The Different Types of Permanent Life Insurance Policies

The following is an excerpt from The Questions and Answers on Life Insurance Workbook: A Step-by-Step Guide to Simple Answers for Your Complex Questions. Since this is a workbook (meant for you to fill in sections of it), you can't get the full meaning/impact in a basic blog post. But I think you'll get most of the key ideas.

Think of a permanent/cash value policy as a bucket into which you pour liquid money. The bucket has a spigot at the bottom, and the company turns the spigot to drip money out of the bucket to pay for the expenses associated with the policy, such as cost of insurance (COI)/mortality expenses and other expenses (including overhead and other policy specific fees). Meanwhile, money left in the bucket earns interest at a rate declared by the company. It’s your responsibility to keep enough money in the bucket (by making adequate, timely premium payments) to pay the policy expenses as they come due. Even though you must put enough money into the bucket to keep the policy in-force (otherwise it will lapse), there is complete discretion as to when premium payments will be made—annually, semiannually, quarterly, or monthly—and in what amounts—depending on how often payments are made and whether you have the option (as with some policies) to choose your payment amount based on a range provided by the insurance company.

There are a few different categories of permanent life insurance, and each category may present multiple options. It would be impossible to cover all of those here, so please review the content on permanent policies in Questions and Answers on Life Insurance if you are considering this path. Here I will outline the basic information for the most common forms of permanent life insurance and help you determine which category of permanent life insurance may be best for you.

Review the following information, check those types of insurance that are most interesting to you, and then perform the self-assessment at the end of step 2 to determine which types of policies will really meet your needs and preferences.

Whole Life

With whole life, the insurance company promises to pay a certain death benefit upon your death, regardless of when that occurs, up to a certain agreed-upon age based on mortality and expense projections, along with dividend scale assumptions. All three components are projected and integral to a whole life policy. The company often pays you the full face value of the policy if you live to the end of the specified mortality table, which, as its name suggests, tabulates your life expectancy based upon your age and health. But this isn’t always the case and is not always spelled out in the contract. With most forms of whole life, premium payments are made for life at a fixed rate, and the policy cannot be canceled as long as you pay the premiums on time. The cash value normally increases at a consistent rate so that it equals the face value at the age at which the policy expires. Loans against this cash value are often available. Whole life is less flexible than are other forms of permanent life insurance, and the premiums are often higher than some other forms, such as Universal Life.

In Questions and Answers on Life Insurance, I go into great detail about the many and varied forms of whole life insurance options, including Endowment, Limited Payment Whole Life, and Indeterminate Premium Whole Life. However, in the interest of keeping the process in this workbook manageable and succinct, I explore in the following pages just two types of whole life, which are appropriate for most people: Current Assumption Whole Life and Participating Whole Life.

Current Assumption Whole Life

Current Assumption Whole Life policies make use of a current dividend scale in setting the cash value, along with an indeterminate premium structure. The dividend scale is not fixed—it does change—and is usually declared on an annual basis by the insurance company. The gross premiums are fixed, while the net premiums can sometimes be reduced/offset by dividends.

Participating Whole Life

All whole life policies are either participating or non-participating. A participating policy charges a higher premium and in return pays you regular dividends. Dividends are not guaranteed and depend on the company’s actual investment return experience with all of their in-force policies. Dividend options include:

• Cash
• Purchase of fully paid-up life insurance in small increments with each dividend
• Reduction of the next premium payment
• Retention by the company at interest
• Purchase of one-year term insurance in an amount equal to the cash value at the time of purchase.

A trade-off for dividends is with higher or lower or no further premiums. The policyholder under some policies can have the option at some point to switch his or her dividend option to reduce or pay premiums in full. The higher premiums are for particular policies (not always an option) where they are called “limited payment,” though not guaranteed limited payment.
 
Universal Life (also known as Flexible Premium/Adjustable Life)

The biggest difference between Universal Life (UL) and whole life is that UL gives you considerable flexibility as to the amount and timing of premium payments. And the face amount of coverage can be changed (down at any time, up with evidence of continued insurability).

UL is unique in the sense that this type of policy “unbundles” the pricing elements that make up a traditional cash-value permanent policy—interest earnings, mortality costs, and company expenses—and prices them separately. Ideally, this gives you better transparency into the moving parts of your policy. In practice, however, this can get a little complicated. With a traditional whole life policy, you have but one responsibility: to pay the premiums when due. If premiums are paid when they come due, the policy will never lapse, and eventually it will mature as a death claim, period.

UL is different. If the policy owner fails to fund it adequately, UL may turn out to be temporary rather than permanent life insurance. The company may change pricing elements subject to certain limits set forth in the policy. So the company may raise the expense charges and mortality costs and lower the amount of interest credited to the accumulating funds. If these policies are handled incorrectly, they can turn out to be more expensive as you grow older, the cash value can erode, and the policy could end up lapsing if premium payments aren’t high enough to continue to fund the policy (remember the bucket analogy from the beginning of this section). Most UL policies sold prior to the mid-1990s were based on the assumption that the higher interest rates of that era would continue indefinitely. Falling interest rates mean that many of those policies are destined to lapse long before the policy pays off as a death claim due to inadequate premium funding. Furthermore, some UL companies have subsequently increased their mortality and expense charges to levels higher than those illustrated when the policies were originally issued.

Therefore, it’s essential with UL policies that you order an in-force illustration at least every 2 or 3 years, as it’s the only effective way to monitor the progress of a UL policy. (Sample request letters for this purpose are provided in step 7.) An in-force illustration is a report of current values and assumptions compared with guaranteed minimum values.

