In life, we are all exposed to a wide variety of risks, which need to be proactively managed over time. The unknown can be unnerving, and it’s natural to want to reduce, mitigate or even eliminate a specific risk before it rears its ugly head. But where do you start? How can you determine what protections make sense, when you’re unsure of the risks that lie ahead?
Basic Types of Insurance Protection
As an insurance advisor for more than 30 years, I have helped many clients address potential risks that could cause loss within their financial plans. The most common financial losses people face can be mitigated through some form of insurance. But first, it’s important to recognize your risk exposure, quantify the potential financial loss and then identify the cost to protect against a specific loss. Today, the most popular types of insurance coverage people use to protect against financial loss are life insurance, disability insurance and long-term care insurance. In this article, we will focus on life insurance.
Life Insurance Through the Years
As we all know, there is a well-established, multibillion-dollar life insurance industry in the United States, one that generates over $100 billion in premiums annually.1 The first life insurance policies were sold in the U.S. during the 1700s; at the time, the purpose of life insurance was to provide financial protection to distressed widows and orphans. 2 Since then, life insurance has evolved into a highly complex financial instrument. But as life insurance has grown into a more popular vehicle for mitigating risk, many people have fallen into the habit of “setting and forgetting” their policies. Some are unfamiliar with how their policies work; others have never read their policy statement, which is a contract with the insurance company to pay a benefit should something happen.
If you fall into this category, don’t panic! This summary is the first step in helping you navigate through the complex maze of insurance protection available in today’s marketplace. Before we dive in, it’s important for you to undergo a proper risk assessment with your financial advisor, which can help to ensure your coverage actually protects you, your family and your business against specific financial losses.
Life Insurance 101
Like other aspects of your financial plan, your life insurance needs are unique. The right type of coverage can vary, depending on the cost and expected length of the policy, among other factors. Here’s a quick guide to the most common types of life insurance available today.
Term Life Insurance
Of all the options available, term life insurance is the most straightforward — put simply, it is low-cost life insurance coverage for a specified period (one year through 30 years). The term life insurance premium and death benefit can be guaranteed for the specified period, and then the policy expires. A key detail to note is that term insurance can be useful in protecting you and your family against a temporary need or risk — which leads us to permanent forms of life insurance.
Whole Life Insurance
The root of cash value life insurance can be found within whole life policies. The term, “whole life,” connotes that the policy will be in force for your entire life. To achieve this goal with a very high degree of certainty, insurance companies require you to pay an annual premium large enough to cause the policy to “endow.” In plain English, this means that the insuring company collects enough premiums to cause the cash value of the policy to equal the death benefit when the policy owner reaches age 100 (policy maturity), while considering an assumed dividend. The dividend is made up of three components: earned interest, mortality charge and policy expenses.
Traditionally, people have viewed whole life insurance as one of the most expensive options available in the marketplace, since premiums must be high enough to allow policies to endow. However, one must recognize that with a whole life policy comes greater policy longevity, increasing death benefits with age and high cash-value build-up.
On the other hand, whole life policies historically have not provided a high degree of premium flexibility for policy owners. Over time, the rigid premium structure of whole life policies and the requirement to fund for endowment created a need for a more flexible policy structure. Enter, the universal life insurance policy.
Universal Life Insurance
Universal life insurance was created in the late 1970s and quickly gained significant market share throughout the 1980s. At the time, this new form of cash value life insurance created a structure in which the insurance company gave the policy owner control over premiums and policy longevity for the first time. Universal life provided policy owners with the flexibility to pay reduced premiums, skip premiums and even create their own premium structure throughout the life of the contract. However, what many people didn’t realize is that greater premium flexibility shifted more policy risk from the insurance company to the policy owner.
The most significant difference between universal life and whole life insurance is that universal life policies do not have a required policy endowment structure. In other words, this means that the premium flexibility of a universal life policy may lead to insufficient cash value, and as a result, fall short of carrying the policy owner’s death benefit to maturity (age 100), while considering an assumed interest rate and cost of insurance. Unlike whole life, universal life insurance has an interest rate that is credited to the policy’s cash value account monthly, with a cost of insurance that is deducted from the cash value account monthly, as well.
