There are a vast array of life insurance policies out there - do you know the differences between all of them and which benefits you most? Here we break down the two most popular types of permanent life insurance.
The subject of life insurance is very confusing to physicians because there are so many products and solutions AND opinions. In the first article of this series, we discussed the benefits a life insurance policy as a properly structured component of a comprehensive strategy can provide. Now we'll discuss the many types of life insurance coverage.
Essentially, there are two types of life insurance: term and permanent.
Term coverage is much like all other insurance coverage you may purchase. If you die, they pay a death claim. If the coverage lapses or is discontinued, there is no further value. This is used for the pure risk management aspect.
Permanent life insurance on the other hand, may build a cash value. There are many types of permanent policies and this is where the confusion often starts.
Look at the graph below. This is essentially a mortality curve and term life insurance is priced based on such a mortality curve. You can buy a five-, 10-, 15-, 20- or even 30-year term policy where the rate is level for that time, but if you wanted to renew beyond that point, the rates would go up exponentially. Term insurance is very appropriate for someone who has a shorter term need for life insurance. Also, a convertible term policy (which gives the ability to convert from term to permanent without evidence of good health) is very appropriate for young physicians as a way to secure some coverage for a small premium, while you are healthy and the rates are low.
*This is a very generic and simplified graph to illustrate the annual premium pricing differences between the main types of products. Individual circumstances and product design, coordinated by a knowledgeable and experienced advisor will determine the final numbers.
As for permanent life insurance, there are many marketing names and varieties of policies, but for practical purposes, we will outline the two most common; whole life (WL) and a “hybrid” policy.
While products vary by provider, a simplified way to look at the WL is that it was developed many years ago as an alternative to term insurance. The premium is much more expensive than term in the early years, but level throughout your whole life. Because you are paying more for the coverage than the pure risk while you are young, “cash value” is created for the purpose of helping to offset the increasing cost of coverage later in life. This is what helps support the cost for the life insurance when you are older and the cost for insurance is actually more than the premium you are paying. If you pay enough into the whole life policy, it can become paid up.
Some advantages of WL, besides offering lifetime coverage, are that the cash values grow on a tax deferred basis, can be surrendered if needed and could be used as collateral if you need to borrow against them. This multi-purpose asset has gained in popularity in recent years because the cash values grow from one year to the next based on a crediting rate paid by the insurance company.
The disadvantages of WL are also numerous. These policies are not very flexible. If you need to make changes to the policy — raising or lowering the death benefit or the premium amount — this can be cumbersome or impossible depending on the company. Many companies would rather sell you a new policy rather than make changes to an existing policy, potentially resulting in new or higher fees and commissions.
We have run into people who have a dozen policies duplicating policy fees, which is inefficient knowing that other “hybrid” products exist. For people who are very conservative, have quite a bit of discretionary cash flow, and have a need to ensure a death benefit for their entire life, a WL policy may be appropriate.
The hybrid policy is another option in which the annual premium generally falls somewhere between term and WL. This can vary quite a bit, and in general, the higher the premium, the more the opportunity for more cash value … resulting in the potential for the policy to remain in force for a longer period of time.
If maximally funded and you intend to utilize the cash value, these policies should be earmarked for use at around 10-plus years from the time the policy is initiated, as this is not a vehicle for short-term money. Also, remember that the primary reason to purchase a life insurance policy is the death benefit. The graph above illustrates a premium payment and coverage lasting until retirement age.
There are many different hybrid policies, which confuses the subject even more. Usually, the premium is flexible and changeable, the death benefit can vary as your needs change, and there are a variety of methods of crediting the cash value accounts. In general, this flexible choice can be used to implement a part of a financial strategy that should be monitored frequently by the policy owner. Because of all of the options, working with an experienced advisor who knows you and your circumstances is recommended.
When a policy is funded at a much higher level, it can build more cash value and in some cases become paid up. There is an IRS calculation based on your age, and death benefit amount that determines the maximum premium you can pay without the policy becoming a Modified Endowment Contract, which then loses some valuable benefits. Figuring out how much you want to contribute to a policy for all your personal reasons (death benefit, tax deferred growth, asset protection, etc.), and then solving for the least amount of death benefit you need to have will result in a situation where the policy looks best for the long-term “living” reasons.
Again, we cannot emphasize this enough, please work with a very competent agent or advisor on these matters as a mistake here could “taint” your policy and you could lose some of the very valuable tax benefits.
For most physicians, a combination of a hybrid policy and term insurance is the most economical and efficient way to cover your lifetime life insurance needs and use your life insurance for many other financial purposes, especially in a rising federal tax environment.
Jon C. Ylinen is a Financial Advisor with North Star Resource Group and offers securities and investment advisory services through CRI Securities, LLC. and Securian Financial Services, Inc., Members FINRA/SIPC. CRI Securities, LLC. is affiliated with Securian Financial Services, Inc. and North Star Resource Group. North Star Resource group is not affiliated with Securian Financial Services, Inc. but is independently owned and operated. The answers provided are general in nature and are not intended to be specific recommendations. Please consult a financial professional for specific advice in relation to your individual circumstances. 596941/ DOFU 12-2012
Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender charges.
Policy loans and withdrawals may create an adverse tax result in the event of a lapse or policy surrender, and will reduce both the cash value and death benefit.
If a policy is over funded and becomes a modified endowment contract (MEC), the contract's earnings will be taxed as ordinary income at withdrawal, and may be subject to a 10% penalty if withdrawn before age 5-and-a-half.
Please keep in mind that the primary reason to purchase a life insurance product is the death benefit.
This should not be considered as tax or legal advice. Please consult a tax or legal professional for information regarding your specific situation.