Understanding Life Insurance Policies – What Types are Available, and Who are They for

Life insurance policies come in many configurations and variants. Here’s an explanation of three of the most common life insurance policies to help you understand how they work

To the uninitiated, life insurance can seem like a confusing morass. Wading through a sea of numbers and terms that don’t mean what you think they mean, it can be hard to discern the value that a right-sized life insurance policy can provide.

But fret not, you have questions and we’re here to answer them.

Although with the qualifier that this one article is unlikely to answer every single query you may have about choosing a life insurance plan – that’s what your financial adviser is for. When in doubt, give them a call to find out more. 

What this article will cover are the three main types of life insurance plans. By comparing and contrasting one to another, we hope you will be able to understand how life insurance works in general, as well as glean some information on some common variants.

Here we go!

Three main types of life insurance policies

Term life insurance

Let’s start with the category easiest to understand – term life insurance.

A term life insurance policy provides life coverage for a specific period of time (or term). You can choose how much you want to be protected for, the conditions/events to cover, and how long the term of your cover should be.

Your insurer will quote you a premium based on your choices, which is the cost you pay in return for the coverage. As long as you continue to pay your premiums, your coverage will remain intact.

Generally, you will pay premiums for as long as you remain covered under the plan, or until a claim is made. If you fail to pay your premiums, your policy will lapse and you will lose your benefits.

By itself, a term life policy only offers coverage against death and in most cases, total and permanent disability. However, you can also use riders for additional benefits that increase the scope of your coverage, such as for critical illnesses, or accidental death.

This makes term life policies highly capable for protection purposes, while being substantially more affordable compared to other types of plans.

What’s the trade off? Well term life plans do not have a cash value, so surrendering your term life policy doesn't entitle you to a sum of cash.

The only way you will receive a payout from a term life policy is when the policy benefits are triggered by death, disability, illness or injury, etc.

Who is term life insurance made for?

Term life insurance is best suited for those looking for a less-costly way to achieve insurance protection.

They understand they are paying lower premiums for protection only, and are willing to walk away with nothing at the end of the policy term – even if they’ve been faithfully paying their premiums for more than 20 years.

Because term life policies do not accrue cash values, those who choose such policies should be prepared to accumulate retirement savings or build their wealth via other means, such as by investing on their own.  

Some investors believe that by choosing lower-cost term life insurance over more expensive whole life policies, and investing the difference, they would maximise their wealth potential.

But this is a fallacy, as it assumes that the average investor is capable enough to make investment returns on par with those achieved by a multi-million dollar insurance firm staffed by professionals.

Rather, a more pragmatic approach would be to treat term life policy as an alternative for those strapped for cash and yet need to protect themselves and their families from unexpected events.

Whole life insurance

Whole life insurance works very similarly to term life insurance, with the added advantage of providing a cash component. Of course, this comes at a higher premium, but why?

Well, that’s because the premium you pay for a whole life insurance plan comprises a sum to pay for the cost of insurance, with the rest put into an investment fund that is managed by your insurer. This allows your policy to have a cash value that grows over time.

The cash value of a whole life insurance policy may comprise of guaranteed returns only, or a mix of guaranteed and non-guaranteed returns. Plans that offer guaranteed returns only are known as non-participating plans, while those that offer guaranteed and non-guaranteed returns are known as participating plans.

The difference lies in the risk profile. Non-participating plans tend to invest in more conservative instruments that offer more certain, but lower, returns. As such, you will receive a guaranteed cash value, but this is unlikely to match or exceed the total cash value of a participating policy.

Participating policies invest in a wider range of instruments, allowing them to offer both guaranteed and non-guaranteed returns – the latter of which take the form of bonuses and dividends.

The non-guaranteed returns are based on the performance of the market, and paves the way for higher total returns. However, this also means policyholders are exposed to a higher level of risk.  

Another thing to note is that policyholders can take a policy loan against the cash value of their policy to meet other financial uses.

You can repay your loan at your discretion, but do be aware that the amount withdrawn is subject to compounding interest, and the loan amount, along with accumulated interest, is deducted from your policy payout.

Apart from the cash value, the other major component of a whole life policy are its benefits, which commonly cover death and total and permanent disability.

