At the outset it must be understood that life insurance is not, and cannot be, a measure of human “worth.” The intrinsic worth of human life is immeasurable and impossible to replace at any cost. Instead, life insurance is based on the “economic value” of a human life measured in dollars. The basic purpose of life insurance is simply to minimize financial losses caused by death. However, it is not insurance against death happening, but against its untimeliness. Death is inevitable, but no one can predict when it will come. Life insurance removes some of the financial uncertainty associated with untimely death.
The basic purpose of life insurance is to provide some form of substitution for the earnings of the insured when he or she is no longer there. Through the use of policy options, however, life insurance can be expanded to meet many additional needs, from providing income for the insured to acting as a sinking fund for special purposes. However, the basic purpose of life insurance is family protection and the principal benefit of its ownership eventually inures to the family. There are several instances where life insurance coverage is used in a business setting either to protect the business against financial loss upon the death of a key individual (“key person” coverage) or to informally fund certain nonqualified employee benefit plans.
Even when used in a business arrangement, life insurance still generally protects the family. For example, life insurance is often used to protect a surviving spouse against the loss of a family business and the income it produces. Life insurance is also used to provide liquid funds upon a business owner’s death that are earmarked to pay estate taxes. The availability of such funds often prevents a forced sale of assets to pay the taxes, protecting the interests of the surviving spouse and children. Coverage of obligations such as education and mortgage payments guarantees schooling expenses and shelter for the family. When used as a form of compulsory savings or for funding other savings or investment plans, life insurance provides emergency funds for the family and assures completion of family investment objectives.
As mentioned, the common exception to the family protection concept of life insurance is corporate-owned “key person” life insurance, a coverage wherein a corporation protects itself against the financial risks associated with losing a key executive through untimely death. In this instance, no direct benefits are paid to the family of the insured.
Types of Policies
There is disagreement about the number of basic types of life policies. For purposes of this discussion, three distinct types are recognized: term life, whole life, and universal life. (Other sources may cite an additional one or two—endowment or limited payment are sometimes included as basic types.) These types are then further classified according to payment modes, expiration terms, and coverage levels.
Term life insurance is often characterized as “pure” protection in that no benefits are payable at any time except upon the death of the insured during the policy term. It may be illustrated by the following diagram.
If the insured does not die during the term of the policy, the policy expires and no further obligation on the part of the insurer exists. (This can be compared to other types of conventional insurance; for instance, a personal auto policy also has a predetermined premium and specific term. At the expiration of the policy period, the insurer’s obligation ceases.)
If the insured dies during the term of the policy, the beneficiary (the person to whom benefits are paid) will receive the full amount of the policy, without regard to the particular year in which death occurs. With a basic term policy, the annual premium remains constant and is paid for the entire term of the policy and the level of protection remains constant.
In addition to the above-mentioned level term life policy, a number of variations are available for special purposes. Normally, the term of the policy is in multiples of five years, such as five, ten, fifteen, twenty, twenty-five, or thirty year terms. However, there are also term policies that expire when the insured reaches a certain age, 60, 65, or 70 for example. Another variation—re-entry term—allows the insured to pay a lower premium if he or she provides evidence of continued good heath by passing another medical examination every few years. In other words, the insured “re-enters” the term plan at the same premium he or she would pay for a new policy purchased in that year. If the insured does not pass the examination or chooses not to take it, his or her premium will be higher than the “re-entry” premium.
Policy term variations are not the only options under term life insurance policies. Another variation is in the amount of coverage. Basically there are three coverage level options—level, decreasing, and increasing. In other words, as time passes, depending upon the plan selected, the amount of insurance rises, stays the same, or reduces. These plans are used to offset commitments that rise, stay the same, or reduce. Mortgage insurance is normally a decreasing term coverage that offsets the balance owed with the protection level, reducing as the mortgage balance declines. Increasing term life coverage (a money-back guarantee type of coverage in which the insured purchases additional insurance equal to the amount of the premiums; this coverage is most often associated with high premium permanent plans) is written, often as a rider to a permanent plan, to guarantee return of premiums or funds invested periodically over a number of years. The amount of insurance coverage increases as additional premium deposits are made.
