What is Life Insurance?
Life insurance is a contract between a policy owner and the insurance company or carrier. This company/carrier provides the insurance for the insured individual. The person owning the life insurance policy is referred to as the policy owner. Although the person insured under the life insurance policy is usually the policy owner, an insured and a policy owner can be different persons. For example, a policy owner can be a person other than the insured in a business insurance situation, in an estate planning case, or in many other situations. In addition, life insurance is a unique tool to create wealth. In this way, life insurance assures a desired amount of liquid capital is accumulated upon the insured’s death, even if that death occurs immediately after the coverage becomes effective. Depending on the insurance plan, life insurance can also provide funds during the insured’s lifetime, usually referred to as living benefits. These benefits can enable the policy owner to take advantage of other opportunities, such as having funds for a down-payment on a vacation home or to meet emergencies.
A primary use of life insurance is to replace the future lost income that results when someone dies. With personal life insurance, the insured is often the person who produces most of the income in the family. However, people often buy life insurance on the lives of family members who do not work outside the home, such as a stay-at-home spouse who raises the children. Regardless of whether the insured is the primary wage earner or someone else, the insurance company pays a specified amount—called the policy’s face amount or death benefit—normally free of income tax. This amount is paid to the beneficiary upon the insured’s death while the policy is in force. Because many types of life insurance are available, a person must learn the basics about different kinds of life insurance policies to make an informed choice.
Different types of life insurance policies differ in the following areas:
• premium level,
• duration of premium payments,
• guarantees,
• flexibility,
Purposes of Life Insurance
When measured in terms of his or her lifetime earning capacity, an individual’s life may be worth millions of dollars. However, earning power alone does not create a need for life insurance. The financial value of any human life lies in the purposes for which the individual’s earnings might be used. A person’s life clearly has an economic value if some other person or organization expects to benefit financially from the person’s existence. Most income producers either have dependents or expect to acquire some during their lifetimes. People without legal dependents often intend to voluntarily provide financial support to relatives, friends, and charitable or religious organizations. Whether provided during one’s lifetime or through an inheritance, this support may come from income earned during the person’s lifetime or through life insurance proceeds payable upon the person’s death. Life insurance also serves a wide variety of purposes in the business world. The primary purposes of life insurance in business are key person indemnification, business continuation, and protection for employees and executives.
Approaches to life Insurance
There are two basic approaches to life insurance:
1) Term Insurance, which is temporary.
2) Cash value insurance, which provides permanent protection and involves a reserve or savings component.
Premiums are usually guaranteed for the duration of the policy, but some policy types offer flexible premiums.
Term Insurance
Term insurance provides temporary protection because the coverage is for a limited term. The period for which the coverage will be provided may be for 10 years, 20 years or 30 years. It may be term to expectancy, which is term insurance for the period the insured is expected to live, according to the mortality tables. In its purest form, a term policy is purchased for a specified period of time and the face is payable only if the insured dies during this period. Nothing is paid if the insured survives the term period. It is customary, however, for term policies to include provisions relating to renewability and convertibility.
Renewable Term– Renewable-term policies include a contractual provision guaranteeing the insured the right to renew the policy for a limited number of additional periods, each usually of the same length as the original term period. For example, if the insured purchases a 10-year term policy at age 25 and survives this period, he or she has the option of renewing the policy for an additional 10 years without having to prove insurability. The level premium for this 10-year period will be higher than that for the first 10 years, because of the insured’s more advanced age. The insured may renew the policy at age 45 and perhaps also at age 55. However, most insurance companies, because of the element of adverse selection, impose an age limit beyond which renewal is not permitted. A limited number of companies offer term policies that are renewable to age 100.
Convertible Term– The conversion provision grants the insured the option to exchange the term contract for some type of permanent life insurance contract without having to provide evidence of insurability. The options to renew regardless of insurability and to convert without evidence of insurability provide the insured with complete protection against loss of insurability. The conversion is usually effected at the policyholder’s attained age, but it can also be made retroactive to his or her original age. For example, if the insured decides to convert the term policy to whole life at age 32, and to convert at the attained age, the premium on the whole life policy will be the same as if it had been purchased at age 32-which, in fact, it is. However, the policy could also be converted at the original age of 25, and the premium rates on the converted policy will be those the insured would have paid if the whole life policy had originally been purchased at age 25. However, the insured will be required to pay a lump sum to the insurer that is sufficient to bring the reserve on the converted policy to the level it would have reached if originally purchased at age 25.
