What is life insurance?
A common belief about life insurance is that it’s complex and difficult to understand. And at times, it can seem to be. When you consider all of the options available to you such as types of life insurance, additional riders, face amounts, cash value accounts, etc. the details can get overwhelming.
But life insurance as a concept is fairly easy to understand. Life insurance is a contract involving three parties – an insured person, a life insurance provider and a beneficiary. Depending on the product, it is designed to pay a benefit to the beneficiary or beneficiaries when the insured person dies or becomes critically ill.
Life insurance death benefits are generally free from federal income tax,1 making them an attractive option when it comes to legacy planning.
Types of life insurance
Technically, there are many different types of life insurance, but for the purposes of this exercise, we’ll stick to the most common ones: Term, Whole, and Universal life insurance.
Term life insurance
Term life insurance provides coverage for a defined number of years. You generally pay a fixed premium for a policy that covers you for a specific period of time (e.g. 20 years) and the policy pays out a set amount if you die within that time period. As term life insurance typically has no cash value and is limited in duration, it’s usually the most affordable type of life insurance.
Although life is full of happy milestones, we all have to deal with unforeseen challenges that can result in financial hardship. Term life insurance can help your family to continue to meet financial obligations such as mortgage payments or college tuition in the event of your unexpected death.
Term insurance highlights:
Duration of coverage: Choose from 10,15, 20, 25, or 30 years
Premiums: Stay the same for the duration of the initial term period, although will generally increase if coverage is renewed after the initial term period.
Death benefit: Fixed
Cash Value: No
Whole Life Insurance
As the name suggests, it is insurance designed for your whole life. Unlike term insurance, most whole life insurance products can build guaranteed cash value that you may be able to borrow against to pay for things like home renovations or children’s college education.
Some types of whole life insurance are participating, meaning you may be eligible to receive dividends2 which can be used to purchase paid-up additions, left on deposit to accumulate with interest, used to reduce premiums, or be paid in cash. If you are looking for permanent coverage with a guaranteed death benefit, cash value, and premium, then whole life insurance may be a good choice for you.
Whole life insurance highlights:
Duration of coverage: Life
Premiums: Typically stay the same for the duration of the insurance
Death benefit: Fixed
Cash Value: Yes
Universal life insurance
Similar to whole life insurance, universal life insurance provides a death benefit and also builds cash value. One of the main differences between universal life insurance and whole life insurance is that universal life insurance is designed to be flexible, providing premium flexibility within maximum and minimum premium limits. As long as your policy is valid, some policies may allow you to increase or decrease your coverage to suit your needs at various life stages. For example, you can choose to decrease your death benefit as you pay down your mortgage. Keep in mind, if you want to increase your coverage, you may have to undergo a medical exam, even if you submitted to one when you first bought your universal life insurance.
Universal life insurance is also different from whole life in that while the cash value earns interest at a minimum guaranteed interest rate, it may also earn interest at a higher non-guaranteed interest rate. The non-guaranteed interest rate is set by the life insurance provider, and is subject to change, but you will never earn less than the guaranteed rate. Because the policy costs come out of your cash value, depending on the amount of interest earned your premiums may be higher than those of a whole life policy. However, you might be able to skip premium payments for a period of time if there's sufficient cash value to cover the monthly insurance costs. Alternatively, if the non-guaranteed interest rate goes down and you don’t have enough cash value, you may be required to pay additional premium.
Universal life insurance highlights:
Duration of coverage: Life
Premiums: Flexible, may change throughout the duration of the insurance
Death benefit: Fixed or Increasing
Cash Value: Yes
What is cash value?
As mentioned, some life insurance (like whole life insurance and universal life insurance), have a cash value based upon the amount of premiums you pay. Whole life insurance typically has guaranteed cash values, while cash values on universal life insurance may earn interest based on guaranteed and non-guaranteed interest rates. Life insurance with these types of cash value components can be a great way for people to build cash value over time. Cash value can also provide much-needed funds in the event of an emergency because the policyholder may be able to access the cash value as a loan3 or make a partial withdrawal4.
Additionally, some whole life insurance products pay dividends to policyholders. This is called participating whole life insurance. Potential dividends can be used to buy paid-up insurance, applied towards the premium, left on deposit to earn interest, or paid directly to the policyholder. Whole life policies that don’t pay dividends are also known as non-participating.
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1 Foresters, their employees and life insurance representatives, do not provide, on Foresters behalf, legal or tax advice. The information given here is merely a summary of our understanding of current laws and regulations and is not specific to your situation. Prospective purchasers should consult their tax or legal advisor.
2 While dividends are expected on participating products, they are not guaranteed. Past dividends are not an indicator of future dividend performance.
3 Loans can be taken if the policy is in effect and has a positive cash surrender value. Loans will reduce the death benefit and cash values and may affect how long the certificate is in force. The frequency of loan interest accrual and the rate of interest (fixed or variable) will vary based on the product. Death benefit payable is net of the outstanding certificate loan amount(s) (loan amount includes accrued interest). If, at any time, the loan amount exceeds the cash value at that time plus (if applicable) the present value of paid-up additional insurance then in force and the amount of dividends on deposit at that time, then the policy will terminate. Loans may be considered a reportable tax event. You should consider consulting your tax advisor for details on your specific situation.
4 Withdrawals will reduce the death benefit and cash values and may affect how long the insurance contract is in effect. Surrender charges may apply to withdrawals.