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How Life Insurances are Designed


Understanding life insurance is a vital part in total financial planning. As in the article, What Type Of Life Insurance Do You Need?there are two types of life insurances: Term insurance and Cash Value Insurance. 

To understand how life insurances are designed, we need to base it on the three rules of insurance:

1. All insurance is term insurance
2. The cost of term insurance always goes up.
3. There is no free insurance. 
How life insurances are designed
How life insurances are designed
In other words, all insurance is either term or term plus cash. The cost of term insurance always goes up as you get older (the probability of death is increasing). And, you must pay for the term insurance directly or you must have enough cash value to pay for the cost of insurance. 

Basing on these rules, here is how life insurances are designed:


Design of a traditional whole life insurance
Design of a traditional whole life insurance
As shown in the graph, the cost of insurance always goes up. The younger the age, the cheaper life insurance should be. But as you grow older, cost of insurance is very expensive.

The simplest type of insurance is Term insurance. It means pure life insurance where the person is to pay the premium for protection purposes only. However, life insurance companies started incorporating cash values or saving/investment components. The traditional cash value insurance is called whole life insurance.

Whole Life Insurance:
As seen in the graph, instead of paying increasing cost of insurance every year, the premium is fixed for your whole life. Instead of paying a cheap premium for pure term insurance, you overpay in the first few years, to compensate the underpayment on the older years. 
Over-payment on the first few years to compensate the underpayment on the older years
Over-payment on the first few years to compensate the underpayment on the older years
The over-payment is for the cost of insurance, agent's commission, policy charges, and the cash value reserve in your policy. This cash value is then invested by the company to make sure it will grow enough to pay the under-payment during the older years. 

That is why most traditional whole life insurances can be very expensive. If premium is cheap, the coverage may not be sufficient. 

Universal Life Insurance
Another design is called the Universal Life Insurance. Instead of paying fixed premium, the client is given a chance to have flexibility. But, the same with whole life, you overpay in the first few years to compensate under-payment on the older years.
Universal and Variable Universal Life Insurance Design
Universal and Variable Universal Life Insurance Design
The same concept is applied where the over-payment goes to the cost of insurance, agent's commission, policy charges and cash value. 

Variable and Variable Universal Life Insurance
Before, the cash value is managed by the company to grow. But as the industry evolves, clients can now participate in pooled funds (like mutual funds) to maximize their returns. Thus instead of just having the company manage the cash value, the client can now choose a separate pooled fund to where his/her cash value be invested. Just like mutual funds, the client can choose in high-risk, high-return equity funds, or moderate-risk, moderate-return balance fund or low-risk, low-return bond fund. 

With this design, Variable and Variable Universal Life Insurance are born. When you have fixed premium just like the traditional whole life, but you can choose a separate account for your cash value it is called Variable Life Insurance. But when you have flexibility in the premium at the same time you can choose a separate pooled fund, then that is a Variable Universal Life Insurance.

In summary:
Term Insurance - simplest or pure insurance. No cash value. Cost always goes up. 
Whole Life Insurance - fixed premium. Cash value is managed by the company.
Variable Life - fixed premium. Cash value is invested in a separate pooled fund by client's choice. 
Universal Life - flexible premium. Cash value is managed by the company.
Variable Universal Life flexible premium. Cash value is invested in a separate pooled fund by client's choice. 

Different designs to fit different purposes. It is therefore mandatory to understand the basic of these products. However, as is said: "Your future is not in the hands of your employer, government, the bank or your agent. It is in your hands." Thus it is important to invest first in yourself, learn financial education, be your own money manager so you can do-it-yourself. After all, personal finance is personal. 

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