While the principal behind each plan may be the same, there are variations in the rate of increase or decrease. Some plans change at a proportional step rate, others at varying curves as opposed to “straight line” with additional variations in frequency of change. Decreasing term life illustrations show the differences.
Finally, term life policies vary as to premium payment plans. Level premium, for the full length of the policy period, is most common, but many plans are also available in which the premium period is less than policy term. A common example of the shorter premium plan is found in mortgage term insurance where premiums on thirty year policies are paid for twenty years with nothing paid during the last five years. The third premium variation is single payment, in which case the entire policy premium is paid when the policy is issued. In addition to these variations there are also some “step rate” plans, but these are not common. These plans feature premium payments that theoretically increase as the insured’s ability to pay increases. In reality, the plans are a combination of several one-year term policies for rating purposes. Such plans are more common as whole life options, called modified premium plans in many cases.
Most life insurance consultants feel that protection should relate to the need—that short term needs should be fulfilled with term insurance, and permanent needs with whole life coverage. A fitting use, therefore, for term life insurance is any need that exists for a specific period of time but requires no element of savings. Ordinarily such protection is used where current income is considered vital rather than as a coverage of deferred funds. It is useful in covering current obligations such as debts, investment plans, and savings goals or short term obligations, such as income for child rearing years (family maintenance or family income are names given to this use) in case of a breadwinner’s death, or as an “option to buy” more insurance. Term insurance is often used to guarantee the availability of coverage for some future time through conversion privileges, and as a preliminary coverage for short periods of time.
Whole Life Insurance
Whole life insurance is a “permanent” coverage in that it does not expire without paying benefits, either to the surviving insured or to the beneficiaries. Whole life policies combine the protection of term insurance with a “savings” feature enabling the insured to use the policy to build economic security against the perils of untimely death and superannuation (living beyond earning years). In the whole life insurance illustration below, notice that the portion of the policy representing “pure” protection decreases as the “savings” portion increases.
One of the strong selling points of the whole life policy is the “forced savings” feature—when the insured purchases this policy, he automatically has a portion of his premiums set aside for future use. This “savings” may be borrowed against by pledging the policy as collateral, received as a refund by canceling the policy, or used to purchase additional coverage.
Whole life policies are designed so that this savings portion will equal the face amount of the policy when the insured attains a certain age, such as 95. In this case premiums would be payable to age ninety-five.
There is one major difference in the manner in which whole life and term life premiums are calculated. Term life only provides benefits for those insureds who die during the policy term. Whole life premiums include not only this charge but also an amount sufficient to pay benefits to those who survive to age ninety-five. Since the policy is for the person’s entire life and since premium calculations assume no one will live beyond age ninety-five, everyone who survives is paid as if he had died in the 95th year. While more complicated in practice, this additional amount of premium makes up the savings portion. In this respect, the policy is an endowment at age ninety-five terminating at that age by payment of the face amount of the policy to the insured. In the case of the policyholder’s death, the beneficiary has the option of receiving benefits either in a lump sum or in monthly installments. This determination is usually made at the time of policy issuance (see Settlement Options) but may be determined at a later time.
Just as there are many variations used with term life insurance, whole life is similarly adaptable to a number of uses. While the term of the policy is for the insured’s lifetime, full benefits may be made payable earlier than age ninety-five to a surviving insured by using a whole life policy that endows (pays the face amount). An example of such a policy is endowment at age sixty-five. With this contract, premiums are higher than whole life to age ninety-five due to the shortened length of time in which to accumulate the face amount in the savings portion. Premiums for endowment policies are paid from inception of the policy to the age of endowment or death, whichever occurs first.
In many cases an insured may want a whole life policy, but does not want to pay premiums for his or her entire lifetime. For these insureds a limited pay whole life is available. With this policy, premium paying years are reduced to a certain number, often twenty years, with the remaining policy provisions being the same as the basic whole life policy. Naturally, since the length of time to accumulate the necessary premium is shorter, higher annual payments are required.