The right of conversion was once a virtually universal trait of term policies, but this is no longer the case. As price competition in term insurance has intensified, some insurers have determined that by eliminating the conversion privilege, or limiting it to the first five years of the policy, they can offer a lower-priced term product. The consumer should, of course, weigh the lower price of these products against the absence of convertibility.
Variations of Renewal and Conversion Privileges– Renewal and conversion provisions and the premium structure in term policies may be combined in a variety of ways, creating a myriad of different contracts. Many term policies permit renewal for another period at a level premium. Some term policies that start off with a level premium for 5, 10, or 20 years become annually increasing premium policies after that initial period. Still other policies have a re-entry provision that allows the insured to re-qualify through a somewhat abbreviated underwriting process, to continue the policy at a relatively low rate. If the insured does not qualify, he or she may keep the policy, but at a much higher premium. Often, the premium is a multiple of the prior premium; a guaranteed maximum that is stated in the policy. Because these subtle variations in renewability and conversion privileges can produce significant differences in protection and cost, they are important considerations in the selection of term insurance products. Understanding the differences among apparently similar contracts is a requisite for an informed decision.
Advantages and Disadvantages of Term Insurance – The advantages and disadvantages of term insurance stem from its dual character as pure protection and temporary protection. With respect to term’s nature as pure protection, because the premium for term insurance covers protection only, term insurance provides the greatest amount of protection for a given dollar outlay. Because it is temporary protection, it may be better suited to meet temporary insurance needs that would be permanent insurance. As in the case of its advantages, the disadvantages of term insurance also stem from its nature as pure protection and temporary protection. Term insurance is misused when it is used to meet permanent needs. In addition, because insurers are subject to a greater element of adverse selection in term policies than in policies that include an investment element, the cost of term insurance may be somewhat greater than the cost of death protection in permanent insurance.
Whole –Life Insurance
In contrast with term insurance, which pays benefits only if the insured dies during a specified period of years, whole life insurance provides for the payment of the policy’s face amount at the death of the insured regardless of when death occurs. This characteristic-protection for the whole of life-gives the insurance its name. Whole life insurance offers permanent protection and it accumulates a cash value. Some whole life policies also pay a dividend, these are known as participating policies. Whole life insurance may be subdivided into two categories that depend on the length of time during which premiums are paid:
- Ordinary life premiums are paid throughout the insured’s lifetime.
- Limited-payment life premiums are paid only during a specified period.
Characteristics of Whole Life Insurance
Whole life insurance has two key characteristics.
- It offers permanent protection, and
- It accumulates a cash value.
A whole life policy can be either participating or nonparticipating. As explained later, a participating policy may pay a dividend that enables the policy owner to participate in the insurance company’s favorable experience.
Permanent Protection. A whole life contract provides permanent protection that never expires in a policy that never has to be renewed or converted. As long as the policyowner continues to pay premiums when they are due, protection lasts for as long as the insured lives, regardless of his or her health. Eventually, the policy’s face amount will be paid as a death benefit. Most people need some life insurance until their death, if only to pay for last-illness and funeral expenses.
Cash Value or Accumulation Element. As level-premium permanent insurance, whole life insurance accumulates a reserve that gradually reaches a substantial level and eventually equals the face amount of the policy. The contract emphasizes protection, but it also accumulates a cash value that can be used to accomplish a variety of purposes.
Cash values are not generally available during the first year or two of the insurance contract because of the insurer’s cost of putting the business on the books. Common exceptions are single-premium policies and some durations of limited-payment whole life policies where initial premiums exceed all first-year expenses incurred to create the policy and maintain policy reserves. The cash values that accumulate under a whole life policy can provide the basis for a policy loan, or they can be used to support one of the nonforfeiture options listed under additional definitions below.
Straight Whole Life. The term straight whole life refers to a contract in which the premiums are payable for the entire lifetime of the insured (i.e. until age 100). It is also called continuous premium whole life. The principal advantage of straight whole life is that it provides permanent protection for permanent needs and can be continued for the entire lifetime of the insured. In addition, because it includes a cash value, it serves the dual function of protection and saving. The savings element in the policy can be borrowed for emergencies, or it can be used to pay future premiums under the policy. Straight Whole Life has disadvantages when it is used to fill a need for which it was not designed. When it is used to meet a temporary need, the amount of coverage that may be purchased may be less than if the need were met with the term insurance. On the other hand, there are permanent life insurance needs, and permanent insurance should be used to meet such needs. Insurance to provide liquidity for the estate tax purposes, for example, is a permanent need that cannot be met by temporary life insurance contracts such as term insurance.
