November 27, 2003    Copyright © 2003, Greenwich Financial Management Inc.

 

 

Demystifying Insurance, Part 1:

Understanding the Types of Life Insurance

 

            This article begins a series that will explain the basics of personal insurance, including life, accident, health, disability and long-term care.  We will cover the insurance you might obtain for yourself as well as group benefits you may enjoy at work or offer to your employees.  This first part is an overview of types of life insurance.         

 

            People often are confused about the differences among term life, whole life, standard universal life and universal variable life.  How do you choose?  The differences are not hard to explain.

 

            First, some terms: the "policyholder" is the owner of a life insurance policy; the "premium" is the periodic payment, in advance, to keep a policy in force; the "insured" is the person whose death is insured, which may or not be the same as the policyholder; the "beneficiary" is named by the policyholder and receives the "death benefit" if the insured dies while the policy is in force.  Insurance companies "underwrite" the risk of insured persons using such general criteria as sex, height/weight, prior conditions and known risky behaviors; they also administer (especially for larger policies) individual medical examinations.

           

            There are two periods of life insurance: term and permanent.   Term insurance contracts afford the policyholder life insurance coverage on an insured person for a defined period. The contracts are typically renewable without further underwriting until the insured reaches a certain maximum age, such as 75.  As for term life, you're out of luck after that point if you're not dead yet.  Many policyholders abandon term life as they grow older and premiums skyrocket.  "One year term" means that the rate resets upward every year.   "Ten year term" means that the rate is locked for the first ten years, jumps in price at that time, then increases incrementally in each year thereafter (and similarly for "twenty year term," etc.).  Some term life policies are convertible into permanent policies, usually whole life, at the rates prevailing when converted.

 

            With permanent insurance, in contrast to term life, the policyholder can maintain coverage until the death of the insured, assuming premiums are paid as required; the premium payments are exactly level or relatively level.  In effect, you pay much more in early years than you would with term life, in exchange for the benefit that your premium doesn't keep going up (exponentially) as it does with term life, and for the equity you develop in your policy, called "cash value."  Whole life and universal life policies can develop this cash value, but term life by definition never will.

 

            There are in turn two kinds of permanent insurance, depending upon who takes the risk concerning overall rates of mortality and administrative expenses.   In "whole life," the insurance company takes the risk that death rates or administrative costs may exceed actuarial expectations, and obliges itself contractually to accept a level (or "constant") periodic premium payment from the policyholder in return for providing a certain death benefit.   In "universal life," the policyholder takes the risk that mortality rates or administrative expenses may go up, and in the case of at least one reputable insurance company, the policyholder also has enjoyed a benefit if mortality or administrative expenses go down (mortality rates have been declining historically, owing to better sanitation and nutrition and advances in medicine and pharmaceuticals).  Universal life contracts are much more flexible than whole life, allowing many variations in contributions over time.

 

            Finally, there are two kinds of universal life: standard and variable.  In standard universal life, the cash value of the policy is guaranteed to advance at a certain minimum rate, assuming the expenses stay the same; the insurance company makes the investments itself (primarily in bonds and bond-like instruments) for the group of policyholders.  In variable universal life, the policyholder decides on investments from a menu of mutual funds or variable annuity sub-accounts (held in segregated custody for the benefit of the policyholder) and can make periodic changes; here, the policyholder takes the mortality risk and all of the investment risk with the goal of superior performance.  

 

            Next: Tax Benefits of Life Insurance.

 

 

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone (203-531-2877) or e-mail: Szabo@GreenwichFinancial.com.