What is life insurance?
Life insurance is a type of private insurance* designed to protect against two risks: premature death and superannuation (just getting too old). For most people, death at any age is considered premature; "too old" is usually defined in terms of the individual's self-sufficiency or ability to sustain an income.
Types of Life Insurance
There are two sweeping categories for life insurance: term and cash value. For this writeup, term is term and everything else is cash value.
Term Life
What it is:
Insurance in its purest and simplest form. You ask that a set amount of money be paid to some designated beneficiary in the event of your death, and pay a monthly or annual premium. Renewable term policies include a contractual clause guaranteeing the insured the right to renew their policy for a certain number of years without having to prove insurability. Convertible term policies include a contractual clause guaranteeing the insured the right to convert the policy into some type of permanent policy, such as whole life, without having to prove insurability.
Several optional features are offered with term life contracts. One of the most common is disability coverage - amusingly enough, it's essentially insurance for your insurance. For a slightly increased premium, in the event you become disabled (temporarily or permanently), the insurance company will take over your premiums and keep your policy current so it won't lapse. I almost passed up on this feature, but like many grown-ups love to say, the insurance agent told me "Hey. You're young, but you don't know what will happen five years down the road." For $1-$5 a month, the disability coverage tends to be a good value.
Advantages:
Term life typically has the lowest cost for the highest coverage of any life insurance policies out there. It can help a younger person preserve a low premium and start a permanent policy later in life at lower cost.
Disadvantages:
The policy's temporary nature. If all you purchased was term life and when you're 60-something and for some bizarre reason you lose your term policy, you're left with nothing. Term life is temporary, and should be used for temporary needs.
Types of People who Generally Benefit from this Policy:
Younger people with lower incomes and a great deal of financial responsibility (mortgages, children). Used often by individuals wishing to guarantee insurability in the future. Policies taken out on children to cover burial expenses tend to be term policies.
Whole Life
What it is:
The most common type of cash value insurance. Whole life is attractive to many people because it combines protection and savings. In straight whole life policies, premiums are payable for the lifetime of the insured (until age 100). In addition to the death benefit, funds accumulate from the premiums paid in, and the policy can be later used as a retirement fund. Other types of whole life include limited-pay whole life (premiums are only paid for a limited period of time) and single-premium whole life (only one premium is paid).
Advantages:
Permanent funds are accumulated for permanent needs. The insured may borrow against the savings element of the policy in case of an emergency. Also, the savings element may be used to pay future premiums, but this feature should only be used as a last resort.
Disadvantages:
The biggest disadvantage is in the insured not being familliar with his/her own needs, and using whole life to cover a risk for which it wasn't designed, such as a temporary risk. Also, when you borrow against the savings element of a whole life policy, you are obligated to pay an interest rate. A common question that comes up is Why should I have to pay an interest rate if I'm borrowing against myself? Answer: There's an opportunity cost to the insurance company for loaning the money to you. The insurance company would have taken all that money you'd been paying and made interest on it somewhere else, so they figure you should have to pay it if you're taking away that opportunity from them.
Types of People who Generally Benefit from this Policy:
Just about everyone can benefit from this kind of policy because of the savings element. I keep hearing from finance professionals that are strewn about my college speaking to classes and trying to recruit the children there that whole life policies are crap, just "buy term and invest the difference" (in a mutual fund or other investment). Of course, I personally feel that even the finance industry is not immune to trends and fads. This stinks of whole life simply not being trendy right now. Even more likely is that these yahoos are selling competing investments and are just making a pitch. You ought to know what interest rates you'd be getting elsewhere and whether the whole life policy is a good idea, but without a doubt, retirement saving rocks.
BEWARE!
Lemme tell ya a story. One summer I worked for an insurance agent as a personal assistant. The dork actually tried to turn me into a client, and started relentlessly pushing whole life in my face, even though I was 19 and making $8 an hour. It should have been clear to anyone that I could not afford the larger premium required to start a decent policy. Many agents are offered twice the commission on whole life policies as they are on term life policies. You simply must be familiar with the types of policies that are out there and what you really need, or you will get pushed into something you don't really need.
Endowment Policy
What it is:
You win if you live AND you win if you die! This is an increasingly popular policy (overseas) because the insurer pays out the face value if the insured dies OR at the end of the specified period (10-30 years) if the insured survives the period. The face amount of the policy is often referred to as the sum-assured. In a with profits endowment policy, funds accumulate, and the profits are paid out at the end of the period (or at death) with the sum-assured.
Advantages:
The win/win scenario.
Disadvantages:
Obscene premiums. Endowment policies do not count as life insurance in the US because the premiums required far exceed the amount required to cover the death benefit. They are popular overseas, however, and are frequently traded on the market (just search the Internet for "endowment policy").
Types of People who Generally Benefit from this Policy:
These policies are purchased more as an investment than an actual life insurance policy, so it's hard to say that anybody would benefit having this policy as life insurance. The premiums are simply too high.
Variable Life Policy
What it is:
A type of whole life policy. The insured has the power, in this case, to direct where the funds are invested and bears the investment risk in the form of fluctuations in the cash value and death benefit. The premium is fixed, but the face value of the policy moves up or down, depending on the market and the canniness of the insured. The insurance company will offer a wide variety of investment choices, such as stocks, bonds, and money market funds.
Advantages:
Investing in stocks gives the insured great potential for rapid gain in the policy. So in the mid 90s, these policies were nothing but advantages.
Disadvantages:
And then the markets crashed.
Types of People who Generally Benefit from this Policy:
People who get a thrill out of playing with their money gravitate toward these kinds of policies. This policy further fuzzes the line between life insurance and investment.
Universal Life Policy
What it is:
Universal Life was invented in 1979 by Hutton Life. It is a variant of the whole life policy where the premiums, cash values, and death benefit can be adjusted up or down at any time depending on the insured's needs.
Advantages:
The interest on the cash value of the account is usually subject to a minimum, something life 4%. The policy was designed as a cure-all for individuals unsure about their financial future. The flexibility of these policies is a major plus.
Disadvantages:
Insurance companies sometimes set minimum levels for the amount of coverage, but it is possible to find an insurer who offers as little as $25,000 coverage.
Types of People who Generally Benefit from this Policy:
Lots of people! This policy is very similar to a whole life policy, with the added flexibility bonus, so it tailors itself to satisfy the needs of many policyholders.
*Private insurance is characterized by the transfer of
risk from individuals and organizations to professional risk bearers (insurance companies). It is different than social insurance or other programs offered by the government.
Source: Mandi, her education significantly fleshed out by a course titled
6F:102 - General Insurance at the
University of Iowa.
Please don't go out and buy a
policy solely on this information. Insurance agents can be scary, but most of them are very nice and knowledgeable and can help you select the type of insurance that is correct for you. It helps to be armed with this info (and more, besides) when you go shopping for it, however; it becomes infinitely easier to sniff out a bad deal or sleazy agent.