Choosing a life insurance policy: what you should know

While most people have a basic understanding of what life insurance is, the number of different life insurance policies, and companies, creates a complicated landscape. To address common confusions that arise when selecting a life insurance policy, and to empower you to choose wisely, this piece offers a comprehensive overview of the different types of life insurance.

At a very basic level, life insurance is a contract between the policyholder (the individual with the life insurance coverage) and the insurer. The policyholder pays a regular premium (payments for the insurance) for the guarantee of a death benefit payment to the beneficiaries of the policyholder (such as the policyholder’s spouse or children) upon the policyholder’s death. The death benefit is a single-time payment that is generally income tax-free. The size of the death benefit is chosen by the insured based on estimated future financial needs of the beneficiaries.

Insurers use different rate classes (also known as risk-related categories) to determine premium payments. These categories do not affect length or amount of coverage. Rather, they affect the amount of the policyholder’s premium. Rate class is determined by factors such as health, family medical history, and lifestyle. For example, hazardous health activities such as smoking lead to placement in a rate class with higher life insurance premiums.

There are multiple reasons an individual may choose to buy life insurance. Often a policy is purchased to replace income for dependents in the case of death. For example, parents with young children will purchase life insurance to provide a financial safety net for their children if they pass away. Individuals may also purchase life insurance to pay for expenses related to end-of-life tasks such as funeral, burial, and estate administration costs. Life insurance is also used to pay for estate taxes and create an inheritance for heirs.

Importantly, life insurance can also be used to create a source of savings: some life insurance policies create a cash value, a savings account that the policyholder can borrow or withdraw from before death (the interest credited within this account is tax deferred). Ultimately, life insurance policies differ to accommodate the wide range of reasons an individual may purchase life insurance.

Life insurance policies fall under one of two major categories: term and whole life. Term life insurance pays the death benefit only if the death occurs during the term of the policy (which is generally between one and thirty years). Often, individuals purchase term insurance with a coverage period that overlaps with their intended working years to ensure a family’s financial obligations and goals can be met in the case of death. Term life insurance can be further divided into level term policies and decreasing term policies. Level term policies have a death benefit that remains constant throughout the duration of the policy. Conversely, decreasing term policies have a death benefit that drops over the course of the policy’s term.

Whole life insurance (also known as permanent life insurance) pays a death benefit whenever the policyholder dies. Given that these policies have lifetime coverage, whole life insurance premiums are generally higher than term policy premiums.

Whole life insurance can be further divided into traditional whole life, universal life, and variable universal life policies. Traditional whole life policies feature a level (constant) premium and a cash value. These plans are particularly valuable for preserving wealth that can be transferred to beneficiaries.

Universal life insurance plans (also known as adjustable life policies) offer more flexibility compared to traditional whole life policies: universal life policies allow the policyholder to adjust premium payment or coverage throughout the policy life. These policies generally include a cash value that earns interest. Universal life insurance plans can function as long term income replacement (where need extends beyond working years) as well as an estate planning strategy used to preserve wealth.

Variable life insurance plans include a savings account that can be used to invest in stocks, bonds, and mutual funds. If investments perform poorly, the cash value and death benefit may decrease (often a minimum death benefit is guaranteed). Similar to universal life insurance policies, these plans feature a premium that can be modified depending on changing needs.

There are a variety of life insurance policies that accomplish different goals and multiple considerations involved in choosing a particular life insurance policy. Hopefully, this article helped you decide which plan you may want to put your money into depending on your plan and needs.

— Jon Scalabrini