Understanding Life Insurance Terms and Concepts

By Christopher Music

The subject of life insurance is often confusing to the lay person. It’s something that most of us need at some point in our lives, but it isn’t something that is as interesting as our favorite hobby. Therefore, there are tons of opinions about if one should have it and if so, what variety should be purchased.

Why do we need life insurance anyway? From a strictly financial viewpoint, your life has economic value. What you do for a living creates value for not only yourself, but those who depend upon your production for their economic well-being – spouses, children, business partners and associates, etc. Life insurance is used to manage the economic risk for those whose lives would be impacted by your death.

The Basics

First of all, we have temporary or “term” life insurance.

Term Life Insurance is insurance that one purchases for a specific period of time such as 5-30 years. It is pure insurance, just like auto or health insurance—it provides protection if an adverse event occurs, but has no long-term value. When the term expires, the insurance protection discontinues and there is no residual value. One could consider this “renting” or “leasing” insurance.

The other kind is permanent life (also known as “cash value”) insurance.

Unlike term insurance, Cash value insurance takes term insurance and couples it with an investment fund that accumulates a “cash value” in the policy. That cash value comes originally from part of the premium the policyholder pays, which will be higher than cost of term insurance. The cash value then grows as more premiums are paid and as the cash value earns interest. This interest is paid either at an annually declared rate or at a rate that fluctuates with stock market returns, depending on the type of policy. Since cash value accumulates in the policy, the policy will last as long as there is sufficient cash value to cover the costs of the insurance.

3 Types of Cash Value Insurance

There are 3 primary types of Cash Value policies:
1. Whole life
2. Variable life
3. Universal life

With Whole Life insurance, it is designed to provide coverage for your ‘whole life,’ hence the term. These policies have a fixed premium payment for the life of the policy. In addition, the cash value earns interest. If you want guarantees, these are excellent policies.

Variable Life policies are very similar to whole life, except the cash value is invested in ‘variable’ sub-accounts—investment funds very similar to mutual funds where the money is put to work in the stock and bond markets. These too have fixed premium payments, but the policyholder has the potential for greater returns (with greater risk) due to the investment options.

Universal Life is the most flexible type of policy. These policies allow you to make flexible premium payments as long as it’s enough to keep the policy in force and less than the maximum the tax law allows. Universal life policies can be Fixed (similar to a bank CD), Variable (similar to a mutual fund) or Fixed Index (a hybrid of fixed and variable). If you want to use permanent insurance to accumulate wealth, then universal life could be the most flexible option.

Properly structured life insurance contracts can provide excellent wealth building benefits including:
• Protection of the cash value from most creditors
• Possible tax free retirement income
Death benefit protection for your dependents (not subject to income tax) and
• Protection from stock market volatility (if fixed or fixed index policies)

Some consumers have had a bad experience with life insurance at some point in the past. This is simply the result of applying the wrong policy to the wrong circumstances. Each of these types of policies has an exact application just like any other financial tool, and the correct application to the correct situation provides effective and efficient results.

Properly structured life insurance is an integral part of a comprehensive financial plan. They provide economic benefits that are simply not found in other popular financial programs.

Author's Bio: 

After 15-plus years of being a financial planner, Christopher Music decided there had to be a better way. Witnessing financial debacles of big industry and government-driven economies caused Christopher to take action, developing an instrument that measures the success of any financial plan. The Financial Security AnalysisTM (FSA) is the back bone of Music’s firm, Wealth Advisory Associates (WAA). WAA is a financial planning firm focused on helping private-practice physical therapists understand and implement the most effective strategies to achieving financial success and security. Visit www.wealthadvisoryassociates.com