Whole Life Insurance is designed to provide coverage for the life of the insured. Whole life policies generally offer fixed premiums, guaranteed death benefits and are designed to build tax deferred cash value. For that reason, a whole life insurance policy can be described as providing life insurance protection with a savings feature.
When should I consider buying a whole life policy?
Whole life insurance is generally used when the need for life insurance is lifelong, or permanent. In addition it has a built-in savings element since you will pay premiums and hence build up a cash value within the policy. Additionally, whole life insurance may be used as a part of your estate planning.
Premiums for whole life insurance can be much higher than premiums you would pay initially for the same amount of term insurance, but they are smaller than the premiums you would eventually pay if you were to keep renewing a term insurance policy until the insured's later years.Whole life insurance is a good choice for you if you want to ensure that you have a life insurance policy in place for your entire lifetime and can comfortably afford the premiums, or if it fits within the framework of your estate or retirement plan.
How does whole life insurance differ from term life insurance?
Whole life insurance is designed to provide coverage on the insured for the insured’s entire life as long as premiums are paid and the policy has not been surrendered. On the other hand, term life insurance provides coverage only for a fixed period that is stated in the policy.
What are the main types of traditional whole life policies available for purchase?
Non-Participating Whole Life Insurance
A non-participating whole life policy has a level premium and face amount during your entire life. The advantages of such a policy are its fixed costs and relatively low out-of-pocket premium payments. Since the policy is non-participating it does not pay you any dividends.
Participating Whole Life Insurance
A participating whole life policy pays dividends. The dividends represent the favorable experience of the company and result from excess investment earnings, favorable mortality and expense savings. Dividends can be paid in cash, used to reduce your premium payments, left to accumulate at a specified rate of interest or used to purchase paid-up additional insurance which will increase your face amount of coverage. Dividends are not guaranteed to be paid to you.
Within the two broad categories of traditional non-participating whole life insurance and participating whole life insurance there are various whole life plans that are available for you to choose.
Level Premium Whole Life Insurance
Level premium whole life insurance features premium payments that are level and are required to be paid as long as the insured is living. In the early years the premium is more than enough to pay the current cost of insurance protection. The excess, including interest earnings, makes up the deficiency of premiums in later years when annual premium is not sufficient to pay annual cost of insurance. These extra premiums are held and invested by the insurer, creating the "cash value" of the policy.
Limited Payment Whole Life Insurance
If you want to pay premiums for a limited time, the limited payment whole life policy gives you lifetime protection but requires only a limited number of premium payments. Since the premiums are paid over a shorter span of time, the premium payments will be higher than under the ordinary whole life plan. Limited payment plans can provide for the payment of premiums for a set number of years e.g. 10 payment or 20 payment whole life insurance. Limited payment plans can also be based on age e.g. whole life paid up at age 65 or at age 85.
Single Premium Whole Life Insurance
Single premium whole life is a limited payment whole life insurance plan with one relatively large premium payment due at issue. The policy is fully paid up and no further premiums are required. Due to the single premium payment the policy will have an immediate cash value and loan value which could be significant depending on the amount of the single premium payment. Since a substantial single premium payment could be involved, this type of plan may be viewed more as an investment-oriented type of whole life insurance product.
Indeterminate Premium Whole Life Insurance
An indeterminate premium whole life policy is similar to ordinary whole life plan of insurance except that it provides for adjustable premiums. The company will charge a "current" premium based on its current estimate of investment earnings, mortality, and expense costs. If these estimates change in later years, the company will adjust the premium accordingly but never above the maximum guaranteed premium stated in the policy.
Will the scheduled premium payments for whole life insurance change over time?
