Individuals utilize life insurance policies to effectively transfer the risk of financial loss to a third party due to death. Life insurance carriers take on the financial obligation to pay a specified death benefit in return for premiums paid by policy owners for a set amount of time as defined by a life insurance contract. Life insurance coverage is used in personal financial planning and estate planning, as well as business protection planning for a myriad of reasons, depending on an individual's specific need for transferring risk. While some may choose to purchase a life insurance policy to replace income, others obtain coverage to secure a lump sum for financial goals that are not yet fully funded, such as a child's education or retirement savings.

Regardless of the reason for coverage, individuals have a plethora of life insurance policy types available to them, each with specific advantages and disadvantages. The two main categories of life insurance are term and permanent insurance, with subcategories of permanent insurance consisting of whole life, universal life, variable life and variable universal life policies.

Term Life

Term life insurance contracts, also known as pure insurance policies, provide life insurance coverage to individuals for a specific period of time, or term, commonly issued with five-, 10-, 15-, 20-, 25- and 30-year terms. Because an expiration date exists, term insurance is considered temporary coverage. Individuals who obtain a term insurance policy enter into a contract with the life insurance carrier that guarantees a specified death benefit in exchange for a specified level premium throughout the term of the contract. Should a policyholder pass away during that term, his beneficiary receives the total death benefit as a tax-free payout.

Term insurance coverage is best-suited for individuals who want coverage for a short-term need, such as replacement of income during working years, funding a child's college education, or protecting the remaining balance of a business or mortgage loan. Young families often choose term insurance as their primary policy type, and business owners select this type of policy during the startup phase to cover key personnel. Because of their temporary nature, term insurance premiums are far less expensive than permanent policies with a comparable death benefit.

Whole Life

Whole life insurance policies fall under the purview of permanent life insurance contracts, which means coverage lasts throughout a policyholder's lifetime, regardless of how long he lives. Also known as cash value life insurance, whole life is the most common type of permanent coverage on the market because of the guarantees it provides to policyholders. An individual who enters into a whole life insurance contract with an insurance carrier agrees to a specified death benefit amount in exchange for a fixed level premium. As long as the premium is paid in accordance with the policy contract, the insured individual's beneficiaries are paid the total tax-free death benefit at the time he passes away.

Permanent life insurance contracts differ from term not only in their duration but also in providing policyholders a benefit that can be used while they are still alive, known as a policy's cash value. With a whole life policy, a portion of premiums paid are siphoned off into the cash value account within the policy, creating a type of savings for the policyholder. Balances within the cash value account of a whole life policy are guaranteed to receive a set rate of return throughout the life of the policy. Funds within a cash value account held in a whole life policy are tax-deferred and may be borrowed against during the policyholder's lifetime. Any unpaid loan balances against the cash value account are withheld from the final death benefit paid out to beneficiaries.

Whole life insurance is far more expensive than term insurance because of the built-in guarantees for the death benefit, the premiums and the interest rate applied to cash value accumulation. Because of the cost associated with whole life insurance coverage and its lifetime guarantees, this type of policy is best-suited for individuals with long-term protection needs, such as retirement income for a spouse.

Universal Life

Universal life insurance coverage also falls under the permanent life insurance category, but differs slightly from whole life. As a form of permanent coverage, universal life policies provide a guaranteed tax-free death benefit to policyholder beneficiaries based on the amount of premiums paid over time. A universal life contract provides access to cash value accumulation like that of a whole life policy; however, cash value within a universal life policy includes a guaranteed minimum interest rate plus an additional interest payment if and when the life insurance carrier experiences higher returns on its own investments.

In addition to the potential for higher earnings on cash value balances, policyholders of universal life contracts have flexibility in terms of the level of total death benefit, premium amounts paid and payment frequency. After the first year of ownership, universal life policyholders have the option to increase, decrease or skip premium payments, so long as the cash value balance is sufficient to cover all policy expenses. Additionally, policyholders of universal life contracts have the option to select a fixed death benefit payout or an increasing death benefit payout for their beneficiaries. The latter is the equivalent of the pure insurance death benefit plus any accumulation in cash value balances.

Universal life policies are less expensive than whole life policies because the guaranteed minimum interest rate is lower for universal contracts, but premiums are more expensive than term policies. Individuals who are in need of coverage for mid- to long-term financial objectives, or those who want more flexibility in premium frequency and amount, may find universal life more fitting than term or whole life coverage.

Variable Life

Another option within the permanent life insurance category is variable life insurance, which provides policyholders the same long-term coverage and cash value benefits as whole and universal life policies. Variable life insurance premiums are fixed like they are with whole life policies, but cash value balances and death benefits fluctuate. This is because variable life insurance cash value balances are invested in various tax-deferred subaccounts provided by the insurance company. Once policy expenses and charges are paid, the remaining premium amount is moved to the cash value account where it is invested based on the policyholder's investment selections. When the subaccounts perform well, a policyholder's cash value and death benefit rise; when they perform poorly, both the death benefit and cash value fall.

Variable life insurance contracts are best-suited for individuals with a long-term need for coverage. The policyholder takes on the risk of the subaccount performance rather than the insurance carrier, creating a policy that is most appropriate for individuals who want to manage their own cash value accounts and risks associated with them. Cash value balances still grow tax-deferred and are available as a policy loan while the insured is still living. Policyholders of variable life pay similar premiums as those who hold universal life contracts.

Variable Universal Life

Variable universal life insurance coverage is a hybrid of universal life and variable life contracts. Under a variable universal life contract, policyholders have numerous investment subaccounts available to them like they do with variable life policies but also have the flexibility in premium payments and frequency offered by universal life policies. Premium amounts above and beyond the total policy charges and expenses are covered first, with the remaining amount deposited into the cash value account based on the policyholder's investment selections. As with other permanent life contracts, the cash value within a variable universal life policy grows tax-deferred and is available through a policy loan while the policyholder is alive.

The combination of universal life and variable life allows an individual to create a custom policy that suits specific insurance needs for the long-term. However, variable universal life policyholders assume the risk of the underlying investments within the cash value portion of the policy, and death benefit and total cash value can rise or fall over time. Because of the flexibility afforded by a variable universal life policy, policyholders pay slightly more in premiums than universal or variable life policyholders but less than whole life policyholders.

Life insurance coverage is an integral aspect of comprehensive financial planning and estate planning, but there is no single type of life insurance that is most appropriate for every individual. Instead, an evaluation of total death benefit needed, time frame of coverage, and willingness to take on risk within the cash value account are necessary to determine which type of coverage is best-suited for an individual's specific needs.

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