Death benefit is the amount that the insurance company pays out to your beneficiaries when you die.
Let’s take a look at how death benefits differ in Universal Life (UL) insurance.
In general, in insurance, you pay premiums to an insurance company, and in return the company honors their contract with you.
Whole life insurance is an exception. It has a savings element to it and it must play by different rules.
In whole life insurance, premium you pay covers the cost of insurance and the remainder (if there is any) goes towards the accumulation of cash value. Cash value is a separate account, kind of like a savings account with insurance.
When you die, there are two (2) ways how the money gets paid out to your beneficiaries. .
Option A (a.k.a. Option 1) – Level Death Benefit.
Level death benefit means that it’s a set amount. It does not change with the time, and it does not account for inflation and changes in prices. In other words – it carries Purchasing Power Risk. A risk that the same stack of money will not have the same purchasing power at the store in 10, 20 or 30 years from now.
If you get a policy with a 250,000 death benefit, it will pay out that $250,000 regardless of when you die, and how much cash value it has accumulated, tomorrow, 10 years or 30 years from now.
How it Works: The cash value grows every year, and in return allows you to purchase less insurance. Cash value off-sets the insurance cost, and the final payout remains the same.
If you get a policy for $250,000 and overpay the cost of insurance and fees by $100 per month – that means that every month you are buying $100 less in insurance. 1 year in, you have $1,200 in Cash Value and $248,800 in Death Benefit. The next year its $2,400 in CV and $247,600 in DV. And so on.
This is a simplified explanation to help you understand the concept.
In real life the Cash Value will grow faster because of the compounding interest. For example, $100 compounded monthly at 5% interest in a year grows to $1,333, and in 2 years to $2,629.
Key-Point: The Death Benefit is LEVEL. When you die, the insurer takes the face value of the policy ($250,000) and deducts the cash value of the account at the time of death. Insurer pays out the full cash value plus the calculated difference from death benefit. The final payout equals the original face value.
Key-Point: Level death benefit policies are less expensive, because as the time goes by, you are covering more and more of the death benefit with your own savings.
Option B (a.k.a. Option 2) – Increasing Death Benefit.
Death benefit amount rises over the years to help the policy value keep pace with inflation
- If a Policy has a $500,000 death benefit and a $50,000 cash value at the time of death – the policy will pay out $550,000.
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PRO-TIP: Increasing death benefit can be useful if the policyholder wants to eventually:
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- Do a partial surrender of cash value, or
- Take out loans against the cash value
PRO-TIP: Be careful of overfunding the Universal Policy. This can trigger a Modified Endowment Contract (MEC). (Unless you want it to become a MEC, to work for your financial strategy)
PRO-TIP: Most active universal life policies allow the ability to switch between the options, as needed.