Generally, in a traditional whole life policy, the scheduled premium payments remain level. Premiums are generally the same (fixed) every year the insured is alive. The premium payment consists of both life insurance protection and savings. These two elements vary over the life of the insured, but the total scheduled premium payment remains the same for the life of the traditional whole life policy. Some traditional whole life policies however provide for a modified premium payment schedule where the required premium payments may be lower in the early years and then increase to a higher amount which will then remain level for duration of the policy. Be sure to check the data page or specifications page of your policy (usually page 3) to determine the amount of your premium payments and the period for which they are required to be paid.
What is “cash value” and how does it differ from the face amount of the whole life policy?
The face amount is the amount of coverage you wish to provide your beneficiaries in the event of death. The cash value is the value that builds up in the policy. The minimum cash values are set by the Insurance Law and reflect an accumulation of your premiums after allowances for company expenses and claims. When you are young, your premiums are more than the cost of insuring your life at that time. Over time the cash value grows, usually tax-deferred, and the owner may be allowed access to that money in the form of a policy loan or payment of the cash value. The face amount of your policy will be higher than your cash value especially in the early years of your policy. If you surrender your policy you will receive the cash value not the face amount. If you die your beneficiaries will receive the face amount.
May I surrender a whole life policy for its cash value?
Generally, in a traditional whole life policy, yes. Over time, the policy accumulates a cash value, which is similar to building equity in a home. When a policy is surrendered, the owner is entitled to at least a portion of the cash value. The actual amount that the owner receives will depend whether there are any outstanding loans or unpaid premiums that can be deducted from the cash value.
May the policy owner borrow money from the whole life policy?
Generally, yes, to the extent that there are sufficient funds in the cash value to secure the loan. There may be a waiting period of up to three years before a loan is available. If the policy owner borrows from the policy, the cash value is used as collateral, and interest is charged at the rate specified or described in the policy. Any money owed on an outstanding policy loan is deducted from the benefits upon the insured's death or from the cash value if the policy owner surrenders the policy for cash.
Will I need to pay premiums for the rest of my life to keep the whole life policy in force?
For traditional whole life insurance, the amount and duration of premium payments are the same for as long as the insured is alive, but some whole life policies allow you to pay premiums in a single installment, or for a shorter period such as 20 years or until age 65. Premiums for those policies are higher since the premium payments are made during a shorter period. Additionally, dividends, while not guaranteed, in participating whole life policies may be used to pay some or all of scheduled premium payments if you so choose. Whole life policies may also be surrendered and the surrender value then used to purchase a reduced paid-up amount of insurance or used to provide term insurance coverage for a set period of time (extended term). In your whole life policy the available options can be found under what is called the “non-forfeiture” provision.
What is the federal tax treatment of whole life insurance cash values, dividends, and death benefits?
The "interest build-up" portion of the annual increase in the policy's cash value is not taxed annually pursuant to the Internal Revenue Code. Dividends generally are considered to be a "return of premium" and are not taxable as long as the dividends you have received do not exceed the premiums you have paid. Although life insurance death proceeds will not typically be subject to income taxation, they may be subject to federal estate taxation. If you own part or all of the policy when you die, the value of the policy can be included in your gross estate for federal estate tax purposes. State inheritance taxes and federal gift taxes may also apply to life insurance policies/proceeds under specific circumstances. Contact your tax adviser regarding questions about possible income, estate and gift tax consequences surrounding any life insurance you own or are contemplating buying. If the policy is surrendered for its cash value only the excess of the cash value over the amount of premiums you have paid less dividends is taxable.
What are some pros and cons of whole life insurance?
Pros:
Predictable, in most cases premiums are fixed for the life of the insured.
The beneficiaries receive the death benefit no matter when the insured dies, as long as premiums were paid.
The policy may build up cash value, which grows tax deferred.
If you surrender the policy at a later date, the cash value, if any, will be returned to you.
If you stop making premium payments you can receive the cash value or use that cash value to provide a paid up insurance benefit. The company must provide either extended term insurance coverage or reduced paid paid-up coverage. While it is not required that both options be offered many companies do make both available.
Cons:
A more complex product than term life insurance.
