Life insurance is one of the most important purchases you can make to ensure your loved ones are protected. But it is complex and confusing. There are dozens of different types of life insurance and each company has their own unique products. Most people are forced to trust their financial advisors to guide them through the process. However, financial advisors only have a small selection of what is available in the market and many advisors aren’t able to sell all types of life insurance.
If you don’t know what is available and what your options are, you may make a suboptimal life insurance decision.
So what are the main types of life insurance and what are the differences between them?
What Is Life Insurance?
Life insurance is a financial product where you pay the insurance company premiums, and in return they provide a death benefit to the persons you elect upon your death. Life insurance is the main product for the protection pillar of the 5 pillars of personal finance.
There are many ways to calculate how much life insurance you need. But the main objective is to ensure you have enough coverage to maintain the standard of living of your loved ones if you pass.
There are many types of life insurance products. The main types of life insurance are term insurance and permanent life insurance.
Term insurance provides coverage for a set period of time and matures. This means you can outlive your policy and may never receive a payment from the insurance company. Whereas permanent life insurance is there until you die and as long as you pay your scheduled premiums, you can’t outlive it. However, because you are guaranteed a death benefit, permanent insurance typically cost 5 to 15 times as much as a similar term product.
There are dozens of different types of permanent insurance and each life insurance company has their own unique product.
What Are The Different Types of Life Insurance?
The 2 main types of life insurance are term insurance and permanent insurance. There are many sub-categories of each type of insurance product.
The 3 main sub-categories of life insurance are term insurance, group life insurance and permanent life insurance. Then there are further sub-categories of each of these 3.
- Term insurance is insurance you purchase for yourself for a set period of time.
- Group life insurance is a product you purchase through your employer or a group you are a member of (ie- AAA)
- Permanent life insurance is purchased for yourself and doesn’t expire as long as you pay the required premiums
Since your group life insurance options are limited by your employer or memberships, we won’t focus on the product here, other than a quick explanation.
Common Terminology For Life Insurance
Life insurance is complex and has its own language that is daunting if you are unfamiliar with it. Here are some common terms and definitions for life insurance:
Premium = what you pay to the insurance company for coverage
Death Benefit = The amount your named beneficiary gets paid upon your death.
Face Amount = The amount of insurance stated in the contract. Typically your face amount and death benefit are the same at point of sale
Beneficiary = Who you elect to get your death benefit upon your death. You need to declare a beneficiary when purchasing a policy. This can be a person, trust, or often even an entity like a charity.
Account Value or Cash Value = Some insurance products have an investment account embedded within them. When you pay premiums, a portion of the money may get deposited into the investment account. This money can be invested or credited interest by the insurance company and grow over time. This is your money and you can withdraw it, takes loans against it, or use it to lower your cost of insurance.
What is Group Life Insurance?
Group life insurance choices are limited and typically you buy it 1-year at a time through your employer or associated group. The main difference between group life and term/permanent life insurance is that you get a group rate.
When you purchase a term or permanent product, you will go through an underwriting process. This typically involves seeing a healthcare provider for tests and/or answering a series of health questions. With this information, the insurance company is able to group you into a health-rating. Based on that underwriting class, you will get a different premium where the healthier you are determined to be, the lower your cost.
Since group life insurance generally has the same cost for everyone in the group, the healthier you are relative to your peers the better off you would be getting an individual policy. Consequently, if you are unhealthy or unable to get an individual policy, you can pay a lower cost by choosing group insurance.
Often you can retain your group coverage if you switch jobs by converting it into an individual life policy.
Types of Term Life Insurance
Term life insurance is fairly vanilla. The majority of term insurance is level-term. In this product design, you choose a level term period where the death benefit and the premiums are flat for that period.
Level term typically comes in 10, 15, 20, and 30-year level-pay periods. If you purchase your term product through a large insurer, you may have the option to extend your term coverage as well. But your death benefit and premium payments are only guaranteed to be flat for the level period. If you decide to extend your coverage past the level term, you will see a large increase in your premiums or decrease in your benefit.
There is also decreasing face term. This is a much less commonly used product and often used for things like mortgage protection or as part of a business loan. People will often create decreasing coverage on their own by utilizing a term life insurance ladder strategy and stacking multiple level-pay term products.
Types of Permanent Life Insurance
Permanent life insurance can be grouped into 3 subcategories. Whole life (WL) insurance, universal life (UL) insurance, and variable life (VL) insurance.