Another variation in whole life insurance is the modified premium policy. This variation allows purchase of higher amounts of insurance with part of the premium deferred for a few years. Often the amount deferred is that which ordinarily would apply to the savings portion; or a one-year policy arrangement, similar to that previously mentioned in connection with the term life policies, can be used. In some cases the early premiums are level for a certain number of years, then jump to a premium level slightly higher than whole life at the issue age for the remainder of the policy term. In other policies, the early premiums are step-rated, either in flat amounts, such as $1 per $1,000 face amount, or in proportion to the number of years, often 10 percent of original premium each year for ten years. (In the latter example, the original premium is half the ultimate premium level.) Naturally, with this variation the savings portion does not grow as rapidly in early years as it does in the basic policy.
Another premium payment variation is single payment.
This type of policy is often used in estate planning for persons who receive a large inheritance at one time.
It must be noted that there is a difference in term premiums and whole life premiums. For a term policy, for example, of one year, the premium is a set amount. The next year, the cost of the same one-year term policy is higher to cover the increased likelihood of death occurring. Whole life policies usually are different. The premiums are level throughout the length of the contract. In the first year the premiums are higher in relation to the cost of pure insurance protection. In later years, the cost of pure protection is lower, although the benefits of the contract remain the same.
Following are illustrations of the whole life policy variations. The slope of the solid line separating pure protection from savings indicates relative premium costs. The steeper the slope, the higher the annual premium payment. Broken lines indicate growth of the savings portion due to interest accumulation after periodic premium payments cease. The illustrations are for explanatory purposes only; no attempt is made to represent actual policy performance.
A. An endowment at age sixty-five whole life policy pays death benefits as any other policy, but pays full face value to the insured if he survives to age sixty-five.
B. A limited pay, or as illustrated, a twenty pay whole life policy allows the insured to make payments during prime health years.
C. The modified premium policy has low initial premiums. Once normal premium level is reached, savings begin to grow. Normally savings will not be quite as high as with conventional installment payments to age sixty-five, a commonly used age for comparative purposes.
D. Single premium payment completes policy payment and allows the policy to grow to maturity in the manner represented here.
Each of the variations above has been presented separately. In actual operation they are often combined to give the various advantages of each to the insured. In life insurance, the name given to the policy will often reveal what variations are included. Thus, a “twenty pay endowment at eighty-five” combines the limited pay feature with the endowment feature at an age that meets the needs of the insured. This example is illustrated in (E):
There are additional variations of the above examples that do not require extensive discussion. For example, endowment policies can be written to mature in either a certain number of years or at a certain age. Many policies are purchased on the basis of settlement levels—certain amount of income per month after age sixty-five—or on the basis of an amount that can be purchased with an even dollar premium, such as $25 monthly. In addition, some policies pay dividends that add to the savings portion of the policy.
Dividends should not be confused with the term used in connection with investments in the stock market. In most cases, the amount considered to be a dividend is a calculated additional premium that is simply refunded to the insured after a period of use. The term “dividend” comes from the fact that the insured is theoretically receiving a share of earnings from investment of the additional premium by the insurer. These dividends are seldom guaranteed to the insured, but interest on dividend accumulations is often certain. The insured may, if he chooses, receive his dividends in cash, use the dividends to reduce premiums, use the dividends to purchase additional insurance, or allow them to accumulate at interest. Dividend and interest accumulations are paid to the insured or the beneficiary in addition to the face amount of the policy when the face of the policy is paid. Often they are also used as collateral for a loan.
As stated in the discussion of uses for term life insurance, the type of policy purchased depends upon the nature of the need being fulfilled. Whole life policies are best suited to filling needs that are permanent, for the lifetime of the insured, though he or she may be interested in a mode of payment other than lifetime installments. Whole life, at its most basic level, is also used to accumulate large sums of money. The level of protection can be raised by adding a term rider (comparable to the word “endorsement” used in property and casualty insurance) and the amount of savings accumulated and the rate of growth can be tailored by using available variations.
Examples of needs that are permanent—that exist regardless of when death occurs—are burial fund, clean-up fund (for debts not covered by credit life) and an adjustment fund for survivors. In addition, retirement needs for the insured and spouse and the advantages associated with having equity in a policy are available with whole life insurance if the insured survives to retirement.