Higher premiums than term life insurance.
Could be costly if coverage lapses early.
Tuesday, July 1, 2008
Term Insurance vs Whole Life
FOR MOST PEOPLE, the right type of life insurance can be summed up in a single word: term. But before we explain why, it's important to understand the differences between the most common types of insurance available.
The basic difference between term and whole life insurance is this: A term policy is life coverage only. On the death of the insured it pays the face amount of the policy to the named beneficiary. You can buy term for periods of one year to 30 years. Whole life insurance, on the other hand, combines a term policy with an investment component. The investment could be in bonds and money-market instruments or stocks. The policy builds cash value that you can borrow against. The three most common types of whole life insurance are traditional whole life policies, universal and variable. With both whole life and term, you can lock in the same monthly payment over the life of the policy.
Forced SavingsWhole life insurance is expensive: You're paying not only for insurance but also for the investment portion. That extra cost might almost be worth it if these policies were a good investment vehicle. But usually they aren't. Insurance agents like to call these policies retirement plans, emphasizing the "forced savings" inherent in forking over the premiums each month "for retirement."
Leaving aside the fact that there are many better ways to save for retirement, these policies come with high fees and commissions, which sometimes lop off as much as three percentage points from the annual return. On top of that, there are up-front (but hidden) commissions that are typically 100% of your first year's premium. Worse, it's often impossible to tell what the return on the investment will be, and how much of what you pay in goes toward the insurance and how much toward the investment.
Premiums for term insurance are downright cheap for people in good health up to about age 50. After that age, premiums start to get progressively more expensive. The same holds true for whole life policies, though people who need coverage starting in their 60s and beyond may have no alternative but to buy whole life. Most companies simply won't sell term policies to people over about age 65.
Term: Where the Value IsTo get a real sense of the value of term, let's compare a term policy and a universal life policy. Say a 40-year-old nonsmoking male has a choice between a $250,000 Met Life universal policy with a $3,000 annual premium and a same amount of renewable term coverage with a 20-year fixed premium of $350. At the end of one year, the universal policy, assuming it paid 5.7% per year, tax-deferred, would have a cash value of exactly zero (cash value is the amount you would get back if you canceled the policy). But say he had instead invested $2,650 (the difference between $3,000 and $350) in a no-load mutual fund that averaged a total return of 10% annually. At the end of the first year, he'd have $2,841, accounting for taxes on the earnings at a 28% rate. At the end of 10 years, he would have accumulated more than $46,000 in after-tax savings in the mutual fund. Over the same period, the cash value of the policy would have climbed only to $31,819.
That's not to say that whole life insurance is always a bad idea. Wealthy people can use whole life in their estate planning by setting up an insurance trust that will pay their estate taxes from the proceeds of the policy. And for the growing number of people in their late 40s or early 50s who are just starting families, whole life is at least worth a look.
Sizing Up a Whole Life PolicyOne of the great problems with whole life is only an expert can tell if a policy you own or are considering will ever become a decent investment. James Hunt, actuary for the Consumer Federation of America, who has analyzed thousands of policies, notes that whole life policies hardly ever yield a reasonable return unless held for 20 years or more. So if you buy one be prepared to pay into it for the very long haul.
The key to a whole life policy is its internal rate of return -- the yield on the policy after all fees and charges are subtracted. A competent analysis can determine at a minimum whether the weight of the fees and charges built into one of these policies will ever allow a worthwhile return. Such an analysis will also pinpoint the minimum amount of cash value that you can derive from a policy at any given time interval.
Some financial planners, actuaries and accountants can perform internal rate of return analysis on your policy. The Consumer Federation has a service that will do this, calculating the real return year by year and comparing it with other investments. The fee is $50 for the first policy, $35 for each additional. Call 202-387-6121 for more information.