All 3 types of permanent insurance will remain with you until you die as long as your pay the required premiums. Additionally, most permanent insurance has a cash value component. This allows for building up of account value of time.
The account value is like a separate savings & investing account under the policy. You can withdraw this money or take loans against it, although this may have an impact on your death benefit amount.
Whole Life (WL) Insurance
Whole life insurance is like a ‘jack of all trades’. It is relatively expensive insurance, but offers a bit of everything. There is modest account value growth, the premiums are locked in, and if you pay them you are guaranteed to have coverage.
With whole life, there isn’t much flexibility, which can be a good thing when you want a protection product. At issue, you know how much each premium is, what your minimum account value will be, and how much your death benefit is.
Whole life insurance typically pays a dividend on the account value. You can use this dividend to:
- Use to pay some future premium
- Receive as a check (potential tax issues)
- Have insurer put it in a separate savings account
- Purchase fully paid-up additional coverage (similar to a DRIP)
Most WL is the similar between insurance companies. The big difference is in the crediting rates that are offered, each company has a different growth rate on your cash value.
Additionally, WL is sold primarily by mutual companies. Mutual companies differ from stock companies in that the ‘owner’ of the company is you, the policyholder. Whereas with publicly traded stock companies, the owner of the company are the equity investors. This arguably better aligns incentives, in theory.
(Read more about whole life insurance here)
In short, WL is one of the more expensive life insurances, but offers a well-rounded and simpler permanent product.
Final Expense Whole Life Insurance
One different version on whole life is final expense insurance. This is very small WL policies (<$50k of coverage, most are ~$10k) to cover funerals & end of life costs.
Final expense is typically sold to older ages and generally less healthy lives. This means that the relative cost is fairly expensive. Other than that, it is very similar to regular WL.
Universal Life (UL) Insurance
Universal life insurance is similar to whole life insurance but offers more flexibility. Where WL has a strict schedule of fixed premiums, UL insurance allows for flexible premiums. Additionally, while WL has a fixed death benefit schedule, UL insurance has different death benefit options that allow for flexible death benefits.
Universal life insurance also has a cash value account like WL. But the charges on the policy are taken from the account directly in UL. You can pay or less than planned and as long as the account value is positive the policy remains inforce.
UL policies tend to be slightly cheaper than a similar whole life. And you get to invest your account value in different assets. Since you get to invest your account value, if the performance of the underlying funds beats expectations, you may be able to pay less overall premiums. However, if the performance is worse, you may end up having to pay more.
There are 4 main types of UL policies:
- Guaranteed UL (GUL)
- Variable UL (VUL)
- Indexed UL (IUL)
- Indexed-Variable UL or Hybrid UL (IVUL) which is relatively new to the market
The main difference between the 4 is what options you have to invest in.
No Lapse Guarantees (NLG)
One unique aspect of UL policies is many offer a secondary no lapse guarantee (NLG). Since your account value is largely driven by the performance of the investments, there is a chance you pay all your premiums and the account value still goes to 0.
To combat this, many policies have a NLG. The NLG has a 2nd account called the shadow account. This account doesn’t have actual cash value you can access. Instead, it functions as a guarantee that your policy will remain active as long as you pay the required premiums.
The shadow account has its own set of charges and a separate growth rate.
When a UL policy has a shadow account, as long as one of the accounts is positive, your policy remains active.
When you buy the policy, your advisor will run an illustration. They will be able to tell you the premiums you need to pay in order to have the shadow account stay positive to a certain age. Then even if your cash account underperforms, the shadow account will keep your policy inforce.
For example, if you have $100 in your account and need to pay a $75 charge to the insurance company, you are good. But if the market goes down 50% and your account value drops to $50, you would normally have to put in the additional money or have your policy lapses. However, if you had a shadow account that had $1,000 in it, even if you cash account goes to 0 your policy would remain due to a positive shadow account balance.
In short, a NLG is a mechanism that allows for protection against poor market performance so you have certainty around your UL policy.
Guaranteed Universal Life (GUL)
GUL policies have a cash value account that functions like a certificate of deposit (CD) or savings account. The insurance company has a crediting rate that they will credit interest to your account.
Depending on the market, your crediting rate may change. But these policies also have a guaranteed minimum crediting rate that is the absolute lowest interest you will gain on your cash value.