Another type of life insurance policy, universal life, is basically a flexible premium, adjustable death benefit whole life program. In addition to flexible premium payments and adjustable death benefits, the maturity date, benefit options, and interest rates credited to the policy may change over the life of the policy. Among the features of universal life are:
1. Insureds determine their own premium schedule. Premium payments are entirely flexible, with no fixed payments required after the minimum initial premium. In addition, premium payments can “stop” or “go.” If an insured elects to stop making premium payments, the insurance company deducts the cost of insurance automatically from the policy’s cash value. When the entire cash value has been withdrawn, the insured person receives a premium notice for the minimum premium. The insured individual also may increase premium payments and such additional payments are invested by the insurance company, resulting in a growth of cash value. This cash value will continue to grow at an interest rate determined by the company; however, the minimum interest rate payable is guaranteed.
2. Flexibility in coverage. Coverage may be increased or decreased without the issuance of a new contract. However, to increase the amount of death benefit coverage, an insured individual generally has to show that he or she is still in good health.
3. Insured may select either a level or increasing death benefit. The owner of the policy may select a death benefit option. Under what is typically called Option A, the death benefit of the policy equals the policy’s face amount (i.e., a $100,000 policy will pay a death benefit of $100,000). Under what is typically called Option B, the policy’s death benefit equals the policy’s face amount plus an amount equal to its current cash value (e.g., a $100,000 policy will pay a death benefit of $115,000 ($100,000 face amount plus $15,000 current cash value)).
4. Cash value may be withdrawn or borrowed. Additionally, unlike a whole life policy, a universal policy allows the policy owner to access a portion of the policy’s cash value by making a partial surrender. This gives a portion of the cash value to the policy owner while the policy remains in force.
In addition to these features, universal life policies are subject to standard features and provisions of whole life programs. However, these features are enhanced by high current interest rates, and premium rates that are substantially lower than traditional whole life insurance.
A form of protection often associated with life insurance is an annuity, a policy against “living too long,” which is basically the opposite of term life. An annuity has no death benefit—most provide only for return of premium or the savings portion if death occurs before benefit payments begin.
The annuity has about the same variations available as the savings portion of the whole life contract—method of payment, timing of benefits, and determination of benefit amount—but also some features that life contracts have adopted as settlement options. In some cases, selection of a life policy settlement option is equivalent to purchasing a single payment annuity.
The variable annuity is a contract that relates benefits to economic cycles. Instead of purchasing a certain dollar benefit, the contract is bought by benefit units—comparable to shares in a mutual fund—that fluctuate in value as the value of the common stock in which the premiums are invested fluctuate. This allows the annuitant to receive increased benefits, based on stock market trends, as an offset against inflation. In a declining market the opposite may also be true—the benefits are reduced.
Annuities are often purchased by people who cannot buy regular life insurance contracts for reasons of health. Because there is no loading to allow for death, annuities have a low net cost. This is especially true if the annuity covers only one person and does not guarantee any certain amount of benefits. Additional information relating to annuities is under the heading Settlement Options.
Life Insurance Programming
One of the most difficult aspects of selling life insurance is determining, rationally, how much insurance should be purchased. When insuring buildings, producers can use appraisals; with liability protection, probability of loss and maximum settlement amounts can be estimated within “safe” limits. But, it is extremely difficult to determine how much a person is “worth.”
One popular life insurance programming method is based on a balance sheet-budget concept. This approach requires an inventory of resources available, commitments needing lump-sum and installment satisfaction, and incorporates income desires on both a living and dying basis. This information is put on a graph to show periods where income needs exist. (Care should be used in estimating social security resources unless an account statement is secured from the Social Security Administration.) Since the basis of most life insurance plans is permanent insurance, retirement income is calculated first. Once whole life coverage sufficient to provide desired income over social security benefits is determined, monthly interest on this amount is graphically represented to show what survivors will receive in the event of the death of the insured.
In addition to the above permanent needs—the insured is prepared for either living or dying—there must also be preparation for immediate death. Programming for immediate death assumes death at specific points in time and makes necessary arrangements to fit the situation.
