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When you buy a life insurance policy, you specify whom you want to receive the policy’s death benefits when you die. The people you specify are called “beneficiaries.” It’s important to understand that the primary purpose of life insurance is to help your beneficiaries maintain their standard of living after you die. Life insurance isn’t an investment. A life insurance policy is generally guaranteed to pay death benefits when the policyholder dies. With an investment, however, there’s a risk to the payoff – an investor might earn money, but he or she also might lose some or all of it.
While some types of life insurance include a savings component that can provide some retirement income, Texas law prohibits marketing life insurance as an investment or retirement income source. If an agent or company tries to sell you a life insurance policy as a good investment, be careful. Complicating matters somewhat, many life insurance companies also sell a legitimate investment product called “annuities” that are similar in principle to life insurance. People often purchase these investments to provide for retirement because they can provide a steady stream of income over a long period of time.
Insurance companies use a process called “underwriting” to determine which policy applicants to accept and what premium rates to charge. The company will consider certain “risk factors,” including your age, gender, medical condition, and whether you smoke. Younger applicants who are in good health and who don’t smoke will generally be charged lower premiums. The insurer expects that these policyholders will live longer and thus be able to make more premium payments. Older applicants who have health problems or those who smoke can expect to pay significantly more because their risk of early death is statistically higher. Some companies may determine that, based on its review of an applicant’s risk factors, the applicant is too great a risk and may decline to issue coverage altogether.
If a company declines to cover you or charges you more for coverage because of your health status or other factors, keep shopping. Different companies have different underwriting guidelines. If you are accepted for coverage at a higher rate, ask whether your premium can be lowered later. Some companies will lower your premium if you maintain good health for a specified period of time, give evidence that your health has improved, or change to a less-hazardous occupation.
Who Needs Life Insurance?
When purchasing life insurance, be sure to consider your individual circumstances and the standard of living you want to leave for your dependents. If you don’t have anyone depending on you for financial support, you may not need life insurance, or you may need only enough to cover funeral expenses or other financial obligations. The following guidelines can help you decide if life insurance is right for you:
* Families, including single-parent households, generally need life insurance because children depend on their parents’ incomes. Typically, the younger a child, the greater the family’s need for life insurance. It’s a good idea to consider insuring both parents, even if only one is a primary wage earner. This can help ensure that the surviving parent can pay for any increases in the cost of child care if the parent primarily responsible for child care dies.
* Single adults typically don’t need life insurance, unless they are single parents or support someone such as an elderly parent.
* Working couples without children or dependent parents typically don’t need life insurance, particularly if the survivor would earn enough to meet expenses and pay debts without exhausting savings. However, life insurance may be a good idea if only one spouse is employed because the nonworking spouse could maintain his or her standard of living should the working spouse die. Young couples who plan to start a family may want to consider purchasing life insurance since life insurance can cost significantly less when purchased at a younger age.
* Older people whose children are grown and independent are less likely to need life insurance. A well-planned savings program can decrease a family’s need for life insurance as wage earners near retirement age.
Although life insurance is sometimes used to pay for prepaid funeral arrangements, it is often not the best funding source. Make sure you fully review your needs and all of your options to pay for funeral expenses.
You may purchase a life insurance policy on your own life or on the life of anyone who gives their consent for you to do so and agrees to undergo the insurer’s underwriting process. The person who purchases the policy is known as the “policyholder” and is the person responsible for making the premium payments to keep the coverage in force.
Most often, life insurance is purchased by policyholders to insure their own lives and provide a death benefit to a spouse, dependent child, or other family member. However, in some cases you may wish to buy a life insurance policy on someone else and name yourself as the beneficiary. For instance, if you are divorced and your former spouse provides child-support payments, you might want to purchase a life insurance policy on your ex-spouse to guarantee continued support payments if he or she dies.
You may name any individual, organization, or trust as the beneficiary of the policy’s death benefit, or you may choose to name multiple individuals as “shared beneficiaries” and stipulate how the benefit will be divided among them. You may also choose to name “secondary beneficiaries” who will only receive the benefit if the primary beneficiary is no longer living.
