothing. However, Term insurance is relatively cheap exactly because a portion of the people don't die during the term period. Typical healthy young people will pay $100s of dollars a year for a $1 million policy.
Think about it from the insurance company's point of view. If you sell 100 policies and know all 100 policy holders die, then you need to charge more than if you sell 100 policies and only 50 of them die. The people who don't die, their premiums go to help subsidize the cost of those people who die.
There are a few bells and whistles that are typical on term policies.
Term Conversion Rider
First, Term Conversion Riders are fairly standard on term policies. These riders allow you to convert a term policy to a permanent policy without needing to go through underwriting again. I talked about locking in insurability in part 1. The basic concept is you buy more insurance than you need when you are young and healthy to lock in the option to convert to permanent insurance later. There is significant price difference between the best underwriting class and lower underwriting classes.
Not to mention if you do end up getting a disease, you can convert with out any change to your underwriting
Post-level term period
Another interesting feature of term products is that you can typically choose to continue paying after the end of the term policy to keep the benefit. In general, when you buy a term product, you are locking in flat premiums for those many years.
For example, if you buy a 10-year term product for $200 a year. After the 10 years is over and if you don't convert to a permanent product, you can typically keep paying premiums to keep the death benefit. However, the premium you need to pay increases drastically...like really really drastically...and ramps up each year thereafter. This is because the people who remain after the term period tend to be very unhealthy which requires the insurance company to charge much much more.
Permanent Insurance
There are many types of permanent insurance. This is insurance that will remain with you until you die. There are many flavors of permanent insurance available. In general, permanent insurance remains with you until you die as long as you pay the planned premiums. Additionally, there is an account value in permanent products which allows for some cash value build-up that you have the ability to access.
Whole Life Insurance
Whole life insurance is like the jack of all trades. It is relatively expensive form of insurance, but it offers a little bit of everything. There is good account value growth, it is essentially guaranteed, and your premiums won't change.
The good thing with whole life insurance is that it is all pretty much guaranteed. You know how much each future premium is, what your account value will grow to, and the rate of return at each point in time. Whole life insurance pays a dividend on the account value and you can use the dividend to 1) pay some of the future premium, 2) receive as a check (potential tax issues), 3) have the insurer hold it in a separate savings account, or 4) use it to purchase more insurance (similar to DRIP concept with dividend paying stocks. Typically, you can see a 5-7% long-term return on the cash value of the insurance.
In short, whole life insurance is the most expensive type of insurance, but also the most straightforward permanent insurance and offers a nice well-rounded product.
Group Life Insurance
Group life insurance is typically a permanent insurance, but you get it through your employer. Most of the time the insurance is tied to your employment, however you can typically convert it to an individual policy with the insurance company if you want to keep it. Group can be both UL or WL, but since it is sold through your employer it can be broken out as own type of permanent insurance.
The insurance company can't underwrite each individual, therefore they need to set the price high enough to cover the health of the 'average' person. This means that healthier people can typically get better prices by getting their own individual policy and going through underwriting. Less healthy employees are better off taking the group insurance.
Universal Life (UL) Insurance
Universal Life Insurance is similar to whole life insurance, except it is made to be more flexible. Whereas whole life you have a fixed premium you must pay, for UL policies your premiums are flexible. In UL, your premiums go into the account value and charges are taken directly out of your account value by the insurance company. You can pay more or less than planned as long as the account value remains positive.
There are 3 main types of UL insurance - Guaranteed Universal Life (GUL), Variable Universal Life (VUL), and Indexed Universal Life (IUL). All 3 are very similar, with the main differences being the type of investments you can choose in the underlying investment accounts.
GUL is like a CD, it is a guaranteed rate of return on the account value.
VUL has a separate account which allows it to invest in equities/mutual funds/index funds. This is essentially a brokerage account underlying the insurance. Your return can be negative and volatile just like equities. If you have very strong returns you may wind up paying much less returns than expected, but bad returns you may end up paying more.