All universal life policies have a guaranteed interest rate ( or the “floor” rate) and a guaranteed cost of insurance (or the “ceiling” rate). However, keep in mind that if an insurance company ever reaches the dual guarantees allowed by the contract, the policy would most likely lapse quickly, without significant premium payments being made to the policy. Although the universal life policy provides premium flexibility, it also shifts the risk to the policy owner — if the cash value runs out, the policy will lapse.
Variable Life Insurance
To offer owners more control over their policies, some companies introduced a new form of life insurance coverage in the late 1980s: variable life insurance. Since companies offered variable life insurance within whole life and universal life structures, owners could invest their policies’ cash value into a wide array of mutual funds known as “subaccounts.” Throughout the 1990s, high-profile mutual fund families — such as Fidelity, Oppenheimer and Vanguard — with proven track records attracted the masses to variable life insurance.
Although variable life provided policy owners with the opportunity for greater investment performance (and therefore, greater policy longevity), it also shifted more risk from the life insurance company to the owner. Although it wasn’t a primary focus for most policy owners, the potential for poor investment performance could significantly impact a policy’s longevity; plus, more investment options brought increased policy charges. Uncertain market performance and a volatile interest rate environment created the demand for a true guaranteed life insurance product.
Guaranteed Universal Life Insurance
Due to the need for greater safety and stability, a new form of life insurance evolved from the universal life structure. Guaranteed universal life insurance has only become popular in recent years, although it has been modestly available since the late 1990s. Guaranteed universal life is like whole life insurance in that it has a guaranteed premium; however, it will also guarantee a death benefit, even if its cash value runs out.
Today, it seems that the life insurance industry has come full circle, taking back certain policy control while retaining fixed flexibility within a guaranteed policy structure.
Under a guaranteed universal life policy, the insurance company identifies the premium required to guarantee a specific death benefit for a certain time period. Unlike a whole life policy, which seeks a high cash value at age 100, cash value is minimized compared to death benefits under a guaranteed universal life policy. Instead of having access to increasing cash value, the trade-off for policy owners is a guaranteed death benefit. A guaranteed universal life policy provides flexibility by allowing the owner to decide the policy’s longevity, rather than requiring endowment when the policy matures (age 100), as with most whole life policies.
Survivorship Life Insurance (“Second-to-Die”)
The aforementioned life insurance options (apart from term insurance) are available in the form of a survivorship life insurance policy, otherwise known as a “second-to-die” life insurance policy. This is a form of permanent life insurance which insures two lives (typically, two spouses) under one policy and does not pay the death benefit until the death of the second person. Survivorship life insurance has become extremely popular for married couples who seek to protect their wealth from tax erosion upon death and to create a tax-advantaged family legacy, since life insurance is granted with favorable-income tax treatment under the tax code.
Life Insurance with a Long-Term Care Rider
Moreover, the life insurance options mentioned in this list (again, apart from term insurance) are available with a long-term care rider. In today’s long-term care market, it has become extremely difficult for people to obtain a long-term care policy with fixed guaranteed premiums. If you own a standalone long-term care policy, you most likely have experienced premium increases. Without getting into the specifics of a long-term care policy, it is important to know that certain long-term care riders provide guaranteed premiums when tied to a life insurance policy. The riders have similar benefits to those provided by a standalone long-term care policy; however, since the riders are connected to a life insurance chassis, actuaries can integrate long-term care premiums and benefits within the life insurance premium and benefit structure to provide future value to a policy owner.
Whether you’re due for a life insurance policy review or simply need guidance around which of these options are necessary, our insurance experts can help you uncover potential risks within your financial plan and identify the right, cost-effective strategies to address them.
We also have unique process that is designed to help policy owners evaluate and answer important questions about their life insurance coverage, after a disciplined, professional analysis.
Want to learn more about our process and how to address key risks to your financial plan?
Securities, when offered, may be offered through an affiliated broker-dealer Hewins Brokerage Services, LLC, member FINRA; Office of Supervisory Jurisdiction: 2501 Beltline Hwy, Suite 401, Madison, WI 53713, 1-888-520-3040. Securities may also be offered through ValMark Securities, Inc. Member FINRA, SIPC; 130 Springside Drive, Suite 300, Akron, Ohio 44333-2431, 1-800-765-5201. Hewins is a separate entity from ValMark Securities, Inc.