Key Takeaways
- Term life insurance provides pure death protection with no cash value at the lowest cost
- Level term maintains constant premiums and death benefit; decreasing term reduces the death benefit over time
- Convertible term policies allow exchange to permanent insurance without new underwriting
- Whole life offers guaranteed premiums, guaranteed cash value growth, and potential dividends
- Universal life provides flexible premiums with transparent cost of insurance (COI) deductions
- Variable life invests cash value in subaccounts with no guaranteed return and requires securities licenses to sell
- Indexed universal life (IUL) credits interest based on market index performance with a floor and cap
- Variable universal life (VUL) combines premium flexibility with investment subaccounts
Types of Life Insurance
Understanding the different types of life insurance is essential for CFP candidates. Each type serves different client needs, offers different features, and involves different costs and risks. This section provides a comprehensive comparison of term and permanent life insurance products, including the various forms of universal and variable life insurance.
The Two Main Categories
Life insurance divides into two fundamental categories:
| Category | Characteristics | Duration | Cash Value |
|---|---|---|---|
| Term Life | Pure death protection | Specific period (10, 20, 30 years) | None |
| Permanent Life | Death protection + savings | Lifetime | Yes |
Term Life Insurance
Term life insurance provides death benefit protection for a specified period. If the insured dies during the term, the beneficiary receives the death benefit. If the insured survives the term, coverage ends and no benefit is paid.
Key Features of Term Insurance
- Pure protection: Provides only death benefit with no cash value or savings component
- Lowest cost: Most death benefit per premium dollar
- Temporary coverage: Expires at end of term unless renewed
- Renewable: Most policies allow renewal without evidence of insurability, but at higher premiums
- Convertible: Many policies allow conversion to permanent insurance
Types of Term Insurance
| Type | Premium | Death Benefit | Best For |
|---|---|---|---|
| Level Term | Fixed for term | Fixed for term | Most common; predictable costs |
| Decreasing Term | Fixed | Decreases over time | Mortgage protection, declining needs |
| Increasing Term | Increases | Increases over time | Inflation protection |
| Annual Renewable Term (ART) | Increases annually | Fixed | Short-term needs |
| Return of Premium (ROP) | Higher than level | Fixed + premium refund | Those wanting money back |
Level Term Insurance
Level term is the most common form of term insurance. Both the death benefit and premium remain constant throughout the term.
Common Term Lengths:
- 10-year term: Lowest initial cost, suitable for short-term needs
- 20-year term: Most popular choice for young families
- 30-year term: Provides coverage through child-rearing years
- Term to age 65: Coverage until typical retirement age
Decreasing Term Insurance
Decreasing term maintains level premiums while the death benefit decreases over time, typically annually. The death benefit eventually reaches zero at the end of the term.
Common Uses:
- Mortgage protection (death benefit matches declining loan balance)
- Business loan protection
- Decreasing family obligations as children age
Convertible Term Insurance
Convertible term includes an option to exchange the term policy for a permanent policy without providing evidence of insurability (no medical exam or health questions).
Key Provisions:
- Conversion without underwriting protects against becoming uninsurable
- Conversion deadline typically before age 65-70 or end of term
- New permanent policy premium based on attained age at conversion
- Only available to company's permanent products
Exam Tip: Term Insurance Selection
The CFP exam often presents scenarios asking which type of term insurance is appropriate. Key guidance:
- Young families with limited budgets: Level term (maximum coverage for the dollar)
- Mortgage protection: Decreasing term
- Health concerns or anticipating permanent need: Convertible term
- Uncertain short-term need: Annual renewable term
Whole Life Insurance
Whole life insurance (also called ordinary life or straight life) provides permanent death benefit protection with guaranteed cash value accumulation and level premiums for life.
Key Features of Whole Life
| Feature | Description |
|---|---|
| Lifetime Coverage | Policy never expires as long as premiums are paid |
| Level Premiums | Premium stays the same for life |
| Guaranteed Cash Value | Minimum cash value guaranteed by contract |
| Fixed Investment | Insurance company invests in general account (bonds, mortgages) |
| Policy Loans | Can borrow against cash value at stated interest rate |
| Dividends | Participating policies may pay dividends (not guaranteed) |
Types of Whole Life Insurance
| Type | Premium Payment Period | Characteristics |
|---|---|---|
| Ordinary (Straight) Life | Until death or age 100/121 | Lowest premium of whole life options |
| Limited-Pay Life | Fixed number of years (e.g., 20 Pay Life) | Higher premiums, faster cash value growth |
| Single Premium Life | One lump sum | Maximum cash value growth; usually a MEC |
| Paid-Up at 65 | Until age 65 | Policy fully paid at retirement |
Participating vs. Non-Participating
Participating (par) policies are issued by mutual insurance companies and may pay dividends to policyholders. Dividends represent a return of excess premium and are not guaranteed.