IUL pays a crediting rate like a GUL product, but the IUL crediting rate is variable and indexed to some underlying investment. Typically you will be given a cap and floor and your account get credited a number between the cap and floor depending on the index. For example, if you are indexed against the 1-year S&P500 return with a 0% floor and a 5% cap, then 1) if the SP goes down, you get 0% crediting, 2) If SP goes up more than 5%, you get 5% crediting, and 3) if the SP returns anything between 0-5%, you get that amount credited.
UL policies tend to be cheaper than WL and offer some more flexibility around the premium payments. But if the returns come in lower than expected you may end up paying more premiums to keep the policy from lapsing. However, if your account returns are better than expected you will likely pay less premium than expected.
No Lapse Guarantees (NLG)
Base UL policies have an account value that needs to remain positive or the policy is lapsed. If the insurance company needs to withdraw a $100 charge from your account and you only have $50 left in the underlying account, you need to put in enough additionally premium or the policy is surrendered.
Insurance companies developed no lapse guarantee (NLG) riders to add some additional protection to customers. NLGs introduce a secondary account that has no actual value except to track your 'shadow account'. The shadow account has different charges and returns than the actual account value. As long as one of your accounts is positive your policy will remain in force.
How does this typically work?
Imagine a VUL product invested 100% in equities. The policy has a NLG and the NLG shadow account grows at 5% a year (no link to equities). If the equity market tanks your account value may go to 0. However, the shadow account likely will still be positive so you don't need to make a large premium payment.
This mechanism allows for some protection against poor market performance so you can retain your insurance product. However, this additional protection isn't free so policies with a NLG are going to have an additional charge. If you are purchasing the policy more for the death benefit aspect, NLGs are typically worth it. However, if you are purchasing the product for accumulation purposes, the NLG is just an additional fee to drag down your performance.
Part 3 will go more in-depth on the use cases of different products.
Variable Life (VL)
VL isn't very popular and I am including for completeness. It is similar to VUL, but the main difference is that the death benefit can decrease below the initial purchased amount if the market performs poorly.
Types of Underwriting
Underwriting is the process you need to go through when you purchase a policy that helps the insurance company rate your risk. By grouping healthy people with other healthy people the insurer is able to provide a lower premium to that group. Otherwise, if everyone paid the same premium, the healthier people would be subsidizing the less healthy.
In general, the better information the insurance company can get about you, the getter they can classify you and give you lower premiums if you are healthy.
Fully underwritten
Traditionally underwriting involved a medical professional taking your blood, various measurements (weight, height, blood pressure), and a full health history, It is fairly invasive, but it helped the insurance company best put you in an underwriting class commensurate with your risk of dying. If you are very healthy, this is likely still the way that will get you the cheapest premiums.
Good news is the insurance company will pay for all the testing and you get to see the results so it is like a free health check-up.
Guaranteed Issue (GI)
Guaranteed issue is when you don't need to do any underwriting and anyone who applies gets a policy. GI is probably going to give you worse premiums. GI is typically sold through an employer. If your employer offers insurance to all employees, the insurance company isn't going to come in and underwrite each employee. Instead they view the entire block of policies as a group. Therefore, you are basically paying a more than the cost of the average person at your employer.
Have you looked around your office? Not many healthy people I assume
Why worse than average? Typically the healthy people know enough to not go with their employer's insurance, whereas the sick lazy people tend to sign-up for it. This is anti-selection from the insurance companies point of view. Anti-selection happens because the insured knows more about their health than the insurance company (ie - sick person knows they are sick).
Very rarely do you see GI underwriting outside of the employer channel due to anti-selection being even more of a concern. In short, unless you think you are dying very soon, GI is likely not a good choice.
Simplified Issue (SI)
Simplified issue is basically any underwriting in-between full underwriting and guaranteed issue. It can be as short as 8 questions or much longer where the insurance company asks for permission to pull a bunch of medical records and has follow-up conversations. Sometimes you start down a simplified issue path and end up needing to go to full underwriting anyway.
Different companies are at different stages of SI, but it could be a good middle ground of convenience vs price.
Conclusion
There is much more to each of these items, but the above should give a decent enough background. This post is a bit drier than I normally like, but in part 3 I will go over some recommended ways to use insurance.