Types of Life Insurance
Life insurance can be categorized in three different ways:
- By the number of individuals the policy insures - Individual vs. Survivorship Coverage
- By the policy structure - Term Life vs. Whole Life vs. Universal Life
- By the method the cash values are invested - Variable Life vs. Traditional Life
Individual vs. Survivorship Insurance
Individual insurance insures one life, and its death proceeds are payable upon the death of the insured. A survivorship or "second-to-die" policy jointly insures two lives and pays a death benefit at the death of the survivor insured. Generally, the premiums of a survivorship policy are less than those for comparable insurance on either individual life, since the odds of two individuals dying during any given year are substantially less than of one individual dying. With a rated or uninsurable individual, survivorship coverage can usually be obtained, provided the uninsurable individual's spouse is insurable at standard rates.
Term Life vs. Whole Life vs. Universal Life Policy Structures
Term Life Policy Structure
Term life insurance provides death benefit coverage for a specified time period. Premiums may increase annually (annual renewable term) or remain level for period of time (e.g. 10 years) before increasing. Typically term life insurance provides the lowest initial cost and the highest long-term cost for coverage. Policies may be convertible to a permanent insurance policy (whole life or universal life) for a limited period of time from as little as 2 years to possibly as late as age 65. Term insurance differs from permanent insurance in that term insurance does not accumulate cash value while permanent coverage has a cash value component.
Whole Life Policy Structure
Whole life policies have a "bundled" or "black box" architecture. The fixed annual premiums of whole life policies are based on guaranteed interest, mortality and expense charges, and are payable for the insured's lifetime.
Historically, interest earnings have been higher than guaranteed rates and mortality and expense charges have been lower than the guarantees. The excess interest earnings and mortality and expense savings are bundled in the form of policy dividends. The policy dividends can be used by the policyholder to: 1) buy small amounts of paid-up insurance; 2) reduce the premiums; 3) pay for the cost of term riders; or 4) accumulate at interest.
A common method of utilizing dividends is to "suspend" the whole life premiums in later policy years. (If premiums are not "suspended," the dividends increase the policy's cash values and death benefits above the guaranteed levels.)
Under a "suspended" premium scenario, whole life premiums are paid by the policy's annual and accumulated excess dividends (which are not guaranteed). In other words, the premiums are paid from the policy itself, rather than from additional contributions to the policy. If premiums are "suspended" and then later dividends are not as high as expected, cash payments will be necessary to cover the deficit.
Another way to reduce the apparent outlay required for a whole life policy is to blend a basic whole life policy with a term insurance rider. The term portion is not guaranteed, however it requires less premium in early years and projections assume that dividends cover the increasing costs of the term insurance in later years. This technique for reducing the annual premium can be used on either a full-pay or "suspended" premium basis.
Universal Life Policy Structure
Universal life policies have an "open" architecture. The interest, cost of insurance, and expense elements that create the cash value are separately identified and easily measured. 
In simple terms, a universal life policy can be thought of as a bucket with a tap at the bottom. Net premiums (gross premiums paid less premium charges) and interest go into the bucket. Mortality charges, policy administration charges, and cash value withdrawals come out through the tap. The amount remaining in the bucket at any time reflects the policy cash value.
Universal life policies have the added feature of premium and death benefit flexibility for the insured. Premiums may be paid at any time in any amount within a broad range. The policy face amount may be decreased or increased after issue as needs change. Increases will often require the insured to submit new evidence of insurability for the additional coverage.
The premium flexibility of universal life policies may add an additional source of risk for the policyholder. Since premiums are not mandatory as long as there is just enough policy value left in the "bucket" to cover the coming month's cost of insurance charges, the policy owner may be inclined to "skip" or reduce scheduled premiums. As a result, the cash value may drop and the future premiums needed to maintain the policy will become like those of annually increasing term insurance. Those premiums can be prohibitive at higher ages.
This does not mean that the universal life policy has no guarantees. The guarantees are there so long as sufficient premiums are paid. It does mean, however, that a program must be established to monitor the policy as interest rates and actual premium payments change to keep policy values at acceptable levels that will support coverage for the desired coverage period.