Keep Your Old Policy?You've been faithfully paying into that whole life policy a good pal of your brother-in-law sold you 10 years ago. And now you're thinking, "Hey wait a minute, I should be bailing out and getting a cheap term policy." Not so fast. First and foremost, keep in mind the substantial sum you've probably paid in over the years. How much will you get if you "surrender" or cash it in now? The answer to that question can be found in the illustrations you got when you signed on the dotted line. If you can't determine the surrender value you may have to -- heaven forbid -- call your agent and ask. But it's worth taking the trouble before you make a decision.
Most policies don't start to build decent a cash value until their 12th or 15th year. So if you cash in after 10 years, you could be out of a lot of money. And you can be sure that if you surrender in the first five years or so, practically every dime you put in will be down the toilet. The next thing you have to consider is whether you are still insurable at a reasonable rate if you switch to term. That's because you'll have to requalify medically. If you are over 50, smoke or have health problems, you may find it's cheaper to hold onto your old policy. Another option worth considering is a tax-free transfer of the value in your old policy into a better one, perhaps from a low-commission company like Ameritas (800-552-3553).
How to Check an Insurer's RatingsIf you're looking for whole life coverage or a term policy that you'll want to keep 20 or 30 years, the financial soundness of the insurer is a critical concern. You want some assurance the company will be around in case you aren't. For insurance companies, the major credit agencies like Standard & Poor's rate claims-paying ability.
Fortunately, information on the credit worthiness of insurance companies is easy to obtain. Reports are cheap or free over the Internet. You can always contact the insurance company and ask about its ratings, but it's best to get this information independently. In general, go with an insurer rated A or better; the most financially sound insurers are rated AAA, though some rating agencies use slightly different letter grades.
The premier Web site in terms of detail and ease of use, (best of all, it's free) is insure.com where you can get ratings online from Standard & Poor's as well comprehensive reports on individual insurers. Duff & Phelps ratings of claims-paying ability are available free at dcrco.com. AM Best ambest.com has a huge database, but you have to pay for it. While you can access ratings free of charge, a detailed company report will set you back $35.
Make sure any report you get is current, say within the last six months. Be extra careful to confirm ratings you'll find on many of the online quote services, which may be stale.
The basic difference between term and whole life insurance is this: A term policy is life coverage only. On the death of the insured it pays the face amount of the policy to the named beneficiary. You can buy term for periods of one year to 30 years. Whole life insurance, on the other hand, combines a term policy with an investment component. The investment could be in bonds and money-market instruments or stocks. The policy builds cash value that you can borrow against. The three most common types of whole life insurance are traditional whole life policies, universal and variable. With both whole life and term, you can lock in the same monthly payment over the life of the policy.
Forced SavingsWhole life insurance is expensive: You're paying not only for insurance but also for the investment portion. That extra cost might almost be worth it if these policies were a good investment vehicle. But usually they aren't. Insurance agents like to call these policies retirement plans, emphasizing the "forced savings" inherent in forking over the premiums each month "for retirement."
Leaving aside the fact that there are many better ways to save for retirement, these policies come with high fees and commissions, which sometimes lop off as much as three percentage points from the annual return. On top of that, there are up-front (but hidden) commissions that are typically 100% of your first year's premium. Worse, it's often impossible to tell what the return on the investment will be, and how much of what you pay in goes toward the insurance and how much toward the investment.
Premiums for term insurance are downright cheap for people in good health up to about age 50. After that age, premiums start to get progressively more expensive. The same holds true for whole life policies, though people who need coverage starting in their 60s and beyond may have no alternative but to buy whole life. Most companies simply won't sell term policies to people over about age 65.
