Understanding different types of life insurance policies

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Different types of life insurance for different families.

© Witthaya Prasongsin—Moment/Getty Images

Life insurance comes in two basic forms: Term life insurance and permanent life insurance.

Term insurance is similar to other insurance products you might already have, such as homeowner’s (or rental) and auto insurance. It provides a “death benefit” if the insured person dies during the term.

Permanent insurance provides coverage for the life of the insured as well as a cash value investment feature that the policyholder may access within certain parameters. If you’ve heard of a “whole life” policy, that’s one type of permanent insurance. There are also universal, variable, and indexed policies.

And not all term life insurance is the same. So before you can determine what type of policy is best for you, it’s important to understand the differences.

With term insurance, you purchase a policy that covers a set period (known as the term). In contrast to your homeowner’s and auto insurance, which are typically renewed on an annual basis, a term life insurance policy will usually (although not always) provide coverage for a longer period of time, such as 10 or 20 years.

The death benefit is the amount of coverage you purchase. Term policies can range on the low end of $10,000—often meant to cover funeral, burial, and other final expenses—but they are more often in the range of $100,000 and up, depending on your needs and those of your beneficiaries.

The higher the death benefit, the higher the premiums (the cost).

A term life insurance policy often includes an option to renew coverage at the end of the term, but the renewal coverage will cost more than the original premium. Life insurance coverage is priced based on the age and health of the insured. So the guarantee to renew coverage for someone with an unknown health outlook in the future doesn’t come cheap. If your policy doesn’t guarantee renewal, you may have to apply for a new policy when the term ends—and if your health has deteriorated, you could face much higher premiums or be denied coverage altogether.

A level-term policy will maintain the same coverage for the term of the policy. If you have a $500,000 death benefit on day one of a 20-year policy, you’ll have a $500,000 benefit during the 20th year as well.

Families often seek more coverage when they’re younger. Although the income you’d need to replace (should you or your spouse pass away while the kids are young) may be lower now than later in life, young families tend to have less accumulated savings. Plus, you might want more coverage to provide for a future college education and/or a longer-term mortgage on a home.

A decreasing-term policy will provide a higher death benefit in the early years of the policy and decrease over time. This allows a family to purchase the higher level of coverage when it’s needed most, but at a lower overall premium.

Permanent life insurance provides coverage for the entire life of the insured as long as the policy remains in force.

In addition to the death benefit, permanent life insurance provides for the accumulation of a cash value in a policy that compounds over time via earned interest and/or investment returns.

Permanent life policies typically allow the policyholder to access this cash value during the lifetime of the insured.

The cash value should not be confused with the death benefit. If the insured individual passes away and a death benefit is paid, there is no return of the cash value built up in the policy. In other words, a $500,000 policy will pay out $500,000 in death benefits (less any loans or withdrawals).

There are four basic types of permanent life insurance.

Whole life insurance offers predictable premiums, coverage, and cash value accumulation.

Whole life provides coverage for life, with a set death benefit and set premium that will accumulate a cash value over time. The cash value increases based on a set interest rate. Some policies may also provide for a dividend if and when the insurance company holds a surplus of assets from premiums taken in. Think of a dividend as a partial rebate on your premium.

Universal life insurance provides flexible premiums and coverage as life changes. The cash value grows based on a variable short-term interest rate.

Universal life policies introduce flexibility to your premiums or death benefit. Like whole life, universal life is permanent insurance, but it provides more flexibility in the premiums you pay and the death benefit. Depending on your needs, you may be able to reduce your premiums in the future. Alternatively, if you have a need for a greater death benefit than you originally planned, you have the flexibility to increase coverage. This would mean higher premiums and require approval based on the insured individual’s health.

The cash value will accumulate and earn interest based on short-term rates (which fluctuate), similar to a savings or money market account. The cash value may be used to offset the ramifications of reducing premiums or increasing the death benefit.

Variable-universal life insurance provides flexible premiums and coverage as life changes. The cash value grows based on investment in the financial market, which can greatly affect the flexibility of the policy (positively or negatively).

A variable-universal life policy operates like the universal policy, but the cash value is based on returns from an investment portfolio. This may allow the cash value to grow more quickly, but, as with any investment, higher potential returns also come with higher potential risk.

The cash value will fluctuate with ups and downs in investment returns. If the cash value is used to support an increase in the death benefit or a lowering of premiums, a subsequent downturn in the markets and cash value may require increased premiums or a reduction in the death benefit.

Indexed-universal policies are a type of universal life insurance in which interest credited to the cash value is tied to the performance of a market index such as the S&P 500.

Like variable policies, an indexed-universal policy provides flexible premiums and coverage as life changes. The cash value earns interest based in part on the performance of the S&P 500 or whichever benchmark the policy is tied to.

The performance of the index can affect the interest credited to the policy and, in turn, the cash value available to support flexible premiums and coverage. But unlike a variable policy, an indexed-universal policy doesn’t require you to choose investments. And because the policy earns interest based on the index rather than investing directly in it, the cash value won’t necessarily rise or fall by the same amount as the index.

The many different types of life insurance can be confusing and overwhelming for even sophisticated investors. The most important distinction to make is term versus permanent.

Although permanent insurance is significantly more expensive than term, it provides lifetime coverage, a cash value option, and depending on the policy type, greater flexibility. But you’ll still need to decide which of the four basic types is right for you and your family.