GUL policies are the closest to a WL policy in how they function.
Variable Universal Life (VUL)
VUL policies have a separate account which allows you to invest in equities, mutual funds, or index funds. Therefore it is similar to having a brokerage account underlying your insurance policy.
Since you are investing in the market, you can have negative returns on your account value. However, you have the potential to see very strong account value growth in good markets. If the stock market performs well, you may end up paying significantly less premiums on a VUL contract.
There tends to be 2 types of VUL policies, accumulation VULs and protection VULs. Accumulation VUL don’t usually have lifetime NLGs available, but have lower fees. These are often used as tax-advantaged ways to grow wealth for estate planning.
Protection VULs typically have lifetime NLGs. Therefore, they come with higher fees and lower potential account value growth. But you know the maximum premiums you need to pay in order to keep the shadow account inforce to the age you want coverage through.
Indexed Universal Life (IUL)
IUL pays a crediting rate like a GUL product. But IUL’s crediting rate will vary depending on the underlying investment performance. Simple IULs have a cap and floor and your crediting rate will be in the range given.
For example, a 1-year S&P500 point-to-point IUL may have a floor of 0% and a cap of 8%. Then depending on the S&P performance over the year, you will get credited some number between 0% and 8% such that:
- If the S&P goes down, you get credited the 0% floor and don’t lose money
- If the S&P goes up over 8%, you get credited the 8% cap and miss out on the upside
- If the S&P returns a number between 0% and 8%, you get credited that return
In general, IULs should average a stronger crediting rate than GULs over a long-period of time.
Indexed-Variable Universal Life (IVUL) or Hybrid UL
IVULs are a relatively new product on the market. They function similar to a hybrid of IULs and VULs. They are credited like IULs and have a set payoff design, but with one major difference, they can return a negative crediting rate.
However, since you are sharing in more downside, you have the potential for more upside. The caps on IVUL tend to be much higher than IULs and often are uncapped or even allow for you to get a multiplier on the S&P return.
There are infinite possibilities for how a IVUL is structured. Some common ones are:
- Buffered Accounts: A buffered IVUL is when the insurance company absorbs the first X% of negative performance. If you have an IVUL with a 5% buffer and the S&P goes down 8%, you only get a 3% loss. To compensate, these tend to be uncapped, so if the S&P returns a positive 20%, you would get the full 20% credited.
- Deductibles: A deductible account is when you absorb the first X% of losses. If you have a 10% deductible and the S&P goes down 15%, your loss is capped at 10%. Again, these are often uncapped, so you get any positive returns.
- Participation Rate: Participation rates are a performance share. If you have an 80% participation rate, then you will receive 80% of the S&P return both up and down. Products can have participation rates greater than 100% meaning you can get additional returns over when the index returns.
These 3 structures aren’t mutually exclusive and insurance companies mix & match. For example you may be able to choose a lower participation rate with a lower deductible. So you have 5% deductible and get 75% participation on the upside with no cap. Or you can choose a larger deductible and get a 125% participation rate meaning if the S&P returns 10%, you get credited 12.5%.
IVULs are more complex, but allow for you to choose an investment strategy that fits your risk profile. The insurance company is investing in assets and options to design unique payoff structures for you.
Variable Life (VL)
Variable life isn’t very popular. It is similar to WL & VUL. The product invests in equities and depending on the performance the death benefit can increase or decrease. These are hard to find.
Types of Underwriting
Underwriting is the process you go through when you purchase a policy. The insurance company gathers information about you to figure our your mortality risk. They group you with people of similar health and give differing premiums based on the group ‘s risks.
There are different types of underwriting, and the general rule is the more information the insurance company is able to collect on you, the better they can classify your risk. This means the healthier you are, the more likely you want to go through more stringent underwriting so you can get cheaper premiums.
Full Underwriting
Traditionally underwriting involved a medical professional taking your blood, measurements (weight, heigh, blood pressure, etc), and a full health history.
It is fairly invasive, but it helps the insurance company feel secure offering you a policy. If you are very healthy, this is likely the way to get the cheapest premiums.
Additionally, the insurance company pays the cost of underwriting, so you get a ‘free’ health check-up. (Note – the cost is passed back to you overtime in your premiums).
Guaranteed Issue (GI)
Guaranteed issue is the other side of underwriting. GI is largely done with group insurance where you are guaranteed to get a policy and don’t need to do any underwriting.