Term: Where the Value IsTo get a real sense of the value of term, let's compare a term policy and a universal life policy. Say a 40-year-old nonsmoking male has a choice between a $250,000 Met Life universal policy with a $3,000 annual premium and a same amount of renewable term coverage with a 20-year fixed premium of $350. At the end of one year, the universal policy, assuming it paid 5.7% per year, tax-deferred, would have a cash value of exactly zero (cash value is the amount you would get back if you canceled the policy). But say he had instead invested $2,650 (the difference between $3,000 and $350) in a no-load mutual fund that averaged a total return of 10% annually. At the end of the first year, he'd have $2,841, accounting for taxes on the earnings at a 28% rate. At the end of 10 years, he would have accumulated more than $46,000 in after-tax savings in the mutual fund. Over the same period, the cash value of the policy would have climbed only to $31,819.
That's not to say that whole life insurance is always a bad idea. Wealthy people can use whole life in their estate planning by setting up an insurance trust that will pay their estate taxes from the proceeds of the policy. And for the growing number of people in their late 40s or early 50s who are just starting families, whole life is at least worth a look.
Sizing Up a Whole Life PolicyOne of the great problems with whole life is only an expert can tell if a policy you own or are considering will ever become a decent investment. James Hunt, actuary for the Consumer Federation of America, who has analyzed thousands of policies, notes that whole life policies hardly ever yield a reasonable return unless held for 20 years or more. So if you buy one be prepared to pay into it for the very long haul.
The key to a whole life policy is its internal rate of return -- the yield on the policy after all fees and charges are subtracted. A competent analysis can determine at a minimum whether the weight of the fees and charges built into one of these policies will ever allow a worthwhile return. Such an analysis will also pinpoint the minimum amount of cash value that you can derive from a policy at any given time interval.
Some financial planners, actuaries and accountants can perform internal rate of return analysis on your policy. The Consumer Federation has a service that will do this, calculating the real return year by year and comparing it with other investments. The fee is $50 for the first policy, $35 for each additional. Call 202-387-6121 for more information.
Keep Your Old Policy?You've been faithfully paying into that whole life policy a good pal of your brother-in-law sold you 10 years ago. And now you're thinking, "Hey wait a minute, I should be bailing out and getting a cheap term policy." Not so fast. First and foremost, keep in mind the substantial sum you've probably paid in over the years. How much will you get if you "surrender" or cash it in now? The answer to that question can be found in the illustrations you got when you signed on the dotted line. If you can't determine the surrender value you may have to -- heaven forbid -- call your agent and ask. But it's worth taking the trouble before you make a decision.
Most policies don't start to build decent a cash value until their 12th or 15th year. So if you cash in after 10 years, you could be out of a lot of money. And you can be sure that if you surrender in the first five years or so, practically every dime you put in will be down the toilet. The next thing you have to consider is whether you are still insurable at a reasonable rate if you switch to term. That's because you'll have to requalify medically. If you are over 50, smoke or have health problems, you may find it's cheaper to hold onto your old policy. Another option worth considering is a tax-free transfer of the value in your old policy into a better one, perhaps from a low-commission company like Ameritas (800-552-3553).
How to Check an Insurer's RatingsIf you're looking for whole life coverage or a term policy that you'll want to keep 20 or 30 years, the financial soundness of the insurer is a critical concern. You want some assurance the company will be around in case you aren't. For insurance companies, the major credit agencies like Standard & Poor's rate claims-paying ability.
Fortunately, information on the credit worthiness of insurance companies is easy to obtain. Reports are cheap or free over the Internet. You can always contact the insurance company and ask about its ratings, but it's best to get this information independently. In general, go with an insurer rated A or better; the most financially sound insurers are rated AAA, though some rating agencies use slightly different letter grades.
The premier Web site in terms of detail and ease of use, (best of all, it's free) is insure.com where you can get ratings online from Standard & Poor's as well comprehensive reports on individual insurers. Duff & Phelps ratings of claims-paying ability are available free at dcrco.com. AM Best ambest.com has a huge database, but you have to pay for it. While you can access ratings free of charge, a detailed company report will set you back $35.
Make sure any report you get is current, say within the last six months. Be extra careful to confirm ratings you'll find on many of the online quote services, which may be stale.
