Do you need life insurance? If so, what type do you need? Whether you want a cash-value policy or one that builds cash value over time depends on several factors, such as how long you need coverage and how much you want to pay.
Different types of life insurance
Common types of life insurance include:
- Term life insurance.
- Whole life insurance.
- Universal life insurance.
- Variable life insurance.
- Annual renewable term life insurance.
- Fixed-rate level term life insurance.
- Decreasing term life insurance.
In general, life insurance can be divided into two main categories:
- Term life insurance. Most people can benefit from these policies since they last for a specified number of years. It expires without payout if you do not die within the timeframe specified in your policy.
- Permanent life insurance. Generally, these policies cover you for your entire life and contain a cash value component that can be withdrawn or borrowed against while you’re still alive.
Learn more about the differences between term and permanent life insurance.
Term life insurance
Term life insurance contracts are differentiated based on the length of the coverage term, whether they can be renewed, the length of the price guarantee, and whether they can be converted to permanent insurance. Here are the three most common types of term life insurance.
Annual renewable term
Annual renewable term (ART) is pay-as-you-go life insurance. Each year, you pay for your mortality costs for that 12-month period, plus expenses. On each 12-month anniversary, you’re a year older, your mortality costs have increased slightly, and your premium increases slightly as well.
You can renew ART policies every year simply by paying the premium. The ability to renew them could end, per the policy, in as few as ten years, but more typically it’s guaranteed renewable until you’re age 70 or even 100. Future prices are projected but normally not guaranteed for more than five or ten years. Premiums can increase, but most policies have
guaranteed maximum prices. If your health deteriorates, your future rates won’t be affected, and normally you can convert (that is, exchange) the policy to a permanent policy anytime, without medical questions being asked.
Fixed-rate level term
Instead of annual price increases, as with annual renewable term, fixed-rate level term policies allow you to lock in ing for anywhere from 5 to 30 years in 5-year increments. The most common options are 10, 20, and 30 years.
The process of setting up new life insurance policies (administering medical exams, ordering doctor reports, and so on) is expensive. The insurance company can spread these expenses over a longer period by selling level term insurance policies because people keep the policies longer than they keep annual term policies. As a result, insurers compete harder and offer more competitive prices for level term policies than they do for annual renewable term policies.
Most level term policies can be converted to permanent policies anytime, regardless of health (although some policies limit the conversion period to 15 years or so). Also, most can be renewed beyond the first term. Where level term policies differ most dramatically is how that renewal happens and what happens to the price.
Never buy term life insurance that doesn’t have an option to convert to permanent insurance, regardless of your health. You never know what the future may hold, so keep your options open.
Fixed-rate level term policies are divided into two categories:
Traditionally renewable level term: At the end of the first term, traditionally renewable level term policies renew for another period of the same length, without requiring you to requalify medically. The price changes on the renewal date, based on your age. For example, let’s say that when you were 30 years old, you bought a ten-year traditional level term policy at preferred rates. On the renewal date ten years later, you receive a bill offering to renew for another ten years, only now at a preferred 40-year-old rate, without having to qualify medically.
Reentry renewable level term: Reentry level term works exactly like traditional level term in all respects except one: The renewal billing at the end of the original term is for your new attained age, but at sky-high rates that climb higher each year. Only if you’re still healthy and can qualify medically (in other words, if you can reenter) can you reapply for the lowest preferred rates for another fixed term.
Because insurance companies aren’t obligated to offer the lowest rates on renewal, reentry renewable level term policies are the lowest-priced term policies in the insurance market. The bad news is that their renewal price is the highest in the market if you’re no longer in good health.
If you decide to buy this type of policy because of its great frontend price, give yourself a cushion. Buy it for a term of five to ten years longer than you think you’ll need it to protect yourself (somewhat) from possible sky-high rates. And definitely don’t use the policy for a permanent need.
Decreasing term policies have coverage that reduces annually, but the premium stays level for the duration — usually 15 to 30 years. Two types of decreasing term policies exist:
Level decreasing term coverage reduces coverage a flat amount each year. For example, a 25-year level decreasing term policy reduces 4 percent a year.
Mortgage decreasing term coverage reduces to match a mortgage payoff. Like a mortgage, coverage reduces very slowly in the first few years and picks up steam in the later years. The rate of reduction is tied to the mortgage interest rate and the length of the mortgage. So if you buy a 10-year, 7 percent mortgage decreasing term policy, like the mortgage balance, coverage declines much faster than a 30-year, 9 percent mortgage decreasing term policy. The 10- year, 7 percent policy is also far less expensive than the 30-year, 9 percent policy.
The good news about either type of decreasing term policy is that the rates usually won’t change for the duration of the term you choose. The bad news is that your life insurance coverage is reducing at a time when your living expenses are rising — not a good idea. The other bad news is that your life insurance normally ends when the term ends — the policies aren’t renewable. But in all likelihood, your need for life insurance hasn’t ended. And the rates for this type of coverage aren’t nearly as good as level reentry term rates for the same coverage period.
If you’re thinking of buying a decreasing term policy, don’t. Unless decreasing term life insurance coverage is court ordered (covering the mortgage of an ex-spouse and children) or mandatory as part of a loan, buy reentry level term instead of decreasing term. You get coverage that doesn’t decrease and at a much lower cost.
Permanent life insurance
All permanent policies have three components: mortality costs, expense charges, and cash value. Insurers offering permanent insurance compete in three ways: lowering mortality costs, lowering expense charges, and having better investment yield on the cash value.