Limited-Pay Whole Life. Limited-payment whole life is a variation of the whole-life policy, differing only in the manner in which the premium is paid. As in the case of a straight whole-life policy, protection under the limited-pay whole-life policy extends to age 100, but the premium payments are made for some shorter period of time. During the period that premiums are paid, they are sufficiently high to prepay the policy in advance. Thus, under a 20-payment life policy, during the payment period, one pays premiums that are high enough to permit one to stop payment at the end of 20 years and still enjoy protection equal to the face amount of the policy for the remainder of one’s life.
Universal Life Insurance.
Universal Life Insurance was introduced in 1979 by Hutton Life, a subsidiary of the stockbrokerage firm, E.F. Hutton. The essential feature of universal life, which distinguished it from traditional whole life, is that, subject to specified limitations, the premiums, cash values, and level of protection can be adjusted up or down during the term of the contract to meet the owner’s needs. A second distinguishing feature is the fact that the interest credited to the policy’s cash value is geared to current interest rates, but is subject to a minimum such as 4 percent. In effect, the premiums under a universal life policy are credited to a fund (which, following traditional insurance terminology, is called the cash value), and this fund is credited with the policy’s share of investment earnings, after the deduction of expenses. This fund provides the source of funds to pay for the cost of pure protection under the policy (term insurance), which may be increased or decreased, subject to the insurer’s underwriting standards. Universal policyholders receive annual statements indicating the level of life insurance protection under their policy, the cash value, the current interest being earned, and a statement of the amount of the premium paid that has been used for protection, investment, and expenses.
Some insurer’s set the minimum amount of coverage for their universal life products at $100,000; other companies offer contracts with an initial face amount as low as $25,000. As in the case of other forms of permanent insurance, the policyholder may borrow against the cash value, but in the case of universal life, he or she may also make withdrawals from the cash value without terminating the contract. To understand the excitement that universal life insurance (ULI) brought to the insurance market when it was introduced, it should be recalled that interest rates in this country reached a historic high in the early 1980’s. The high rates of interest that were credited to universal life cash values, combined with the favorable tax treatment and the ability to withdraw a part of the cash value (as opposed to borrowing against the cash value), enhanced the contract’s appeal. Universal life enjoyed a phenomenal growth throughout the 1980’s. Although ULI received a warm response in the insurance market when it was introduced, this was primarily a result of timing. It was not an accident that ULI products were first offered during the era of record-level interest rates in the late 1970’s and early 1980’s. Investors who purchased universal life policies in 1982, when the rate on money market funds reached 15 percent, thought that these rates would go on forever. They were wrong. When interest rates inevitably fell, so did the performance of ULI policies. Many insured’s who had been mesmerized by unrealistic projections had purchased the policies with the expectation that the investment earnings would pay future premiums. When the investment earnings on the policy fell short, the insured’s were compelled to pay unexpected premiums to continue their coverage.
Indexed Universal Life Insurance
Indexed Universal Life Insurance can last a lifetime and has the potential to accumulate cash value. Its death benefit and premiums are flexible, but cash values, which are not guaranteed, fluctuate with the value of the account options that you select. Typically account options include a fixed rate account and at least one indexed account, the interest rate of which is based on a market index, although it is not an actual investment in the index itself.
The premiums are flexible in that you may adjust the amount paid and timing of payments, subject to certain limitations. Premiums (after charges are deducted) are allocated to account options—fixed or indexed—that you choose. Paying a specified premium may guarantee the policy against lapse for a limited time or a lifetime.
Other points to consider are 1) generally more expensive than term insurance, 2) the cash value is not guaranteed (excluding money allocated to the fixed-rate account option) by the insurer, so the value will vary with the account options you choose, which are susceptible to market fluctuations, 3) additional premiums may be necessary to keep the policy in effect if the policy has insufficient funds and no guarantee against lapse is in effect, and 4) because premiums are flexible, you may pay too little or withdraw or borrow too much of the cash value and cause the policy to lapse.
Additional Definitions:
Nonforfeiture Options– A set of choices available regarding how a life insurance policyowner can use the policy’s cash value. These choices include the options to surrender for cash, buy a reduced amount of paid-up whole life insurance, or buy extended term insurance.
Adverse Selection– Selection against the insurance company. It is the tendency for those who know that they are highly vulnerable to specific pure risks to be most likely to acquire and retain insurance to cover related losses.