Whole Life Insurance
Whole life is a type of permanent life insurance. It’s called permanent because a whole life policy provides life-long protection and is guaranteed to do so by the insurance company. With whole life, you pay a fixed premium for life, instead of the increasing premiums found on renewable term life insurance policies.
Since the word “term” in term life insurance means a period of time, one could say that the term for whole life insurance is the term of all of your life. It is not technically called lifetime term insurance, but in a way it could be described that way.
How long does it last and should you get this kind of insurance?
With whole life insurance policies, as long as you pay the premiums, the death benefit will be paid. These policies are designed and priced for you to keep over a long period of time.
It’s important to remember that if you’re not sure that you’re going to keep this kind of insurance policy then it’s probably the wrong type of insurance for you. In that case, you should look at term life insurance.
The biggest difference between whole life insurance policy and the different types of term policies is that whole life insures something that will unfortunately happen for certain - one’s death. Term insures the possibility of you dying during the term period, whether that is 1 year or up to 30 years depending on the type of term insurance you get.
Whole life also has a cash component. This cash value can grow and interest is credited to the cash value. Interest growth in these policies is tax-deferred. You don’t pay taxes on the growth. If you die, your beneficiary also does not pay income taxes on the benefit received. If you cash in the policy and you receive back more than you put in, you pay income taxes only on the amount above what you put in.
There are differences among these policies. Some of these policies are from mutual life insurance companies, which means that the insurance company is owned by the policyholders. Mutual company policies can pay dividends to the policyholders that can both enhance cash values and increase the insurance amount. Your lifeinsure.com representative can show you comparative quotes from different highly rated insurance companies.
Another type of whole life is Survivorship life insurance, which is a type that covers two people and pays the insurance amount when both people have died. This is used often in estate planning to create cash to pay the estate taxes.
Since the word “term” in term life insurance means a period of time, one could say that the term for whole life insurance is the term of all of your life. It is not technically called lifetime term insurance, but in a way it could be described that way.
How long does it last and should you get this kind of insurance?
With whole life insurance policies, as long as you pay the premiums, the death benefit will be paid. These policies are designed and priced for you to keep over a long period of time.
It’s important to remember that if you’re not sure that you’re going to keep this kind of insurance policy then it’s probably the wrong type of insurance for you. In that case, you should look at term life insurance.
The biggest difference between whole life insurance policy and the different types of term policies is that whole life insures something that will unfortunately happen for certain - one’s death. Term insures the possibility of you dying during the term period, whether that is 1 year or up to 30 years depending on the type of term insurance you get.
Whole life also has a cash component. This cash value can grow and interest is credited to the cash value. Interest growth in these policies is tax-deferred. You don’t pay taxes on the growth. If you die, your beneficiary also does not pay income taxes on the benefit received. If you cash in the policy and you receive back more than you put in, you pay income taxes only on the amount above what you put in.
There are differences among these policies. Some of these policies are from mutual life insurance companies, which means that the insurance company is owned by the policyholders. Mutual company policies can pay dividends to the policyholders that can both enhance cash values and increase the insurance amount. Your lifeinsure.com representative can show you comparative quotes from different highly rated insurance companies.
Another type of whole life is Survivorship life insurance, which is a type that covers two people and pays the insurance amount when both people have died. This is used often in estate planning to create cash to pay the estate taxes.
Term Life Insurance
Term is simple. You pay a premium for a period of time (the term) from one to thirty years and if you die during that time the insurance is paid to the person or persons you designate to receive it - called the beneficiary(ies).
Term life insurance usually has the lowest premium in the early years, making it the most affordable life insurance - initially. Term does not build cash value.
It covers you for a specified period of time (usually from 5 to 30 years, you choose). If you purchase a $1,000,000 term life insurance policy for 20-year period and you die in any of those 20 years, your beneficiary receives the million dollars.