Dividend Options (CRAPO mnemonic):
- Cash - Receive dividend as cash
- Reduce premiums - Apply dividend to reduce next premium
- Accumulate at interest - Leave with insurer to earn interest
- Paid-up additions - Purchase additional paid-up insurance
- One-year term - Purchase one-year term insurance
Non-participating (non-par) policies are typically issued by stock insurance companies and do not pay dividends. Premiums are usually lower than par policies.
Exam Tip: Dividend Taxation
Dividends from participating policies are considered a return of premium and are tax-free until cumulative dividends exceed cumulative premiums paid. This is a common CFP exam topic.
Universal Life Insurance
Universal life (UL) is permanent life insurance that offers flexibility in premiums and death benefits. It unbundles the components of a life insurance policy, showing the cost of insurance, expenses, and cash value growth separately.
Key Features of Universal Life
| Feature | Description |
|---|---|
| Flexible Premiums | Pay more or less (within limits) as circumstances change |
| Adjustable Death Benefit | Increase or decrease face amount |
| Transparent Costs | See exactly how premiums are allocated |
| Interest Crediting | Cash value earns interest at current rates |
| Cost of Insurance (COI) | Monthly mortality charges deducted from cash value |
How Universal Life Works
- Premium Payment: Client pays premium (or skips payment if cash value sufficient)
- Expense Charge: Insurer deducts administrative expenses
- Cash Value Credit: Remainder added to cash value account
- Interest Credited: Cash value earns interest (current rate, subject to minimum guarantee)
- COI Deduction: Monthly cost of insurance charges deducted based on age and amount at risk
Universal Life Death Benefit Options
| Option | Description | Characteristics |
|---|---|---|
| Option A (Level) | Death benefit stays level | Amount at risk decreases as cash value grows; lower COI |
| Option B (Increasing) | Death benefit = face amount + cash value | Amount at risk stays constant; higher COI |
Guaranteed Universal Life (GUL)
Guaranteed Universal Life focuses on providing permanent death benefit protection at the lowest possible cost, with minimal cash value accumulation.
Features:
- Lower premiums than traditional UL or whole life
- No-lapse guarantee ensures coverage continues if minimum premiums paid
- Minimal or no cash value
- Limited flexibility compared to standard UL
Risks of Universal Life
- Interest Rate Risk: Current crediting rates may decline
- Lapse Risk: If cash value depleted, policy lapses or requires additional premiums
- COI Increases: Cost of insurance rises with age
- Illustrations May Disappoint: Projected values based on current rates may not materialize
Variable Life Insurance
Variable life (VL) is permanent life insurance where the cash value is invested in separate account subaccounts (similar to mutual funds). Investment performance directly affects cash value and may affect the death benefit.
Key Features of Variable Life
| Feature | Description |
|---|---|
| Investment Control | Policy owner chooses from available subaccounts |
| No Guaranteed Return | Cash value fluctuates with market performance |
| Separate Account | Cash value held separately from insurer's general account |
| Guaranteed Minimum Death Benefit | Most policies guarantee a floor on death benefit |
| Securities Registration | Must be sold with a prospectus; requires securities license |
Variable Life vs. Whole Life
| Feature | Variable Life | Whole Life |
|---|---|---|
| Cash Value Investment | Subaccounts (stocks, bonds) | General account (conservative) |
| Investment Risk | Borne by policy owner | Borne by insurer |
| Cash Value Guarantee | None | Yes |
| Death Benefit | May fluctuate | Guaranteed |
| Upside Potential | Unlimited | Limited to dividends |
| Licensing Required | Securities (Series 6 or 7) + Life | Life only |
Subaccount Options
Variable life policies offer various investment subaccounts:
- Equity subaccounts (growth, value, international)
- Bond subaccounts (government, corporate, high-yield)
- Money market subaccount
- Balanced subaccounts
- Specialty subaccounts (real estate, sector funds)
Exam Tip: Variable Life Licensing
CFP exam questions may ask about regulatory requirements. Remember that variable life insurance is considered a security and requires:
- A securities license (Series 6 or Series 7)
- A state life insurance license
- Sale must include delivery of a prospectus
Indexed Universal Life (IUL)
Indexed Universal Life (IUL) credits interest to the cash value based on the performance of a stock market index (such as the S&P 500) without directly investing in the market.
