Life insurance is more than simply an "umbrella" that protects your family financially in case something happens to you. Life insurance can also be an investment. As such, it's a good idea to pick a life insurance policy that fits your unique situation as an individual and an investor.
Below is a guide to the most common types of life insurance, with advice on how to determine which is best for you.
Term Life Insurance
Term life insurance may be great for young married couples who are just starting out but need a way to protect their spouse or children (i.e., the beneficiaries) financially in case the worst happens to one (or both) of the parents.
As its name denotes, term insurance pays out a death benefit for a specific pre-determined period of time -- a term -- usually from covering your dependents from one to 30 years. Because most term policies expire before the policy holder dies and consequently never pay a claim, term life insurance coverage tends to be the most affordable.
Term insurance is quite simple to understand: it pays a death benefit to the beneficiaries in case the policyholder (i.e., you, if you purchased the policy) dies. It has no "cash value," meaning it's not an investment, but rather straightforward insurance protection. Unlike other kinds of insurance, term life insurance premiums typically stay the same year after year, until the policy expires.
Whole Life Insurance
Whole life insurance is best suited for individuals who expect evolving financial needs during their lifetime and have low tolerance for investment risk.
As with a term life policy, both the premium amounts and the death benefit under a whole life insurance plan stay the same every year until the policy expires. And though the premiums for whole life insurance term policies are more expensive than premiums for term life insurance, whole life policies offer financial tools that extend beyond a death benefit -- giving you borrowing power for emergencies or potentially giving you more money later on in life.
Here's how whole life insurance works. When you pay your premium, you are guaranteed that your beneficiaries will receive a death benefit if you die when the policy is active. But unlike with term life, part of each premium payment is set aside for you, the policyholder, allowing the "cash value" of your policy to steadily build over time. Insurance companies typically invest this part of your policy in safe money market funds or in conservative-growth mutual funds. If you run into financial trouble, you may borrow against these cash values to help you through hard times. And if you cancel your policy before you die, you as the policyholder are entitled to the built-up cash value, meaning you can take that money with you.
Universal Life Insurance
Universal life insurance is best for those investors willing to accept greater risk and uncertainty, in return for the potential upside of benefiting from higher interest rates.
As with whole life insurance, universal life insurance lets you build cash value and gives you permanent death benefit protection. However, unlike whole life insurance, universal life offers a death benefit that you can calibrate to your needs, flexible premium payments, and cash values that are tied to current interest rates.
Universal life policies pay out a current interest rate comparable to prevailing rates paid by money market accounts. These rates aren't guaranteed for the contract's lifetime; they fluctuate with market conditions.
Variable Universal Life Insurance
Variable universal life insurance may be best for those looking for the most control over their cash-value investments.
These flexible plans offer policyholders the most useful investment tool kit our of any life insurance policy. It's generally similar to universal life insurance, but you can direct your insurance company to invest the underlying cash value in several portfolio sub-accounts. Carriers typically offer the usual equity and fixed income options. This way, you can apply your life insurance cash value according to your own personal asset allocations model.
This type of policy confers the most risk to the policyholder, but it also makes possible the greatest opportunities for gains. As an investor, you can integrate your variable universal life insurance policy with your entire portfolio, adding yet more diversification to your investments.
Tip: Consider Inflation in Your Plan
Before you start shopping life insurance providers, here's one last quick tip: the purchasing power of any life insurance you buy today will be eroded over the years by inflation.
Inflation may not be a factor if you are purchasing a term life insurance policy for only a few years, but if you are considering a policy with a longer time horizon -- say, 20 years or more -- or if you are obtaining whole life insurance quotes, the effect of inflation should be part of your equation. For example, if your household currently needs $50,000 per year and inflation rises 3.5% annually over the next 20 years, you'll need $100,000 annually by that time to keep your current standard of living. Keep that in mind when talking to your agent!
If your family or your spouse depends on your income, life insurance can give you peace of mind that they'll be taken care of financially if anything should happen to you. If you want more affordable premiums and only need the insurance protection for your family until the kids move out, a 15-year or 30-year term life policy may be a wise option for you. But if you want another investment avenue outside of your retirement accounts that you can tap anytime throughout your life, you may consider one of the other life insurance options.