If you ever shop for a life insurance policy, you’ll quickly realize that selecting the right type of policy can become overwhelming. To anyone who isn’t an insurance salesperson, the differences and details can be really confusing. In the hopes of clearing things up, let’s cover the four different types of life insurance.
Why Do Different Types of Life Insurance Exist?
The life insurance industry is actually a very old one. Over the decades, the products that they offer have grown and expanded along with different customer needs.
Remember, insurance is simply a means to hedge against a risk. In the case of life insurance, it’s the means to hedge against the financial risk of you dying. More specifically, this risk would be the financial hardship for your family if you were to die.
However, there are other certain situations where the risk of death may need to be hedged, such as business partnerships or potential estate taxes.
Over time, different types of policies were created to address each different type of situation that called for life insurance. Let’s get into the four different types.
Term Life Insurance
Term life insurance is the cheapest, easiest and simplest type of life insurance policy. Not coincidentally, it’s also the type of insurance that fits most people’s needs.
How does it work? Simply put, you select the length of the policy (it’s term) and the amount of insurance. Over the term, you pay a fixed premium. Once the term is over, the policy expires. There’s no cash value that accumulates.
If you die during the term of the policy, your beneficiaries receive the policy death benefit. That’s it. Pretty simple, right?
Whole Life Insurance
Whole life insurance (WL) is intended to insure someone for their whole life. It’s called permanent insurance, which means that it’s designed so that the person can’t outlive the policy. Whole life is the oldest type of life insurance.
How does it work? Simply put, you select the death benefit amount and pay the premiums for the rest of your life. You build up a cash value that doesn’t go away or expire. You can surrender the policy and get the cash value back. If you die, your beneficiaries receive the death benefit of the policy.
Paying premiums for the rest of your life sounds like a long time, right?
Well, quite often the policy dividends can become large enough such that the policy starts paying for itself at some point. So, in practice, most people don’t end up paying premiums right up until they die.
Aside from the ability to take a loan against the cash value of the policy, whole life does not offer much flexibility in what you can change or modify once the policy is in place.
Universal Life Insurance
In order to address some of the flexibility issues associated with whole life, universal life was created. Universal life (UL) is intended to cover the insured for his or her entire life, just like whole life.
How does it work? It works almost exactly like a whole life policy. The difference is the additional flexibility created by adding a few features.
In a UL policy, you can modify the death benefit and premium payments over time. So, if your insurance needs change in the future, this type of policy has the flexibility to change with you.
Of course, added features come with a cost. The premiums on these policies increase over time, so making sure that they are properly funded in the early years is key. These policies can “collapse” when the cash value goes to zero, often catching the policy owners by surprise.
Variable Universal Life
Variable universal life (VUL) insurance takes the idea of universal life insurance and creates more flexibility around the cash value. Specifically, it gives you the option to choose how your cash value is invested.
Why would you want to choose different investments for your cash value? Some people want a bigger return than the fixed or guaranteed dividend rates found in whole life or UL policies.
However, risk and return are forever related. Along with investments that have the potential for higher returns come the risk of losing value. VUL policies can sometimes get into big trouble when their cash values decline with their investments.
Unlike whole life and universal life, VUL policies do not allow you to take a loan against the cash value. Loans would be a big risk to the insurance company if the cash value dropped below the value of the loan!
Choosing The Right One
Assuming you actually need a life insurance policy in the first place, deciding between the different types of policies can be overwhelming. If you find yourself in this position, always come back to the idea that insurance only exists to hedge a specific risk.
In most cases, term insurance fits the bill. The financial risks of dying tend to decline over time for most people.
However, permanent insurance such as whole, universal and VUL policies, tend to pay larger commissions to the salesperson. Always take a moment and ask yourself what you actually need. Remember, “You can’t hedge the world.”
If you need help figuring out what type of policy best fits your needs (or if you even need life insurance at all), click here to set up a quick, complementary introduction call to see if Prana Wealth is a good fit.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. In the past, we’ve helped plenty of clients answer their questions about life insurance and we’re here to help when you need us.