You can also purchase riders to add other benefits to your whole life plan if there are particular events you’re especially worried about.

Who is whole life insurance made for?

Whole life insurance is a bundled product made to fulfil both protection and wealth accumulation goals. They are ideal for those who want an all-in-one-plan to cover both of these needs.

Another advantage of whole life policies is that for most plans, premiums are fixed and do not increase with age.

Also, because a portion of your premiums are invested on your behalf, purchasing a whole life policy may be considered as a form of passive investing (although some critics take the view that you could achieve better returns investing on your own, which, as explained above, is a fallacy that somehow stubbornly persists).

In any case, the earlier you start a whole life policy, the better your outcome tends to be at the end; this is due to the magic of compounding, which really racks up your gains the more time you give it.

Note, though, that whole life policies represent a long-term financial commitment and surrendering your policy early can result in losses, especially during the initial few years. The key is to strike a balance between protection level and affordability.

If in doubt, start with a smaller sum assured, and look into raising your coverage as your budget and needs (such as having a baby) increase in time.

Investment-linked plan (ILP)

At first glance, an ILP seems very similar to a whole life plan. It also combines both insurance protection and investment, but has a few added features that may appeal to some policyholders.

Before we delve into the details, it’s important to understand what’s going on under the hood.

What you need to know is that an ILP is an investment plan that provides insurance benefits; meanwhile a whole life plan is an insurance plan with a cash component.

This is how an ILP looks in action. The premiums you pay are used to purchase units in selected investment funds. Some of those units are then sold off to pay for the cost of insurance. This process is repeated monthly, due to how unit trusts are traded.

Right away you can spot a problem with this model: Your account has to pay the bid-ask spread, and this is repeated at least twice each month – once when purchasing units, and once more more when selling units off to pay for the cost of insurance.

Also, your account value will fluctuate according to market trends, although the theory is  that over the long run ILPs should chart a trajectory on par with the market.

However, it’s important to address another shortcoming of this model. As the cost of insurance goes up as you age, more and more units have to be sold off as a result, leaving lesser units to continue growing your wealth. Hence, ILPs can be said to have diminishing returns.

Ok, so do ILPs have any redeeming qualities? Actually, yes – ILPs offer a higher degree of flexibility than other types of life insurance plans.

Once your account accumulates a high-enough cash value, you can opt for a premium holiday – that’s when you temporarily stop paying your premiums. And, you can also make withdrawals from your ILP for other financial needs.

Both of these can only be carried out to a limit – you’ll need to keep a certain percentage of your policy value if you want to continue enjoying insurance coverage

A note on investment-focused ILPs

A lot of the issues we identified in the preceding section apply to traditional ILPs. There is a new type of ILPs, called investment-focused ILPs, that works in a slightly different way.

Instead of selling your units to pay for insurance costs, investment-focused ILPs invest your premiums completely. The insurer then insures you for a sum assured equal to your account value; as your investment returns grow, so does your account value – and by extension, your level of insurance coverage.

When the policy benefits are triggered, you receive either 101% to 105% of premiums paid, or your account value – whichever happens to be higher.

Who are ILPs made for?

Bear in mind that ILPs are investment plans that happen to offer insurance coverage.

The idea behind an ILP is to make use of market forces to build your wealth, hopefully high enough to meet important needs, such as retirement.

Once your account value has grown large enough, you can choose to surrender your plan to receive its accumulated cash value. This lump-sum can then be used to fund your needs.

Therefore, ILPs may be ideal for individuals who are familiar with investing and comfortable enough with short-term volatility to watch their account value swing up and down without panicking.

Also, it’s important to select an ILP model that suits you. Remember that traditional ILPs give you a set level of coverage from the get go, while with the newer, investment-focused ILPs, you will need to give sufficient time for your insurance coverage to build up.

When in doubt, ask your financial adviser

We’ve covered a lot but trust me, this is just the tip of the iceberg. We haven’t even touched on universal life policies, or endowments and annuities, or direct life insurance.

Nonetheless, the three types of life insurance we’ve covered in this article should make for a good starting point.

Understandably, you may have even more questions after reading this than when you started; if so, consider consulting a trusted financial adviser to help you determine the best fit for you.

Read these next:

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