Life Insurance Types Compared — CFP Exam Study Guide

Term life insurance provides coverage for a specific period (the 'term'). If the insured dies during the term, the death benefit is paid to the beneficiary. If the term expires and the policy is not renewed, there is no payout. Term life policies are generally the most affordable option for a given death benefit, especially for younger individuals.

Several types of term life exist. Level term policies have a death benefit that remains constant throughout the term. Decreasing term policies, often used to cover mortgage debt, have a death benefit that decreases over the term. Convertible term policies allow the policyholder to convert the term policy to a permanent policy (like whole life or universal life) without evidence of insurability.

Key features: Low initial premiums, no cash value accumulation, death benefit paid only if death occurs during the term. Renewal premiums typically increase significantly at the end of each term.

Whole life insurance is a type of permanent life insurance that provides coverage for the insured's entire life, as long as premiums are paid. It features a guaranteed death benefit, a guaranteed cash value accumulation, and level premiums. A portion of each premium payment is allocated to the cash value, which grows on a tax-deferred basis.

Variations include: Ordinary whole life, where premiums are paid until death or age 100-120; Limited-pay whole life, where premiums are paid for a specified period (e.g., 20-pay life or life paid-up at age 65); and Single-premium whole life, where one lump-sum premium payment covers the entire policy.

Key features: Guaranteed death benefit, guaranteed cash value growth, level premiums, and potential for policy loans against the cash value. Higher premiums compared to term life.

Universal life (UL) insurance is another type of permanent life insurance that offers more flexibility than whole life. It features adjustable premiums and death benefits. The cash value grows based on current interest rates, subject to a guaranteed minimum rate. Policyholders can increase or decrease premium payments (within certain limits) and can also borrow against the cash value.

Types of UL include: Traditional UL, as described above; Guaranteed UL, which focuses on providing a guaranteed death benefit, often with little or no cash value accumulation; and Indexed UL, where the cash value growth is linked to the performance of a market index (e.g., S&P 500), subject to caps and floors.

Key features: Flexible premiums and death benefits, cash value growth tied to interest rates or market index, potential for higher returns than whole life but also greater risk. Mortality and expense charges can erode cash value.

Variable life (VL) and variable universal life (VUL) are permanent life insurance policies that combine life insurance coverage with investment options. The cash value is invested in subaccounts, which are similar to mutual funds. The death benefit can fluctuate based on the performance of the subaccounts, although VL policies typically have a guaranteed minimum death benefit.

VUL offers more flexibility than VL in terms of premium payments and death benefit adjustments. Both VL and VUL policies carry investment risk, as the cash value and death benefit are not guaranteed (except for the VL minimum death benefit). These policies are considered securities and require a prospectus.

Key features: Investment options within the policy, potential for higher returns, significant investment risk, and higher fees compared to other life insurance types. Require a securities license to sell.

Life insurance enjoys favorable tax treatment. Premiums are generally not tax-deductible (except in certain business contexts). Cash value growth is tax-deferred, meaning taxes are not paid until the cash value is withdrawn or the policy is surrendered. Death benefits are generally income tax-free to the beneficiary.

A Modified Endowment Contract (MEC) is a life insurance policy that is overfunded according to IRS rules. If a policy becomes an MEC, withdrawals and loans are taxed as income first, and any gains are subject to a 10% penalty if the policyholder is under age 59 1/2. The '7-pay test' determines if a policy is an MEC. If the cumulative premiums paid during the first seven years of the policy exceed the net level premiums that would have been paid on a 7-year pay whole life policy, it is an MEC.

Understanding the tax implications of life insurance is crucial for the CFP exam. Be familiar with the rules regarding premiums, cash value growth, death benefits, and MECs.

Section 1035 of the Internal Revenue Code allows for the tax-free exchange of certain insurance contracts. Specifically, a life insurance policy can be exchanged for another life insurance policy, an annuity contract, or an endowment contract. An annuity contract can be exchanged for another annuity contract. An endowment contract can be exchanged for another endowment contract or an annuity contract.

A 1035 exchange allows policyholders to switch to a different policy without triggering a taxable event. However, an annuity cannot be exchanged for a life insurance policy.

This provision is commonly used to upgrade to a policy with better features or lower costs without incurring immediate tax liabilities.

Life insurance plays a critical role in business planning. Key person insurance protects a business against the financial loss that could result from the death or disability of a key employee. The business owns the policy, pays the premiums, and is the beneficiary.

Buy-sell agreements are used to facilitate the transfer of ownership of a business in the event of the death, disability, or retirement of a business owner. Life insurance is often used to fund these agreements, providing the surviving owners with the funds to purchase the deceased owner's share of the business.

Split-dollar life insurance is an arrangement where the employer and employee share the cost and benefits of a life insurance policy. This can be a valuable tool for executive compensation and retention.

Selecting the appropriate life insurance policy depends on the client's needs, goals, and risk tolerance. Term life is suitable for temporary needs, such as covering a mortgage or providing income replacement during child-rearing years. Permanent life insurance is appropriate for long-term needs, such as estate planning or providing a legacy.

Factors to consider include: the client's budget, the desired level of coverage, the need for cash value accumulation, and the client's investment risk tolerance. Understand the trade-offs between premiums, cash value, flexibility, and risk for each policy type.

For the CFP exam, practice analyzing client scenarios and recommending the most suitable life insurance policy based on the given information.