Demystifying Life Insurance

Life insurance can provide exponential financial leverage to families and individuals in a variety of circumstances and planning scenarios. It can be used to simply replace income in the event of the death of an income earner, to provide cash to an estate for tax settlement, to fund business succession or continuation plans. This précis is the first in a short series that will attempt to demystify the life insurance world and shed light on some powerful strategies.

Very often clients ask us to review, explain, and make recommendations regarding their life insurance. Our clients’ questions run the gamut from how much should be purchased to how it might be used in complicated estate planning scenarios. The place to start is the three basic types of life insurance:

• Term
• Universal Life
• Whole Life

Term insurance operates as the name implies. One pays an annual premium over the course of some term of years to be awarded a certain amount upon the death of the insured. One-year renewable, five, ten and, twenty-year terms are pretty standard term insurance options. Term insurance does not build cash value.

Universal Life (UL) and Variable Universal Life (VUL) are variants of a type of insurance known collectively as “universal life” and is a bit more complicated.

UL has term insurance and cash value features that are bundled together under one policy. It is considered to be a “permanent” policy because excess premiums are paid and credited to the cash value. In a typical UL policy the cash value is credited with a fixed interest rate for a set period (usually one year). UL policies can be flexible in terms of the amount in excess premiums that can be paid into the policy. These excess amounts are subject to limits set by the IRS.

VUL is very similar to UL except the cash value account consists of variable sub-accounts. These “sub-accounts” usually shadow a publicly traded mutual fund. The term “variable” generally refers to the fact that the underlying investment will fluctuate in value. Almost any type of publicly traded mutual fund can be held in a VUL. The idea is that the cash values can build more quickly because they are being invested.

Because cash values grow tax deferred and withdrawals (if they are allowed) may receive favorable tax treatment both ULs and VULs can be used creatively in a variety of financial planning scenarios. Using universal life to help pay educational expenses or provide income in retirement are examples. I will explain more on insurance strategies based on ULs and VULs in my next installment of this series.

The third category is Whole Life insurance. Whole Life is considered to be a true permanent policy as it provides death benefit coverage for the “whole” life of the insured. There are basically two types of whole life policies: “participating” and “non-participating”.

In a non-participating contract all policy values are established at issuance. This means that death benefit, cash values, and premiums are pre-set.

In a participating contract the policy owner shares in any excess profits the company makes or the company may refund any overages in premium and will return these back to the policy. These are called dividends and there are many ways in which they can be used. Choosing the correct dividend option is important because it can affect the long-term performance of the policy.

Life insurance and its uses is a very broad topic. There are many important factors that need to be accounted for when considering using life insurance as a financial strategy. These include the financial strength of the underwriting company, the performance of the underlying assets, the underwriters’ claims experience, and fees to name a few. This brief introduction is designed to help explain some basic insurance types and terminology. In future installments of this series I will dig deeper into some very powerful and interesting strategies and explore how, with careful planning, life insurance can be used to build integral advantages into a family’s financial circumstances. I am always available for questions and/or discussion in the meantime.

 

Dwight Davenport

Principal, Vodia Capital, LLC