Life insurance policies are generally one of two types (although these types can be blended): term insurance or permanent insurance. Term insurance usually has lower premiums in the early years of the policy with rapid increases in later years. The policies are for a specific period of time and may be guaranteed renewable if an extra premium is paid. Without this guarantee, proof of insurability may be required for each renewal of the policy. Term insurance does not build up a cash value and premiums must be paid for every year that the policy covers.
Term insurance is appropriate for a short-term need for the coverage, such as to provide funds to repay a home mortgage. It is also appropriate for young people who have a need for the death benefit protection, but who are unable to afford the higher premiums of permanent insurance.
In early years, permanent insurance often has higher premiums than term insurance. These higher premiums pay for the cost of the term insurance and the balance is held within the policy for investment. The investment buildup inside a permanent life insurance policy generates an associated cash surrender value. This cash value may generate internal policy income that can be used in later years to pay the policy premiums. Premium payments made with the income from the cash value can allow the owner of the policy to stop making cash premium payments at some point. A policy with this feature is usually called a vanishing premium or limited pay policy.
Under current tax laws, the investment element of permanent insurance compounds without the imposition of income taxes (similar to an individual retirement account or IRA). In addition, life insurance proceeds are generally not subject to income tax. Therefore, if the policy is never surrendered and is held until the death benefit is paid, the policy income and capital gain is never subject to income tax. These special income tax rules generally allow a faster growth in value for an investment within a life insurance policy (even with the associated insurance costs) than for an investment that is subject to annual income tax payments.
Permanent insurance is available in three general types: whole life, universal life and variable life. Whole life policies generally have fixed premium amounts and can be limited pay policies. Insurance company "dividends" are paid or added to the value of the policy as a result of favorable investment performance in that insurance company's underlying investments. These investments are generally of a conservative nature. Therefore, the policy dividends are limited by the returns associated with these types of investments. The insurance companies guarantee certain minimum results (for example, a guaranteed rate may be 4 percent). The cash value buildup in the policy may be accessed via loans or a surrender of the policy, but cannot otherwise be withdrawn.
Universal life policies generally allow for flexible premiums (in other words, the cash premium can be changed as desired) and can be limited pay policies. The insurance company sets an interest rate from time to time to determine the earnings that are added to the policy value. These interest rates are based on the favorable investment performance in that company's underlying investments. The investments associated with universal insurance are generally similar to the investments within whole life insurance. Therefore, the earnings are also limited by the returns associated with these types of investments. The insurance companies guarantee certain minimum results (for example, a guaranteed rate may be 4 percent). However, the performance guarantees are structured differently from whole life, which may allow for a reduced premium because of the expected investment performance. If the investment performance expected is not achieved, however, significant additional cash premiums may be needed to continue the policy. The cash value buildup in the policy may be accessed via withdrawals, loans, or a surrender of the policy.
Variable life policies are generally structured as universal policies (allowing for flexible premiums and cash value withdrawals) and can be limited pay policies. The policy owner has the ability to direct the underlying policy investments among a group of investment optionstypically within a family or families of mutual funds offering investments such as domestic equities, bonds, and international equities. The policy owner's ability to direct the investments into equities presents the opportunity for an expectation of greater long-term returns along with the accompanying higher volatility and risk of these investments. Because of the expectation of higher returns to assist in the payment of the later year premiums, the anticipated policy cash premiums associated with limited pay policies are typically less than other permanent insurance products. The accumulated cash values in variable life policies are kept separate from the insurance company¹s assets and are not subject to the claims of the company's creditors which is an important benefit of these policies (unlike whole life and universal life insurance).