How does life insurance work?

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Everyone knows that life insurance pays out when the named person dies.  The idea is to protect loved ones from a sudden loss of financial support.  But there are three basic types of life insurance that differ in their details.

Term life insurance is known as “pure” life insurance, because it will pay out the death benefit if the named person dies within the defined term (anywhere from one to 30 years), but if the named person does not die, no portion of the premiums will be returned to the policyholder.  It simply insures against loss of life, and the relatively low premiums reflect this.  Most term life insurance policies are renewable and convertible. 

Whole life insurance has no predefined term; it provides death benefit protection over the “whole” life of the insured, as long as premiums are paid.  A whole life policy also combines an investment component with the insurance component: it accumulates a cash value which the insured can withdraw or borrow against over their lifetime.  However, compared to other forms of investing, life insurance policies tend to offer a relatively low rate of return (not least because of the fees and commissions involved in insurance policies).  Consult someone knowledgeable about financial planning before choosing a whole life insurance policy.

Universal life insurance has a cash value that is determined by short-term interest rates rather than the stated long-term rate of a whole life policy.  Premium payments in excess of the cost of insurance are added to the policyholder’s interest-bearing account.  While the interest rate can fluctuate, it cannot fall below the policy’s stated guaranteed interest rate.  Consult someone knowledgeable about financial planning before choosing a universal life insurance policy.

The following chart summarizes the pros and cons of term, whole, and universal life insurance.

Pros and Cons of Insurance Types
TypeAdvantagesdisadvantages
Term
  • Maximum coverage per premium $
  • Meets coverage needs for up to 30 years
  • No savings feature
  • No lifetime coverage
Whole life
  • Fixed premiums
  • Tax-deferred cash accumulation
  • Lifetime coverage
  • Inflexible premiums
  • Rate of return may be lower than for other investments
  • Surrender charges
Universal
  • Lifetime coverage
  • Flexible premiums
  • Flexible death benefit
  • Pricing based on current interest-rate assumptions
  • Death benefit may drop below adequate coverage if interest rates decline
  • Premiums may rise if interest rates decline