Demystifying Life Insurance

By Matt Mormino, CFP® | Nov 20, 2023 |

Life insurance provides essential financial protection for your loved ones in the event you pass away prematurely and can be used as an estate planning tool as well. But with many complex policy options, getting the right coverage can be daunting. This guide covers key terminology, policy types, features, and steps to take when evaluating and purchasing life insurance so you can find the best solution. 

Why Life Insurance Matters

Life insurance pays out an income tax-free death benefit to your chosen beneficiaries if you die while covered under an active policy. This critical benefit helps replace lost income to maintain your family’s lifestyle, cover debts like an outstanding mortgage, and meet financial goals like funding a child’s future college education.

We all face various risks in life – accidents, illnesses, and other unpredictable events. Financially speaking, the hazard is a loss of future earnings. One option is to self-insure these risks by relying on personal savings, equity in a home, a spouse’s income, or other family support.

Key Life Insurance Terms and Policy Types

Life insurance is a contract where you pay ongoing premiums to an insurance company that provides a lump-sum death benefit to your designated beneficiaries if you pass away while covered under the active policy. The insurer will thoroughly underwrite and evaluate your risks before agreeing to issue a policy. Certain events and activities are automatically excluded from most life insurance policies, like dying while committing an illegal act, acts of terrorism or war, or engaging in a hazardous activity that is specifically excluded, such as skydiving.

The two main categories of life insurance are:

Term life insurance provides temporary coverage for a defined period of time, typically 10, 15, 20, 25, or 30 years. Term coverage has the benefit of affordable premiums due to the limited coverage period, with the downside that coverage expires when the terms ends unless the policy is “convertible” into a permanent policy. There are different types to consider:

  • Level term: Premiums remain the same for the entire term length. This is the most common and recommended type of term policy.
  • Decreasing term: Premiums stay level, but the death benefit amount gradually declines over the term duration.
  • Annual renewable term Coverage is guaranteed for the term but is renewed yearly, meaning that premiums start extremely low but increase as the insured ages.

Permanent life insurance provides coverage for “life” if the policyholder continues to pay the required premiums. (Despite a “life” coverage, there is a term limit, but it’s usually 110+ years—past the point where it is pertinent.) These have more expensive premiums, but some policies can build cash value that can be borrowed against or withdrawn. There are different types of permanent life insurance:

  • Whole life offers guaranteed level premiums and a death benefit amount for life. Annual dividends from the insurer help offset premium costs over time. 
  • Universal life allows flexible premium payments within certain limits. The death benefit can also be adjusted up or down over time. Policy performance is based on dividends earned and interest credited.
  • Variable life premiums are invested in various sub-accounts with varying risks and returns, ultimately impacting the death benefit amount. It’s akin to investing in a 401(k). A policyholder chooses an allocation to different sub-accounts with different market exposure – e.g., domestic equities, foreign equities, etc. – and the return is based on the performance of those sub-accounts.
  • Variable universal life combines the flexible premium structure of universal life with the sub-account investments of variable life policies.

Common life insurance policy features and options

Group life insurance is obtained via an employer or through membership in an organization. It often guarantees limited coverage amounts without medical underwriting at a lower cost. However, it is important to understand that if an individual leaves the organization, they’ll also have to leave the group coverage. If you leave that employer or organization, group life can usually be converted to a portable individual policy. Still, not always, and the cost will increase when it is portable.

Accelerated Death Benefit Rider (ADB) allows the insured tax-free access to the death benefit if the insured has a long-term care need, or is diagnosed with a terminal illness. Rider will depend on each insurance company.

Accidental death and dismemberment (AD&D) provides a benefit in the event of a death occurring due to an accident. It may also pay defined cash amounts for certain injuries like limb loss or eyesight, even if non-fatal. This coverage is typically offered as part of group term life policies. It’s rarely part of individual policies.

Survivorship or second-to-die life insurance covers two lives (often spouses or partners) jointly and only pays the death benefit when the second insured person passes away. Premiums are typically lower than comparable individual policies since the insurer collects payments over a longer expected period before benefits are triggered. These policies can be useful for estate planning purposes.

A Conversion option may allow for a term policy to be converted into a permanent policy with the same company. This feature usually has an age limit to time frame for conversion. It uses the same health rating as original policy with no medical needed and is useful if a health status changes or a policy is needed for a longer period of time.

Non-insured ownership allows someone other than the person whose life is insured to own the life insurance policy. This is common with parents purchasing coverage for the lives of their children. It can also occur when a life insurance trust owns a policy for estate planning purposes.

Recruit a Personal CFO

Buying insurance policies can be an emotional experience, as it forces you to contemplate things that could go wrong in your life or business; it also brings your mortality back and center.

A Personal CFO will not only be able to guide you through the process step-by-step, but they will also help you make informed decisions based on your needs and circumstances.

If you’re currently looking for a Personal CFO who knows the insurance market and offers the kind of tailored advice that will help you secure the brightest possible financial future, please get in touch.

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