If you are still living at the end of the term, your insurance policy is over unless you can renew the policy. When you renew (assuming your policy has that feature) it will renew at a higher price reflecting your now older age. Term insurance has no buildup of cash as with whole life insurance. Some term life insurance policies do offer a return of premium.
Term life insurance usually has the lowest premium in the early years, making it the most affordable life insurance - initially. Term does not build cash value.
It covers you for a specified period of time (usually from 5 to 30 years, you choose). If you purchase a $1,000,000 term life insurance policy for 20-year period and you die in any of those 20 years, your beneficiary receives the million dollars.
If you are still living at the end of the term, your insurance policy is over unless you can renew the policy. When you renew (assuming your policy has that feature) it will renew at a higher price reflecting your now older age. Term insurance has no buildup of cash as with whole life insurance. Some term life insurance policies do offer a return of premium.
Life Insurance Top 10
Top things to know
1. All policies fall into one of two camps.
There are term policies, or pure insurance coverage. And there are the many variants of whole life, which combine an investment product with pure term insurance and build cash value.
2. Insurance is sold, not bought.
Agents sell the vast majority of life policies written in the U.S. because the life insurance industry has a vested interest in pushing high-commission (and high-profit) whole-life policies.
3. Whole life is expensive.
Policies with an investment component cost many times more than term policies. As a result, many people who buy whole life often can't afford an adequate face value, leaving themselves underinsured.
4. Whole-life policies are built on assumptions.
The returns quoted by the agent are simply guesses - not reality. And some companies keep these guesses of future returns on the high side to attract more buyers.
5. Keep your investing and insurance strictly separate.
There are better places to invest - and without the high commissions of whole-life policies.
6. Buy enough term coverage to fill your needs.
Life insurance is no place to skimp, especially with rates at historic lows.
7. Match the term of the policy to your needs.
You want the policy to last as long as it takes for your dependents to leave the nest - or for your retirement income to kick in.
8. Buy when you're healthy.
Older people and those not in the best of health pay steeply higher rates for life insurance - so buy as early as you can, but don't buy until you have dependents.
9. Tell the truth.
There's no sense in shading the facts on your application to get a lower rate. Be assured that if a large claim is made, the insurance company will investigate before paying.
10. Use the Web to shop.
Buying life insurance has never been easier, thanks to the Internet. You can get tons of quotes - and avoid the pushy salespeople.
1. All policies fall into one of two camps.
There are term policies, or pure insurance coverage. And there are the many variants of whole life, which combine an investment product with pure term insurance and build cash value.
2. Insurance is sold, not bought.
Agents sell the vast majority of life policies written in the U.S. because the life insurance industry has a vested interest in pushing high-commission (and high-profit) whole-life policies.
3. Whole life is expensive.
Policies with an investment component cost many times more than term policies. As a result, many people who buy whole life often can't afford an adequate face value, leaving themselves underinsured.
4. Whole-life policies are built on assumptions.
The returns quoted by the agent are simply guesses - not reality. And some companies keep these guesses of future returns on the high side to attract more buyers.
5. Keep your investing and insurance strictly separate.
There are better places to invest - and without the high commissions of whole-life policies.
6. Buy enough term coverage to fill your needs.
Life insurance is no place to skimp, especially with rates at historic lows.
7. Match the term of the policy to your needs.
You want the policy to last as long as it takes for your dependents to leave the nest - or for your retirement income to kick in.
8. Buy when you're healthy.
Older people and those not in the best of health pay steeply higher rates for life insurance - so buy as early as you can, but don't buy until you have dependents.
9. Tell the truth.
There's no sense in shading the facts on your application to get a lower rate. Be assured that if a large claim is made, the insurance company will investigate before paying.
10. Use the Web to shop.
Buying life insurance has never been easier, thanks to the Internet. You can get tons of quotes - and avoid the pushy salespeople.