Guaranteed Universal Life

Guaranteed Universal Life policies comprise one of the fastest growing segments of the life insurance industry. These policies guarantee the death benefit as long as all scheduled premiums are paid in full when due. These policies may or not accumulate a cash value—they are designed to provide coverage past age 95/100 and up to age 120. Most insurance policies will terminate (mature) at age 95 or 100 and cash out at that time, leaving the insured to self-insure. In essence, they function as a lifelong term life insurance policy, where you have the option to accumulate a cash value. A note of caution: if you miss a scheduled premium or pay less than the total premium due, you may lose the guaranteed death benefit.

Equity-Indexed Universal Life

Equity-Indexed Universal Life (EIUL) is a newer form of UL insurance that is extremely complex and combines elements of variable life (which you’ll read about next) into the mix. Thee main differences between this and traditional UL is in how excess interest is credited. Most EIUL policies have two separate accounts that can be used to credit interest. One account has a fixed interest rate that is declared by the insurance company periodically. The second account provides an equity index option that offers you the opportunity to earn rates of interest based on positive equity (stock) market returns. However, the cash value of the EIUL policy is not exposed to losses due to negative market returns.

The amount of interest credited to your cash value is tied to the performance of the policy’s particular equity index. Companies use a range of indexes that include the S&P 500, Dow Jones Industrial Average, Lehman Brothers Bond Index, and FINRAAQ. In years where the index performs well, the interest credited to the policy’s cash value rises, and in years where the index performs poorly, the interest rate falls. Typically EIUL policies guarantee that the interest rate will never fall below zero so that the policy won’t lose money if the stock market index declines.

The first thing to watch out for is that these policies usually have a cap or limit on the amount of interest that can be credited to your policy. Therefore, if the cap is 10 percent, and the index return is 14 percent, you will only earn 10 percent. The reasoning is that this would offset the liability the life insurance company assumes in years where there is a negative return in the stock market index.

The insurance companies can, at their discretion, also adjust what is called the participation rate, so that a policy owner receives a lesser percentage of the total return. This is an important thing to look for. Some companies will offer a 100 percent participation rate guaranteed for the life of the policy. But if a policy has an 80 percent participation rate, and the policy has a cap of 10 percent, the most you will ever earn on the policy is 8 percent (80 percent of 10 percent).

There are also different indexing methods that are used in measuring the market return, which you should understand before signing a policy. You can learn more about those methods on my website.

Variable Life and Variable Universal Life

As with Universal Life polices, Variable Life and Variable Universal Life policies provide death benefits and cash values to beneficiaries. But here’s the crucial difference: whereas the premiums paid into most standard UL polices earn interest within a life insurance company’s General Account, as it’s known, Variable Life policies earn interest on a portfolio of investments that you as the policy owner choose from a selection offered by the company (key: check the selections). In addition, a Variable Life or Variable UL policy may be surrendered for its cash value at any time, and the policy owner also has the option of exchanging the policy for an annuity contract.

Depending on how financially savvy you are, selecting your own portfolio can be an acceptable aspect of this type of policy or a very dangerous one. When an insurance company invests your premium into their General Account, it bears the risks inherent to investing, and credits your policy with interest based on the account’s performance. There’s no direct link between the company’s investment portfolio and the declared interest rate on your policy. But with Variable Life policies, there’s a direct link between the cash value of your policy and the performance of the portfolio of sub-accounts you choose. You bear the risk. The cash value and death benefit of your policy is not guaranteed. (But some policies do guarantee that the death benefit cannot fall below a minimum level.) So if your portfolio does well, the earnings on the cash value of your policy may exceed what you would have earned through a standard UL. But if the performance of your portfolio tanks, you’ll have to put in additional funds to keep your policy in force. That can get pricey, and could endanger your policy.

While you may see tax advantages with this type of policy—you are earning returns or income that you do not have to pay taxes on—there are fees associated with the policies that may offset the tax advantages. Federal and state premium taxes average around 3 percent of premiums. Mortality and expense charges assessed against cash values can range from .6 to .9 percent. Asset management charges can vary from .2 to 1.6 percent. And surrender charges can typically exceed the first year’s premium and last 10 to 15 years.

Overall, the costs of Variable Life policies can be higher than other types of permanent policies.

You’ll get a legally entitled prospectus from an insurance company before you purchase either a Variable Life or Variable UL policy. And you’ll definitely want to read it, even though it’s lengthy and tedious to pore through. If you have a tough time understanding it, find someone who does who can explain it to you. (But if you have to do that, ask yourself: Is this the right kind of policy for me?) Many factors affect the performance and well-being of a Variable Life or Variable UL policy. For advice on the investment accounts, always consult a properly licensed financial/investment advisor.

Joint-Survivor (Second to Die) Life Insurance

Joint-Survivor Life is a type of coverage that can be a part of any type of permanent cash-value policy. This type of coverage insures two people (usually spouses) and pays a benefit only at the second death. It’s used primarily for estate planning purposes, as the estate tax is usually only payable at the second death.

Comments

[Dinheiro Frugal]

Life Insurance should be simpler, shouldn't it? There are so many options and so many details that I seriously doubt that anybody knows exactly what the best option is in his personal situation.

[Eucharist]

Hi, thanks for this very good article.

Regarding the Whole Life Insurance the "Participating" type, are there any very good USA insurance companies which allow clients outside the USA (from Europe in my case), to purchase these type of insurance policies?

Thanks in advance for your feedback,
Eucharist