Life insurance may be divided into two basic classes – temporary and permanent or following subclasses - term, universal, whole life and endowment life insurance.
Temporary Term Insurance
Term assurance: provides for life insurance coverage for a specified term of years for a specified premium. The policy does not accumulate cash value. Term is generally considered "pure" insurance, where the premium buys protection in the event of death and nothing else.
There are three key factors to be considered in term insurance:
- Face amount (protection or death benefit),
- Premium to be paid (cost to the insured), and
- Length of coverage (term).
Various insurance companies sell term insurance with many different combinations of these three parameters. The face amount can remain constant or decline. The term can be for one or more years. The premium can remain level or increase. A common type of term is called annual renewable term. It is a one year policy but the insurance company guarantees it will issue a policy of equal or lesser amount without regard to the insurability of the insured and with a premium set for the insured's age at that time. Another common type of term insurance is mortgage insurance, which is usually a level premium, declining face value policy. The face amount is intended to equal the amount of the mortgage on the policy owner’s residence so the mortgage will be paid if the insured dies.
A policy holder insures his life for a specified term. If he dies before that specified term is up, his estate or named beneficiary receives a payout. If he does not die before the term is up, he receives nothing. In the past these policies would almost always exclude suicide. However, after a number of court judgments against the industry, payouts do occur on death by suicide (presumably except for in the unlikely case that it can be shown that the suicide was just to benefit from the policy). Generally, if an insured person commits suicide within the first two policy years, the insurer will return the premiums paid. However, a death benefit will usually be paid if the suicide occurs after the two year period.
Permanent Life Insurance
Permanent life insurance is life insurance that remains in force (in-line) until the policy matures (pays out), unless the owner fails to pay the premium when due (the policy expires OR policies lapse). The policy cannot be canceled by the insurer for any reason except fraud in the application, and that cancellation must occur within a period of time defined by law (usually two years). Permanent insurance builds a cash value that reduces the amount at risk to the insurance company and thus the insurance expense over time. This means that a policy with a million dollar face value can be relatively expensive to a 70 year old. The owner can access the money in the cash value by withdrawing money, borrowing the cash value, or surrendering the policy and receiving the surrender value.
The four basic types of permanent insurance are whole life, universal life, limited pay and endowment.
Whole life coverage
Whole life insurance provides for a level premium, and a cash value table included in the policy guaranteed by the company. The primary advantages of whole life are guaranteed death benefits, guaranteed cash values, fixed and known annual premiums, and mortality and expense charges will not reduce the cash value shown in the policy. The primary disadvantages of whole life are premium inflexibility, and the internal rate of return in the policy may not be competitive with other savings alternatives. Also, the cash values are generally kept by the insurance company at the time of death, the death benefit only to the beneficiaries. Riders are available that can allow one to increase the death benefit by paying additional premium. The death benefit can also be increased through the use of policy dividends. Dividends cannot be guaranteed and may be higher or lower than historical rates over time. Premiums are much higher than term insurance in the short-term, but cumulative premiums are roughly equal if policies are kept in force until average life expectancy.
Cash value can be accessed at any time through policy "loans". Since these loans decrease the death benefit if not paid back, payback is optional. Cash values are not paid to the beneficiary upon the death of the insured; the beneficiary receives the death benefit only. If the dividend option: Paid up additions is elected, dividend cash values will purchase additional death benefit which will increase the death benefit of the policy to the named beneficiary.
Universal life coverage
Universal life insurance (UL) is a relatively new insurance product intended to provide permanent insurance coverage with greater flexibility in premium payment and the potential for a higher internal rate of return. There are several types of universal life insurance policies which include "interest sensitive" (also known as "traditional fixed universal life insurance"), and equity indexed universal life insurance.
A universal life insurance policy includes a cash account. Premiums increase the cash account. Interest is paid within the policy (credited) on the account at a rate specified by the company. Mortality charges and administrative costs are then charged against (reduce) the cash account. The surrender value of the policy is the amount remaining in the cash account less applicable surrender charges, if any.
With all life insurance, there are basically two functions that make it work. There's a mortality function and a cash function. The mortality function would be the classical notion of pooling risk where the premiums paid by everybody else would cover the death benefit for the one or two who will die for a given period of time. The cash function inherent in all life insurance says that if a person is to reach age 95 to 100 (the age varies depending on state and company), then the policy matures and endows the face value of the policy.
Actuarially, it is reasoned that out of a group of 1000 people, if even 10 of them live to age 95, then the mortality function alone will not be able to cover the cash function. So in order to cover the cash function, a minimum rate of investment return on the premiums will be required in the event that a policy matures.
Universal life insurance addresses the perceived disadvantages of whole life. Premiums are flexible. Depending on how interest is credited, the internal rate of return can be higher because it moves with prevailing interest rates (interest-sensitive) or the financial markets (Equity Indexed Universal Life). Mortality costs and administrative charges are known. And cash value may be considered more easily attainable because the owner can discontinue premiums if the cash value allows it. And universal life has a more flexible death benefit because the owner can select one of two death benefit options, Option A and Option B.
Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at maturity (usually at age 95 or 100). With each premium payment, the policy owner is reducing the cost of insurance until the cash value reaches the face amount upon maturity.
Option B pays the face amount plus the cash value, as it's designed to increase the net death benefit as cash values accumulate. Option B offers the benefit of an increasing death benefit every year that the policy stays in force. The drawback to option B is that because the cash value is accumulated "on top of" the death benefit, the cost of insurance never decreases as premium payments are made. Thus, as the insured gets older, the policy owner is faced with an ever increasing cost of insurance (it costs more money to provide the same initial face amount of insurance as the insured gets older).