Whole Life or Universal Life?
Theoretically, if the assumptions for Whole Life and Universal Life are the same (mortality charges, expense loads and interest credit rate), the cost should be the same and the outcome should be the same. With Whole Life, there is little control over the assumptions and the premium is fixed based on the guaranteed interest rate in the contract.
With a typical Universal Life policy, the premium is based on the projected interest rate over the lifetime of the policy contract. If the guaranteed rate is 4% for a Whole Life Contract, and the projected rate is 6% for the Universal Life Contract, then the annual premium would be lower for the Universal Life policy, since the higher interest earned would make up the difference in premium deposits. However, when the dividend credit of the Whole Life contract is factored in, which would match the 6% performance of the Universal Life policy, they should end up economically the same.
There are many reasons why advisors favor one type of insurance over another. For example, Whole Life is preferred for its disciplined approach to premium payments, and when higher annual premium payments are not an issue. On the other hand, Universal Life is favored for its premium flexibility (i.e., premiums may be spread -out to match annual gift tax exclusions, and budgetary limitations). In addition, because of Universal Life's "bucket" architecture, if the policy does not perform as well as expected, the coverage period may be reduced, (for example, from age 100 to age 95), without the need for additional premiums.
Traditional Insurance vs. Variable Insurance
Traditional Insurance
The cash values of traditional permanent insurance, whether it is whole life or universal life, are invested in the insurance carrier's general account portfolio. The general account portfolios of all insurance carriers consist mostly of investment-grade bonds and mortgages. (The volatility of common stock limits its use in a carrier's general account. In addition, states limit the use of equity investments in general account portfolios. As a result, on average, equity investments only account for 4-5% of the life insurance industry's general account portfolio.)
Variable Life Insurance
Variable life's distinguishing feature is that its cash values are invested in separate account funds, much like mutual funds. The policy owner chooses from alternatives made available by the carrier. All the investment risks for these funds, including the loss of principal, are passed directly through to the policyholder. With this added investment risk come some significant advantages of the variable form:
Better Long-Term Performance Potential
Equity investments such as common stock have performed much better than bonds and mortgages over the long term. For example, for the 15 years ending with 1990, the total return on equities held by insurance companies averaged 14.7% / year, while their bond and mortgage portfolios averaged just above 10.5%. Separate accounts allow access to these higher potential equity yields inside a life insurance policy.
Reduced Carrier Discretion Over Policy Results
Variable policies must pass the total investment return of the separate accounts through to policy cash values, reduced only by a fixed spread and direct fund administration expenses. The carrier cannot increase profits or make up for inadequate cost of insurance or expense loads through discretionary decreases in credited investment yield.
Increased Disclosure of Actual Investment Strategy and Performance
The prospectus and annual reports accompanying variable insurance disclose the investment philosophy of each fund and actual past returns. This level of information is not typically available for the assets backing traditional insurance products.
Greater Protection Against Potential Carrier Financial Problems
If an insurance company becomes insolvent, all general account assets back the liabilities of all general account products as well as the claims of creditors. However, the assets of the separate account cannot be used to satisfy general account obligations. Although this protection from general account creditors has not been tested in all states, it has been upheld where tested by recent carrier insolvencies.
This separate account protection applies to cash values, ensuring that they will be accessible on a timely basis, even for amounts in excess of the state guarantee fund limits. However, because the portion of the death benefit payment in excess of the cash value is payable from general account assets, in a troubled company, variable insurance does not ensure the payment of this excess any more than would a general account product.
Variable products are not as appropriate for clients wishing a guaranteed cash value, having a short duration insurance need, or wanting death benefit protection at the lowest possible cost. Usually, there are added expenses (ranging from .3% to 1.5% of annual yield) that arise from the higher costs of developing and administering variable insurance. On the other hand, for a longer term purchase, the potential incremental equity performance can significantly overcome the added administrative expense.
Life Insurance Due Care, Prepared and Researched by M Financial Group, 2nd Edition, 1994, (p.257-258).