FOOL SCHOOL
Types Of Life Insurance

August 14, 2002

Life insurance is one of the most profitable insurance products that you can sell to a consumer. The traditional old life companies still have a big chunk of the market, selling life insurance by itself or bundled together with investment products. And because life insurance was such a great business idea to start with, the marketing people have started to sell it over and over again to the same customers hidden behind different names.

Any life insurance policy has:

• an "owner" who is paying for the policy
• the "insured" that the policy covers
• the "death benefit" that stipulates how much is to be paid in the event of an untimely demise while the policy is in force
• and a "beneficiary" who gets the money

Life insurance, then, is a form of insurance that pays a fixed amount to beneficiaries if a specific person dies during the period when the policy is in force and premiums have been fully paid. The only differences between this and other variations, which aren't called life insurance, are who the beneficiary is and how the person covered has to die. For example, for mortgage insurance, the beneficiary is the bank or building society that gave you the mortgage.

Here's a quick run through the essentials of life insurance -- and what to avoid.

Term life insurance

Term insurance is, as the name suggests, a policy which only pays out if you die within a specified term. This could be 10, 20, or 30 years from taking out the policy. This is the simplest type of life cover, and it usually demands that you pay a premium on some sort of regular basis in order to be covered. The amount of that premium depends on both the amount of money you have agreed as the death benefit and the statistical likelihood you will die. You are effectively gambling with the Life Company on whether or not you will die during a certain period. If you die you "win" and someone gets the payout. If you don't die you "lose" and you get nothing at the end of the insured period because you are still alive. This is one bet we all want to lose.

Term insurance is reassuringly cheap (they can't believe many of us are going to die, then). People with long memories will know that about ten years ago, term insurance premiums were hiked by up to 250 per cent on the back of medical reports about the predicted spread of AIDS. The epidemic never happened, and the cost of insurance has tumbled in the last few years. But it goes to show how quickly things can change if the insurer thinks it is going to have to shell out some serious cash.

Barring a global viral catastrophe, the cost of term insurance should keep dropping. A man of 40 now can expect to live another 40 years, and a 40 year old woman 44 more years.

Just because nothing involving insurance can ever be simple, there are several main types of term life insurance. The first, level term, is the most commonly advertised. This is a form of term insurance that locks in the premium costs for as long as you hold the policy ie: you pay the same amount throughout. It means you pay over the odds each month when you are younger, but that is balanced by savings on the "real" cost of premiums as you get older. You also get the benefit of paying at today's prices. As the real value of your premiums erodes in future, you make substantial savings.

Other types of term insurance include:

• Escalating term insurance: these schemes demand you pay more each year, so the amount you would get at death goes up. They tend to be cheap when you are fit and young but more expensive as you get older.
• Increasing term insurance: you increase the amount of death payment at set times or whenever you choose (such as when you have a child). Obviously you then have to pay more each month. A better alternative is renewable term insurance -- you can get this option built in to some ordinary level term insurance plans. It allows you to take out a new term insurance plan when your original deal ends, regardless of your state of health at that time.
• Decreasing term insurance: the monthly payments stay the same, but the amount of cover you get for that goes down every year. This sort of insurance is sometimes sold alongside a repayment mortgage, and the death benefit drops in line with the amount you have left to pay off on your loan. It's also useful for parents -- as your children grow up and leave home, you will only need to insure for a smaller amount of death benefit.
• Convertible term insurance: a way for the insurer to get you to (you guessed it) take out an investment-cum-insurance policy in future. The selling point is that the price of your future investment policy is based on your health when you bought the cheapo term insurance. Fools will avoid these deals.

Whole of life policies

For once, the insurance industry has dreamed up a name that accurately describes what they are trying to sell you. When you buy a whole of life scheme, it covers you right up until death -- whenever that may be. Provided, of course, that you keep paying in the premiums.

The problem is that this sort of policy is expensive and complicated. The money in your account earns some interest each year. Depending on how fast that grows, your annual premiums can actually go down over time, and there may come a stage when the interest on your pot of savings will cover all your premiums so there's nothing more to pay. Sounds good? Naturally there is a catch. These schemes are expensive for you to set up (although there's lots of lovely commission for the salesman, of course).

Salesmen try to persuade their clients that a whole of life policy is a good investment. They do this by highlighting the fact that after several years it will have a cash-in value. This may or may not be equal to the amount of money you have squirreled away in it over the years. So despite the fact that the surrender value of a whole of life policy grows over time, it is growing at a slower rate than money invested in an index tracking fund or other Foolish investment.

As always, you need to make your own decision about what sort of life cover you think you need. But the simplest kind is a level term insurance policy with a renewable option so you've got cover for as long as you need it. Ultimately you just want a lump sum to be payable to your dependants should you drop dead at an inconvenient time! You can invest the rest of your cash in the usual places such as an index tracking ISA until you've accumulated enough not to bother with life insurance anymore.

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