The Three Core Life Insurance Types
Before anything else, anchor this memory trick:
Memory Trick: Term = Temporary, Whole = Wealth building, Universal = Unfixed premiums.
| Policy Type | Premium | Cash Value | Best For |
|---|---|---|---|
| Term | Lowest; fixed for term | None | Pure death benefit; income replacement while kids are young |
| Whole Life | Fixed, higher | Guaranteed, grows tax-deferred | Permanent need, estate liquidity, wealth transfer |
| Universal Life | Flexible (within limits) | Earns current interest rate | Need premium flexibility; can overfund or underfund |
When to Recommend Each
- Term: Temporary need (mortgage payoff, 20-year income replacement, key-person coverage for a startup). Cheapest way to get a large death benefit.
- Whole Life: Client needs lifelong coverage, wants a guaranteed cash value accumulation, or the estate needs liquidity to pay estate taxes. Dividends are a bonus.
- Universal Life: Client's income is variable (business owner, commission-based) and needs premium flexibility. The flexible premium can be dangerous — policy lapses if CSV runs dry.
Exam Trap: Whole Life Dividends
Exam Tip: Dividends on participating whole life policies are considered a return of premium — they are NOT taxable until the total dividends received exceed the cumulative premiums paid (your basis). Only after you've recovered basis do dividends become taxable income.
CSV Loans
Policy loans against cash surrender value are not taxable events. However:
- Unpaid loans reduce the death benefit dollar-for-dollar.
- If the policy lapses while a loan is outstanding, the loan amount becomes taxable income to the extent it exceeds basis.
- No repayment schedule is required — but interest accrues.
Coinsurance Formula (Property Insurance)
The CFP exam tests this formula regularly for homeowners and commercial property:
Formula: Payment = (Amount Carried / Amount Required) × Loss
Where "Amount Required" = 80% of replacement cost (typical coinsurance clause).
Where "Amount Required" = 80% of replacement cost (typical coinsurance clause).
Example: Home replacement cost = $500,000. Required coverage (80%) = $400,000. Client carries only $300,000. Loss = $100,000.
Payment = ($300,000 / $400,000) × $100,000 = $75,000 (client self-insures $25,000).
Umbrella / Excess Liability
- Umbrella kicks in after underlying policy limits (auto, homeowners) are exhausted.
- It also broadens coverage — umbrella may cover claims excluded under the underlying policy (e.g., libel, slander, false arrest).
- Requires minimum underlying limits (often $300K auto liability, $300K homeowners liability) to qualify.
Memory Trick: Umbrella = Over and Above. It sits on top of underlying coverage AND covers more types of claims.
Quick Reference: Key Insurance Concepts
| Concept | Rule |
|---|---|
| Insurable interest | Must exist at policy inception for life insurance |
| Incontestability clause | After 2 years, insurer cannot contest for misrepresentation (except fraud) |
| Grace period | Typically 30 days after missed premium before lapse |
| Misstatement of age | Benefit adjusted to what premiums would have bought at correct age — policy not voided |
| Suicide clause | Usually 2 years; if suicide within 2 years, return of premiums only |