In some cases, a creditor may have an interest in the life of a loan recipient. The creditor may purchase a life insurance policy to cover the balance of the loan in case the recipient dies before repayment. Businesses also sometimes purchase policies on the lives of certain key employees who are vital to company operations.
This publication generally discusses life insurance from the perspective of an individual purchasing a policy on his or her own life to benefit a single named beneficiary. Unless otherwise noted, however, the same rules apply to policies purchased by third parties and policies with multiple beneficiaries.
The Main Types of Life Insurance
Life insurance can generally be classified as either “term life,” “cash value life,” or a combination of the two. Term life coverage is typically less expensive and less complex. These policies pay only once – with a specified death benefit when the insured dies – and only if the person dies during the specified term that the coverage is in force. Cash value life policies typically provide a variety of features and benefits in addition to the death benefit, and they typically cost more. The key feature of all cash value life insurance is a savings component that accumulates over time and may be withdrawn, invested, or borrowed against during the policyholder’s lifetime, depending on the policy terms.
In addition to a basic life insurance policy form, your agent or company will likely offer a choice of “riders” that can be added to a policy to extend, limit, or modify the coverage. Riders that increase coverage typically increase the premium.
Term Life Insurance
Term life policies take their name because coverage only lasts for a specific period of time – such as one, five, 15, or 20 years – or until the insured reaches a certain age. The cost of term life generally increases as you get older. For people under age 40, term life generally provides the largest death benefit per premium dollar of any type of life insurance.
Term life policies typically don’t include a savings component. If you die during the term, the insurance company pays the amount of the death benefit specified by the policy. If you don’t die during the term, the policy lapses, no benefit is paid, and you must either renew or purchase another type of coverage if you wish to keep life insurance.
Term life can be a good choice for young families with children. You may only need coverage until the children are old enough and financially able to provide for themselves.
Common features of most term life policies include:
* Convertibility. You can exchange the policy for permanent life insurance of equal value without taking a medical exam or any further underwriting. For example, you could transfer a $100,000 convertible term policy into a $100,000 cash value policy without having to answer questions about your health or medical history. However, your premium will probably increase because cash value coverage typically costs more than term life. Convertibility can be an important feature if your health declines and you become unable to qualify for a permanent policy through a separate application. Converting to a cash value policy can also allow you to begin using your policy to build savings. Insurers typically only allow policyholders to convert term life policies before age 65.
* Renewability. You can extend the policy for additional terms, regardless of your health and without having to pass a medical exam. This can be another advantage of term life coverage as you age or if you become ill. Even if you no longer meet an insurer’s underwriting criteria, the company still must renew. Terms can renew at 20, 10, or five years, or even annually. Premiums generally increase at each renewal term. Annually renewable premiums can be extremely high for policyholders past middle age. If you’re paying high annually renewable premiums, you may want to convert to some other type of coverage.
Term life insurance typically comes in one of three common policy variations:
1. Level term coverage pays a death benefit that remains constant over the term. For example, a 20-year level term policy with a $100,000 death benefit will always pay that amount, whether the insured dies in the fifth or 15th year. Depending on the policy, your premium for level term coverage will either remain constant or increase at a scheduled rate.
2. Decreasing term coverage pays a death benefit that decreases over the term at a scheduled rate. For example, a 20-year decreasing term policy may begin with a $100,000 death benefit that decreases by $5,000 per year. If you die in the 11th year, the policy pays $50,000. Decreasing term coverage can be a good option to provide for children in the event of a parent’s early death since the need for coverage typically decreases as they near adulthood. A disadvantage of decreasing term coverage is that its convertibility value also decreases each year. Premiums typically remain constant over the term.
3. Increasing term coverage pays a death benefit that increases over the term at a scheduled rate, which is often pegged to inflation. For example, a 20-year increasing term policy may begin with a $100,000 death benefit that increases by 5 percent of the face value per year. If you die in the 12th year, the policy would pay about $155,000. Premiums typically increase each year for increasing term policies relative to the benefit increase.
Cash Value Life Insurance
Cash value life policies provide both a death benefit and a way to accumulate funds over time. However, the primary purpose of cash value coverage is to provide permanent life insurance protection, not to serve as a retirement or savings plan.