The first immediate death situation assumes leaving a family with minor children. (Most insureds will have social security benefits payable from death until the youngest child reaches age eighteen; mother’s and father’s benefits cease when the youngest child reaches age sixteen, child’s benefits are generally payable until the child reaches age eighteen.) After the youngest child’s benefits are eliminated at eighteen (and to a certain extent when parent’s benefits cease when the child reaches sixteen), the surviving spouse enters a “blackout” period during which nothing is received from social security until he or she becomes eligible for widow(er)’s benefits at age sixty.
An insurance program to guard against financial hardship in such a scenario would have to take the following needs into consideration: family maintenance expenses beyond those provided for by social security prior to the children’s’ majority; maintenance expenses for the surviving spouse after cessation of parent’s benefits and prior to social security widow(er)’s benefits (the blackout period); additional income to provide for expenses beyond basic family maintenance, such as college education, etc.; and any additional income beyond that provided by social security during retirement years.
The second immediate death situation is where the death of an income-providing spouse occurs after the children have reached majority age (thereby eliminating social security parent’s benefits), but prior to the surviving spouse’s 60th year. In this situation, the surviving spouse is subject to the same maintenance expenses during the benefits “blackout” period; any additional income beyond social security retirement payments after age sixty; and perhaps educational and other expenses for children past majority age. Family maintenance, family income, or a combination of both will provide the necessary or desirable funds.
Other insurance programming methods use income anticipation as a base. One, called “maximum earning potential,” uses estimates of future earnings, discounted by an appropriate interest factor, to arrive at a desirable figure for insurance coverage. Another, “capitalized value of earning capacity,” is similar except that the final figure above is modified to reflect mortality prospects. These methods, and others like them, attempt to arrive at an amount that the insured should purchase to achieve personal financial security. The benefit of using one of the above programming methods lies not in the accuracy of the figures, but in arriving at an answer to the question of how much a person is worth to his or her family.
When a life insurance policy is purchased, the insured is, in reality, buying money for the future. However, he is also buying something else, often overlooked, and that is the right to have this money managed safely and efficiently so maximum benefits from it are available to the recipient. The insured selects a settlement option that details the payout of benefits. These options apply with only minor differences to both life and annuity contracts.
A major consideration in the selection of a settlement option is the choice of recipients of the proceeds. There are a number of very important considerations in this regard requiring assistance from the insured’s professional financial advisers. Specific identification of the beneficiaries is essential, by qualification if not by name, with care not to eliminate legitimate beneficiaries while avoiding unnecessary taxation of proceeds. Life policies should be checked periodically for correctness in listing beneficiaries.
There are basically three choices of settlement available to the insured—payment in a lump sum, installments, or allowing proceeds to remain with the insurer at interest. With each of these options there are additional choices that can tailor the payout to meet the desires of the insured while keeping the plan flexible enough to prevent undue control by a “dead hand.”
Most financial advisers recommend starting a program by leaving the proceeds at interest with full right of withdrawal, if no other preference is made. This approach has many advantages—flexibility and immediate income to the beneficiary are the principal ones. Interest is usually paid monthly, but in special cases, such as when the beneficiary is a minor, insurers will let the interest accumulate.
Lump sum payment of the entire policy proceeds is the option presumed unless other arrangements are made. Normally when a lump sum settlement is desired, the entire sum is paid at once. However, some insurers will allow lump sum settlements to be paid in several installments, for example two or four payments within a few years (often used for education purposes).
Another variation is deferred lump sum, used when minors are beneficiaries, for payment several years after the date of death. Some insurers hesitate to use this option since it entails certain obligations concerning determination of qualifications to receive benefits, if tied to contingencies other than death of the insured.
The third settlement option is installment payment of proceeds and of interest, if any. A number of variations of this option are available. Installment payment may be a percentage or specified amount of the declining balance; payment for a specific number of years or until proceeds are exhausted; or a lifetime income to one person or several persons set up to begin immediately after death or deferred for a short period of time. The option selected depends upon the insured, the beneficiaries’ circumstances, and personal desires.
Life insurance contracts can be programmed to fill many needs of a family. The more attention paid to goals and methods of reaching the insured’s goals, the more effective will be the insurance program. A significant part of security is the confidence the insured has in the product and the chance that it will perform properly.