Permanent policies vary by
- Whether they guarantee mortality and expense costs
- Whether they guarantee the yield on the cash value
Three types of permanent life insurance are on the market: whole life, universal life, and variable life. Every life insurance company offers hybrids of these three.
People who choose whole life insurance want a lifetime policy with zero risk. They want the insurance company to guarantee, for life, the monthly cost. If an epidemic breaks out, significantly killing off a large part of the population and raising mortality costs to the insurance company, this policy cost isn’t affected at all. Conversely, if science reduces heart disease rates and cures cancer, lowering deaths and mortality costs, the insurance company reaps more profits because it continues to receive the higher, guaranteed mortality charges of the whole life policy.
The same is true for expense costs. If the insurance company’s expenses rise because it buys a new building or pays agents higher commissions, it can’t pass on those higher costs to the whole life customers. Similarly, if it improves efficiency and cuts costs, only the insurance company reaps the benefits.
Finally, a whole life policy pays a minimal but guaranteed rate of return — usually from 2½ percent to 4 percent for life — so guaranteed, in fact, that the policy contains a page showing what the cash value will be for each year of the future. Today, 4 percent guaranteed looks good. Twenty years ago, when interest rates were in the double digits, it looked horrible.
With whole life, the insurance company takes all the risks. You take none. The insurance company bites the bullet when things sour and reaps extra profits when things improve.
If you buy a whole life policy that offers dividends, you share a little in good years and overpay in bad years. See the sidebar “Life insurance dividends” for more information.
In the 1980s, interest rates were rising to unexpectedly high levels, approaching 20 percent. Inflation was running rampant. Not only were the fixed rates of whole life eliminating most new sales, but existing customers were dropping their old policies in droves as, one by one, insurance companies began to offer a more flexible policy called universal life insurance, which has flexible rather than fixed interest rates on the cash value. At that time, a 13 percent to 14 percent return was common. Universal life later proved to be both good news and bad news for consumers.
The good news is that universal life is a flexible product. Everything that’s fixed and guaranteed in a whole life policy is flexible and non-guaranteed.
The risks of changes in mortality costs, expense costs, and interest rates are mostly passed on to you. If costs decrease or interest rates rise, you reap the benefit. If costs rise or interest rates plummet, you’re primarily the one who takes the hit. The only risk the insurer takes is that the universal life policy has a ceiling on how high the mortality charges can go and a guaranteed minimum interest rate on the cash value — usually 2½ percent to 4 percent.
What I like about a universal policy is its flexibility — not only its adaptability to changing market conditions, but also its flexibility with the death benefit. With whole life, if you want to raise your coverage, you have to take out an additional policy. With universal life, you can lower the death benefit at any time and keep the same policy. You also can raise the benefit anytime, if you can prove good health, without having to buy additional policies.
Another thing I like about a universal policy is the ability to vary premium payments: to lower them or even temporarily suspend them, such as during hard times, or to pay in additional amounts when the rate of return is attractive — especially considering that the earnings are tax-sheltered (free of income tax until withdrawal). With universal life, you have the option at any time of dumping large additional sums into the cash value account, subject to federal maximums.
When attached to life insurance, the term variable means that you have half a dozen or more investment options with your cash valuing investing in the stock market. The good news with variable policies is that you have the potential to outperform what you would have earned under a non-variable contract. The bad news, as with any stock market risk, is that you can lose part of your principal.
If you choose a variable policy, understand upfront that if the cash value principal declines, you’ll have to make up the loss and pay increased premiums to fund the policy properly.
Making Your Choice
Clearly, a potpourri of different types of life insurance is out there. How do you choose among them? Here are a few pointers:
If you have a permanent need, buy permanent life insurance. If you need it but can’t afford it, buy a cheap reentry level term that’s convertible to permanent, regardless of your health. A permanent need is a need that, no matter how old you are today, will require cash for your survivors when you die — paying estate taxes, supporting an adult child with Down’s syndrome in a group home, continuing to support a favorite charity after your death, or providing supplemental lifetime income to a surviving spouse.
If you have a nonpermanent need, buy term life insurance. Examples of nonpermanent needs include covering living expenses while the children are growing up, paying off a mortgage, or paying for the children’s college education.
Buy annual renewal term insurance if your need is pressing for only a year or two, but only if the price is less than that of a ten-year reentry level term policy.
Buy reentry level term if your need is great and your budget is small, such as if you’re a parent with young children. However, make sure that you’re clear on when the initial level term period ends. If you still need life insurance at that time, you may need to convert what you have into a much higher-priced permanent policy if you can’t qualify medically for reentry. For that reason, I recommend that you buy reentry term insurance for a period of at least five to ten years longer than you think you need it. Also, because you want the company to be around when you convert, make sure that the quality of the insurance company is high. I suggest an A. M. Best rating of A or better.
For a small charge, some reentry term products offer a guarantee that, at the end of the first level term period, you can renew for another term at the low reentry rate regardless of your health.
Unless you’re 100 percent sure that you won’t need coverage beyond the first term, buy this option if it’s available.
Buy only guaranteed renewable and convertible term products. You never know what the future may hold.
Buy traditional non-reentry level term coverage anytime you find its pricing reasonably close to reentry term costs, or if you’re willing to pay extra for the peace of mind of keeping preferred rates for another term without ever having to requalify.
Unless the price is significantly lower, always buy privately owned term life insurance rather than the optional group life insurance through employers, associations, or creditors and banks. Coverage from the latter sources can end (such as coverage from your employer ending when you leave your job).
Be very wary about buying decreasing term life insurance. Prices usually aren’t that competitive, and coverage is normally not renewable. Plus, people’s coverage needs rarely decrease.