Initial premiums for cash value insurance are typically higher than for term life insurance because you’re also purchasing the savings feature. However, cash value premiums generally increase at a slower rate. If you buy a cash value policy at a young age and continue the policy into middle age, your premium will likely be lower than they would for a term life policy with a comparable death benefit.
A portion of each cash value premium is placed into an account that accumulates over time. This is the policy’s “cash value.” The amount may grow at a fixed interest rate, be tied to indexed interest rates, or increase according to the performance of stocks, bonds, or other securities in which the account is invested, depending on the policy type.
A policy may allow you to withdraw from the cash value, use it as collateral for a loan, or use it to make future premium payments, depending on the terms. Withdrawing all of the cash value cancels the policy and ends coverage, however.
When you die, beneficiaries may receive only the policy’s stated death benefit or the benefit plus any remaining cash value, depending on the policy terms. Premiums will be higher for the second option.
It typically takes at least three to five years for a policy to build significant cash value. Moreover, if you withdraw some or all of the money before a specified time period, you will likely incur a substantial “surrender charge,” which can be as high as 10 percent or more. You may also be liable for income taxes on the money. If you purchase a cash value policy, try to keep it for at least 15 to 20 years. About half of the people who purchase these policies cash them in within five years, which is often a financial mistake.
Cash value life insurance can be a good option for people with financial discipline.
The two most common variations of cash value insurance are:
1. Whole life insurance. Whole life insurance remains in force for the duration of the insured’s lifetime or until the policy is cashed in, provided that the premium is paid. You never have to renew. Premiums either remain constant or increase at a scheduled rate. Part of each premium goes to pay for the death benefit, part to pay the insurer’s overhead costs and profit, and part to increase the cash value. Some whole life policies are “participating,” meaning they may also pay a dividend depending on the performance of the cash value investment account. Typically you will have the choice of receiving the dividend in cash, adding it to your policy’s cash value to purchase additional death benefits, or using it to pay future premiums.
Dividends are not guaranteed. Some policies fail to pay dividends at the insurer’s projected rate, while others may exceed the projection. Your agent may present you with a detailed chart called an “illustration” that shows a policy’s projected earnings. Ask for the company’s history of dividends projected versus dividends actually paid. The agent shouldn’t object.
2. Flexible premium universal life insurance. The key feature to this type of policy is flexibility. Within certain limits, a flexible premium universal policy will allow you to choose the amount of coverage, the premium you pay, and the cash value you build. As long as the premiums continue to be paid and the monthly deductions don’t deplete the cash value, the policy will remain in force until the “maturity date,” at which point coverage ends and the cash value is paid to the policyholder.
Some flexible premium policies pay a guaranteed rate of return. Others are “variable universal life” policies whose value depends on the performance of stocks, bonds, or other investments. For this reason, agents and brokers who sell variable life insurance in Texas are required to maintain a federal securities license in addition to the standard state insurance license. The precise rules and policy terms for flexible premium policies can be complex. It is a good idea to consult a financial or estate planning adviser to ensure you fully understand the policy details before purchase.
A flexible premium policy will allow you to adjust the amount you pay in premium, the death benefit, or the cash value at any time. Any adjustment you make will impact one or both of the other areas: Increasing your premium will build either your cash value, death benefit, or both.
Many flexible premium policies will even provide the option of lowering your premium payments below the amount needed to pay the insurer’s overhead expenses. The company will then deduct that amount from your cash value. But be careful with this option. If the cash value reaches zero, you will have to resume paying the full amount of the premium out of pocket or the policy will lapse. The contract will state that the insurer is required to send you an annual report of the state of your cash value and also notify you if at any point you’re in danger of losing your policy because of insufficient cash value.
Most flexible premium policies contain a provision for a “secondary guarantee,” or a no-lapse premium benefit. A “primary guarantee” is the payment of the premium necessary to cover the monthly deduction. If the primary guarantee isn’t satisfied, a secondary guarantee may keep the policy from lapsing. The secondary guarantee provides a benefit whereby payment of a premium that would not be large enough to pay for the monthly deduction satisfies the no-lapse condition and keeps the policy in force.