Buy Term; Invest Difference
Insurance authorities for years have discussed the merits of various insurance programs over others. However, no comparative discussion has caused more controversy than whole life versus decreasing term and investing the difference in stocks, bonds, money market funds, etc. On the surface, figures tend to favor the term alternative, especially if the insured has picked the right investment vehicle. Depending upon the market assumptions, the difference can be significant.
However, when faced with this alternative, the best suggestion appears to be to let the insured decide which alternative provides the financial security he or she is seeking. Most stock market analysts will demand, and mutual fund sales persons do likewise, that the individual have sufficient life insurance and other savings before investing. The most important question for the insured to answer is not whether the investment will perform, but whether he will. As many in mutual fund sales know, it is easy to want to put money aside, but if an individual is not accustomed to saving regularly, through good times and bad, he will interrupt the investing and not begin again. This personal trait is more important than the story the numbers tell in resolving the issue for an individual insured.
Most of this discussion has assumed insurance on the primary wage earner for family purposes. In addition to this there are a number of policies that have a more restricted appeal. The most common, the family plan policy, has grown to the point of being almost a standard coverage.
The basis of the family plan is to provide insurance on all members of the family at one low cost. This is accomplished by writing permanent coverage on the principal wage earner, a level term coverage on the other spouse, and a convertible “blanket” term coverage on all children, regardless of health, including those yet to be born. Premiums for this coverage are quite within reason for nearly any young family, though too often the policy is sold as being “enough.”
Another specialized coverage insures more than one person. While typically the coverage expires upon death of one of those insured, there are variations that allow conversion to other insurance and those that continue as an individual policy after death of the first insured. A policy insuring two lives that pays a death benefit at the first death is called a joint life policy. In contrast, a policy insuring two lives which does not pay a death benefit until the death of the surviving insured is called a survivorship life policy or second-to-die policy. Such policies are often used in estate planning. Further, these policies have had special appeal in partnership arrangements for “buy and sell agreements” and for husbands and wives. Some insurers will write this coverage on others with insurable interests in each other.
The “jumping juvenile” or special juvenile plan is a specialized coverage that was popular before universal life insurance was introduced. Instead of having only a modified premium, the juvenile plans commonly also have modified protection, a lower face amount during early years. The path of increase from the initial amount of coverage to the ultimate level, often reached at age 21, differs from plan to plan. Some remain at initial level until the insured’s 21st birthday; others make periodic increases, often doubling the amount of coverage prior to that point eventually reaching a protection level comparable to other juvenile plans. Initial premiums for these special plans vary from low annual installments to high single payments without regard to age. In most cases the ultimate premium is approximately the same as other whole life plans at that age though no savings are accumulated until after premiums reach the higher level. The main advantage to the insured is protection during juvenile years with guaranteed permanent coverage at age 21. Since universal life insurance with its flexible premium payments and death benefit amounts has been available, older policies such as the jumping juvenile type of coverage have decreased in popularity.
There are, of course, hundreds of additional special policies, but most are variations of the policy types discussed in these pages. Typical differences lie in the rate of accumulation of the savings portion or level of protection in relation to premium costs. The producer who finds the variations confusing will do well to remember one thing: you only get what you pay for. This is especially true in life insurance, though it requires an additional phrase: you have to make full use of the options to get it.
Taxation of Life Insurance
First, the death benefit of a life insurance policy is usually received free of income tax by the policy’s beneficiary. Two exceptions to this general rule are when the policy has been transferred or sold for value and when the policy does not meet the federal tax law definition of life insurance. In these instances, all or a portion of the death proceeds may be taxed to the beneficiary.
Second, premiums paid to purchase personal life insurance policies are not deductible for income tax purposes.
Third, dividends received on life insurance policies are generally not taxable until the policy holder has received more in dividends than he or she has paid in premiums.
Finally, if the policy allows the policy holder to borrow against the policy, the amount of the loan is not taxable to the policy holder when received (unless the policy has failed a test in the tax law and become classified as a “modified endowment contract”). Further, the interest paid on the policy loan is not deductible to the policy holder, at least in most instances.
Copyright © 2012, The National Underwriter Company
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