How IUL Interest Crediting Works
| Component | Description |
|---|---|
| Index | Policy tracks one or more market indices (S&P 500 most common) |
| Floor | Minimum interest credit (typically 0-2%), protects against market losses |
| Cap | Maximum interest credit (typically 8-12%), limits upside |
| Participation Rate | Percentage of index gain credited (60-100%) |
| Spread/Margin | Some policies deduct a spread from credited interest |
IUL Crediting Example
If the S&P 500 returns 15% in a year and the policy has:
- 0% floor
- 10% cap
- 100% participation rate
Credited Interest: 10% (limited by cap)
If the S&P 500 returns -10%: Credited Interest: 0% (protected by floor)
IUL Pros and Cons
| Advantages | Disadvantages |
|---|---|
| Downside protection (floor) | Upside limited by cap |
| Tax-advantaged growth | Complex crediting methods |
| Premium flexibility | Caps and participation rates not guaranteed |
| No direct market risk | Higher fees than term or GUL |
| Potential for higher returns than traditional UL | Illustrations may be overly optimistic |
Exam Tip: IUL is NOT a Security
Despite the market-linked interest crediting, IUL is not considered a security because the cash value is not directly invested in the market. IUL does not require a securities license to sell and requires only a life insurance license.
Variable Universal Life (VUL)
Variable Universal Life (VUL) combines the features of universal life (flexible premiums, adjustable death benefit) with variable life (investment subaccounts). It offers maximum flexibility but also maximum risk.
VUL Features Comparison
| Feature | Universal Life | Variable Life | Variable Universal Life |
|---|---|---|---|
| Flexible Premiums | Yes | No (fixed) | Yes |
| Adjustable Death Benefit | Yes | Limited | Yes |
| Investment Options | None (general account) | Yes (subaccounts) | Yes (subaccounts) |
| Cash Value Guarantee | Minimum rate | None | None |
| Securities License Required | No | Yes | Yes |
Who VUL is Best For
VUL may be appropriate for:
- Clients seeking permanent coverage with investment flexibility
- Those comfortable with market risk
- High-income individuals who have maxed out other tax-advantaged accounts
- Long time horizons to ride out market volatility
- Clients who will actively manage investment allocations
VUL Risks
- Investment Risk: Cash value can decline significantly in poor markets
- Lapse Risk: If poor investment returns deplete cash value, policy may lapse
- Complexity: Requires understanding of both insurance and investments
- Fees: Typically higher expense loads than mutual funds
- COI Increases: Rising costs of insurance can consume cash value in later years
Comprehensive Life Insurance Comparison
| Feature | Term | Whole Life | Universal Life | Variable Life | IUL | VUL |
|---|---|---|---|---|---|---|
| Duration | Temporary | Permanent | Permanent | Permanent | Permanent | Permanent |
| Premiums | Lowest | Fixed | Flexible | Fixed | Flexible | Flexible |
| Cash Value | None | Guaranteed | Min. guarantee | Market-based | Index-linked | Market-based |
| Death Benefit | Fixed | Fixed | Adjustable | May vary | Adjustable | Adjustable |
| Investment Control | N/A | None | None | Subaccounts | None | Subaccounts |
| Investment Risk | None | None | Interest rate | Market | Limited | Market |
| Best For | Temporary needs, limited budget | Guaranteed coverage, conservative clients | Flexibility, moderate risk tolerance | Growth-oriented, risk tolerant | Growth potential with downside protection | Maximum flexibility, sophisticated investors |
Settlement Options
When a policy matures (death or endowment) or is surrendered, the proceeds can be paid in various ways:
| Option | Description | Tax Treatment |
|---|---|---|
| Lump Sum | Entire amount paid at once | Death benefit tax-free; interest taxable |
| Interest Only | Principal retained; interest paid periodically | Interest is taxable income |
| Fixed Period | Equal payments over specified period | Exclusion ratio applies |
| Fixed Amount | Specified amount paid until exhausted | Exclusion ratio applies |
| Life Income | Payments for beneficiary's lifetime | Exclusion ratio applies |
Selecting the Appropriate Policy Type
Matching Policy to Client Needs
| Client Situation | Recommended Policy Type | Rationale |
|---|---|---|
| Young family, limited budget, temporary need | 20-30 year level term | Maximum coverage at lowest cost |
| Mortgage protection | Decreasing term | Death benefit matches declining balance |
| Estate planning, permanent need | Whole life or GUL | Guaranteed permanent coverage |
| Retirement income supplement | Cash value policy | Access to tax-advantaged funds |
| High earner wanting tax-advantaged savings | UL, IUL, or VUL | Flexibility and potential growth |
| Business buy-sell agreement | Term or whole life | Depends on duration of agreement |
| Conservative, wants guarantees | Whole life | Guaranteed values |
| Growth-oriented, understands risk | VUL | Investment control and upside potential |
Which type of term life insurance would be MOST appropriate for a client who wants to cover a 30-year mortgage that will have a declining balance over time?
Which of the following statements about universal life insurance is CORRECT?
An indexed universal life (IUL) policy has a 0% floor, 10% cap, and 100% participation rate. If the S&P 500 index returns 18% for the year, what interest rate will be credited to the policy's cash value?