Insurance is an asset to be managed. The purpose of life insurance is to lessen the financial risk of losing a spouse or partner. There are four basic types of life insurance policies being sold today.
1) Term Life Insurance. This is the simplest form of insurance and is sometimes called basic insurance. The policy is for a certain amount of coverage for a certain period of time. If the covered person does not die in the period of contract, then there is no payment to the beneficiaries under the policy. Think of term life insurance as multi-year car insurance. Most term life insurance policies will have a level payment feature so the same premium is paid over the entire length of the policy.
Hidden hazard: Look for a clause that the term insurance is guaranteed renewable each year. Without this clause, if the health of the insured declines at some point during the policy term, the policy can be cancelled by the insurer, which would render the insured uninsurable.
2) Whole Life Insurance. In a whole life policy, the premium is higher than under a term life policy because part of the premium goes to cover the cost of a term insurance policy, and the rest of the payment is used to build up cash inside the policy.
The rate of interest that the insurance company pays on this cash build-up is called the “crediting rate.” In a whole life policy, the crediting rate is set at the beginning of the policy and does not generally change. The cash build-up inside the policy (aka “cash value”) can be used to finance the cost of the policy in later years so that at some point, the owner of the policy can stop making payments because the policy will remain in effect by using the cash build-up to pay the premiums.
Hidden Hazard: Be sure to obtain an illustration from the insurance agent of the cash build-up to confirm that the date at which the policy becomes self-sustaining is the point that has been targeted.
3) Universal Life Insurance (UL). UL is very close to whole life insurance. As with a whole life policy, the UL premium is higher than under the term life policy. Part of the premium goes to cover the cost of a term insurance policy, and the rest of the payment is used to build up cash inside the policy. With UL, the crediting rate paid by the insurance company on the cash value build-up can change over the term of the policy. If the crediting rate increases, the cash build-up inside the policy could happen faster (in theory) than the minimum guaranteed crediting rate written into the policy. Again, as with a whole life policy, the cash build-up inside the UL policy can be used to finance the cost of the policy in later years, so at some point, the owner of the policy can stop making payments, and the policy will remain in effect.
Hidden hazard: Be sure to obtain an illustration from the insurance agent of the cash build-up to confirm that the date at which the policy becomes self-sustaining is the point that has been targeted.
There are a number of other features of UL such as flexible premium payments, but all such fancy features generally work to the detriment of the build-up in cash value and the point at which the policy becomes self-sustaining. For this reason, whole life insurance should be preferred over universal life insurance.
4) Variable Universal Insurance (VUL). As with whole life and UL policies, VUL premiums are higher than under the term life policy. With VUL, however, while part of the premium goes to cover the cost of a term insurance policy, the rest of the payment is used to invest in sub-accounts such that (in theory) the cash build-up inside the policy could be even better than that of the whole life or UL policy, depending on the investment results of the investment manager. The investment manager is sometimes referred to as the sub-account manager.
Hidden hazard: Since no crediting rate is usually guaranteed, there may or may not be a cash build-up in the VUL policy. If the cash build-up does not keep pace with the increasing cost of the inherent term life policy, the VUL policy owner will have to make additional payments in order to keep the insurance part of the policy in force. By their nature, term, whole life, and UL are real life insurance policies. But with VUL, the owner is not only buying term life insurance but is also asking the insurance company to manage investments on the side. Skip VUL and with the exception of a whole life or UL for estate liquidity purposes, buy term life insurance instead and manage your own investments separately.
For most insurance needs, term insurance is fine, but a small whole life or UL type policy purchased affordably early on can provide estate liquidity to help the executor of the estate and heirs cover immediate expenses.
Scott Anderson, CPA, CFP®, EA is the CFO and Vice President of Tax Strategies for GW Financial, Inc. He earned his MBA from Stanford University. Scott has spent over 35 years in corporate accounting and finance, including experience with several entrepreneurial opportunities in venture capital startups and corporate turnaround situations. He has served as Chief Financial Officer for two emerging public companies and has his own active practice in tax, financial, and investment planning for individuals and small business owners.