Little in life is more complicated than life insurance. Few people outside the industry, and possibly not everyone inside it, understand all the ins and outs of choosing the right size and type of policy.
On top of that, life insurance is expensive. So if you make the wrong choice, you may be out a lot of money and your beneficiaries may not get the protection you expect.
All insurance is complicated, of course. Indeed, it has become synonymous with fine print and escape clauses that somehow always seem to let the insurer off the hook. One company is even advertising that it won't sell you a policy until you understand it. What this suggests about the way other companies -- and perhaps this company in the past -- market their products is not exactly reassuring.
But for many people, life insurance represents a prudent way of protecting loved ones against financial hardship in the event of the person's untimely death. So they need to address the question of how much insurance they should buy and what kind of policy or policies they should have.
This column last week provided a work sheet for calculating insurance needs. Today it looks at the various types of policies that are out there. Neither the work sheet nor this discussion is meant to take the place of expert advice; it is intended, rather, to give a general picture of needs and options.
The first question, of course, is whether you need life insurance at all. You may not. If there is no one depending on your earning power -- no young children, for example, who will be needing college money -- and your estate is not so large and illiquid that your heirs need instant cash for taxes, you probably don't need a policy.
If your death would mean economic hardship for someone, you do need insurance. But what kind?
Insurance can be divided several ways. There are group policies and individual policies. There are term policies and cash-value policies.
To understand the differences, look first at the way insurance works. Basically, insurance is a bet. The insurance company bets that if you give it some money, either all at once or over a period of time, it can invest that money and make enough to pay you the promised benefit when you die.
Plainly, the company doesn't always win. People who take out policies and die a year or two later cost the company money. But in the aggregate, the company believes that enough policyholders will live out their life expectancies to provide a profit.
Policies that offer only a death benefit and cover only a specific period of time are called term insurance. These policies usually offer the most death benefit per premium dollar, and they make excellent sense for consumers who need insurance but only for a limited time.
For example, a term policy could be used to ensure that money will be there for college. "But eventually the kids get out of school, so you don't need that money anymore," said William G. Brennan of the accounting firm of Ernst & Young.
Likewise, a term policy could fill in for your salary if you die, protecting your spouse. But "pension plans kick in" after you reach a certain age, and if yours provides an adequate survivor benefit for your spouse, you probably don't need insurance, Brennan said.
But there are some drawbacks to term insurance. Premiums often rise with age. Renewal may require a physical examination, which you can't be sure of passing. So for longer-term needs, Brennan suggests a cash-value policy.
In such a policy, part of the premium goes to cover the death benefit, just as in a term policy. But an additional part of the premium goes into some sort of savings or investment vehicle. With traditional whole-life policies, this is a savings plan, and the insurer guarantees to pay a certain interest rate to you. This feature allows the company to keep the premiums level as the policyholder ages.
As time passes, this money, known as the "inside buildup," accumulates, creating a fund that the policyholder can borrow against or get returned if he or she cancels the policy.
Whole-life policies were widely criticized for providing inadequate returns on the investment portion of the premium. Such criticisms helped lead to the development of other, more investment-oriented cash-value policies.
One such type is called universal insurance. These policies promise a higher rate of return, at least initially. However, the return is usually reset at intervals and may fall in later years.
Another relatively new type is variable life insurance. Generally, the policyholder is offered a choice of investment vehicles -- mutual funds, money market funds and the like -- and can allocate the investment portion of the policy. The investment risk falls on the policyholder -- that's what they mean by variable -- but for the person who thinks he or she can beat the returns offered by other policies, variable life can be attractive.
Much is made of the favorable tax treatment of the inside buildup. But Brennan cautioned that the returns on most cash-value policies are not good enough to make them worthwhile as pure investments. "Unless there is a real insurance need," these policies usually "aren't the investment of choice," he said.
Also, people who sell insurance often show how the premiums can disappear on these policies after a few years as the investment component of the policy builds up enough value to pay for the cost of the policy's premiums. While this can happen, Brennan urged consumers to examine the investment return assumptions the seller is using to make sure they are realistic.
Two other developments in life insurance also are worth noting.
The first is called "survivor life" or "second-to-die" policies. These cover two lives, usually a husband and wife, and pay on the death of the second. Since the insurer's risk is spread further, these policies are usually somewhat cheaper than the same coverage on a single life. They are most often used in estate tax situations. Since assets may pass from one spouse to another at death without tax, estate taxes are more important for the second death, which is when these policies pay.
The second is a feature or rider being offered by some companies that allows the insured to draw down the death benefit prior to death to pay for nursing home expenses. This feature may add to the cost, but for consumers worried about nursing home costs, the benefit may be worth the cost.Last Sunday's article on computing life insurance needs gave an incorrect figure for the maximum size of an estate that escapes federal estate taxes because of the estate and gift tax credit. The credit eliminates federal tax on estates up to $600,000 in value.