Since people who opt into their GI group life policies tend to be less healthy, the premiums on it tend to be higher.
There are some individual policies that are sold through GI. These tend to have a few ‘knockout’ questions to ensure you aren’t buying a policy while actively dying. But outside of this, you get the policy with no underwriting. Again, these tend to be expensive as it is assumed only unhealthy lives would go this route.
Simplified Issue (SI)
Simplified issue underwriting covers any underwriting process between GI & full underwriting.
Typically this is answering a list of health questions but not going through an active screening by a medical professional.
The insurance company saves money by not paying for a medical professional to do a health check. But they have higher uncertainty around your health. This trade-off means SI policies can be fairly close in price to full underwriting.
Most online insurance companies use some form of SI underwriting.
Life Insurance Product Availability
Lastly, with 100s of different life insurance products out there, your selection will be impacted based on where you purchase your insurance.
Financial advisors will screen products and choose ones that they want to sell. This means that depending on where you buy your life insurance you will see very different product options. Some insurance agents only sell products of a single company.
Additionally, products that have investment risk (VUL and IVUL) require a separate license to sell. This means a large swath of insurance salesman can’t even offer those products to you.
When looking at life insurance options, it makes sense to shop around to ensure you aren’t being limited based on who you are purchasing through.
The Final Word – Types of Life Insurance
This post only scratched the surface on describing the different types of life insurance. Each insurance company can have multiple types of products. For example, a company may have a protection VUL and accumulation VUL.
And since each company designs their products with different customers in mind, the cash value growth and benefits will differ between products. Therefore, not all GUL/VUL/IUL/WL/IVUL are created the same.
Even with a simple vanilla term product, some companies offer a more robust list of riders for free or a fee. For instance, term conversion riders come standard on some term products but aren’t even available to buy on others.
When looking to purchase life insurance, you may want to shop around at different advisors and agents and find a policy that is right for you.
Frequently Asked Questions (FAQs):
Life insurance is a financial product where you pay the insurance company premiums, and in return they provide a death benefit to the persons you elect upon your death. Therefore, life insurance is a way to provide your future income to help cover the cost of living of your family. Life insurance is the main product for the protection pillar of the 5 pillars of personal finance.
Life insurance protects your loved ones if you die unexpectedly. It is a way to help provide the lost income and cover your family’s expenses.
The main types of life insurance are term life insurance, group life insurance, and permanent life insurance.
1) Term life insurance can further be divided into level term and decreasing face term
2) Group life insurance is offered through employers or member groups like AAA
3) Permanent insurance is made up of whole life insurance, universal life insurance, and variable life insurance
Further, universal life (UL) is made up of 1) Guaranteed UL, 2) Variable UL, 3) Indexed UL, and 4) Indexed-Variable UL or Hybrid UL.
Term insurance has an expiration date and you may outlive your coverage. Whereas permanent insurance will be there until you die. Most permanent insurance also has a cash value account which can grow over time. For these additional benefits, permanent insurance is typically 5 to 15 times more expensive than a similar term policy.
Whole life (WL) insurance is a simple permanent product. The premiums you pay and the death benefit amount is scheduled and known at the point of sale. Universal life (UL) offers flexibility both in the premiums paid and death benefit growth. If you prefer fixed and scheduled products WL is the choice. If you don’t mind being a little more hands-on policy management, UL can be a better value.
The main difference between the many types of universal life (UL) products is what you can invest your account in. Guaranteed UL gives a high-yield interest credit with a guaranteed minimum annual rate. Variable UL allows for owning equities in your separate account that can lead to higher account value growth but with a chance for negative returns. Indexed UL has a floor of at least 0% and a cap. The interest credited to your account is tied to an underlying fund, like the S&P500.
Indexed-variable UL or hybrid UL is a mix of variable UL and indexed UL (IUL). The interest credited to your account is based on the performance of an underlying fund. However, unlike IUL, you can have negative returns. There are many designs of IVUL that can buffer you from initial losses, cap your losses, and have a multiplier on the returns of the underlying fund.
No. Despite a slew of claims to the contrary, indexed universal life (IUL) is just another potential tool. IUL products have a floor of at least 0% and a cap on your returns. Depending on how the index moves over a period, your account value will grow at a rate between the floor and cap.
IUL like all permanent insurance, is more expensive than term. And due to the higher premiums the commissions paid are high. But the product has a market fit.
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