Life Insurance Overview
Life insurance or life assurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a sum of money upon the occurrence of the insured individual's or individuals' death or other event, such as terminal illness or critical illness. In return, the policy owner (or policy payer) agrees to pay a stipulated amount called a premium at regular intervals or in lump sums. There may be designs in some countries where bills and death expenses plus catering for after funeral expenses should be included in Policy Premium. In the United States, the predominant form simply specifies a lump sum to be paid on the insured's demise.
As with most insurance policies, life insurance is a contract between the insurer and the policy owner (policyholder) whereby a benefit is paid to the designated Beneficiary (or Beneficiaries) if an insured event occurs which is covered by the policy. To be a life policy the insured event must be based upon life (or lives) of the people named in the policy.
Insured events that may be covered include:
Serious illness
Life policies are legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; for example claims relating to suicide, fraud, war, riot and civil commotion.
Life based contracts tend to fall into two major categories:
Protection policies - designed to provide a benefit in the event of specified event, typically a lump sum payment. A common form of this design is term insurance.
Investment policies - where the main objective is to facilitate the growth of capital by regular or single premiums. Common forms (in the US anyway) are whole life, universal life and variable life policies.
Parties to contract
There is a difference between the insured and the policy owner (policy holder), although the owner and the insured are often the same person. For example, if Joe buys a policy on his own life, he is both the owner and the insured. But if Jane, his wife, buys a policy on Joe's life, she is the owner and he is the insured. The policy owner is the guarantee and he or she will be the person who will pay for the policy. The insured is a participant in the contract, but not necessarily a party to it.
The beneficiary receives policy proceeds upon the insured's death. The owner designates the beneficiary, but the beneficiary is not a party to the policy. The owner can change the beneficiary unless the policy has an irrevocable beneficiary designation. With an irrevocable beneficiary, that beneficiary must agree to any beneficiary changes, policy assignments, or cash value borrowing.
In cases where the policy owner is not the insured (also referred to as the cestui qui vit or CQV), insurance companies have sought to limit policy purchases to those with an "insurable interest" in the CQV. For life insurance policies, close family members and business partners will usually be found to have an insurable interest. The "insurable interest" requirement usually demonstrates that the purchaser will actually suffer some kind of loss if the CQV dies. Such a requirement prevents people from benefiting from the purchase of purely speculative policies on people they expect to die. With no insurable interest requirement, the risk that a purchaser would murder the CQV for insurance proceeds would be great. In at least one case, an insurance company which sold a policy to a purchaser with no insurable interest (who later murdered the CQV for the proceeds), was found liable in court for contributing to the wrongful death of the victim (Liberty National Life v. Weldon, 267 Ala.171 (1957)).
Contract terms
Special provisions may apply, such as suicide clauses wherein the policy becomes null if the insured commits suicide within a specified time (usually two years after the purchase date; some states provide a statutory one-year suicide clause). Any misrepresentations by the insured on the application is also grounds for nullification. Most US states specify that the contestability period cannot be longer than two years; only if the insured dies within this period will the insurer have a legal right to contest the claim on the basis of misrepresentation and request additional information before deciding to pay or deny the claim.
The face amount on the policy is the initial amount that the policy will pay at the death of the insured or when the policy matures, although the actual death benefit can provide for greater or lesser than the face amount. The policy matures when the insured dies or reaches a specified age (such as 100 years old).
Costs, insurability, and underwriting
The insurer (the life insurance company) calculates the policy prices with intent to fund claims to be paid and administrative costs, and to make a profit. The cost of insurance is determined using mortality tables calculated by actuaries. Actuaries are professionals who employ actuarial science, which is based in mathematics (primarily probability and statistics). Mortality tables are statistically-based tables showing expected annual mortality rates. It is possible to derive life expectancy estimates from these mortality assumptions. Such estimates can be important in taxation regulation.[1] [2]
The three main variables in a mortality table have been age, gender, and use of tobacco. More recently in the US, preferred class specific tables were introduced. The mortality tables provide a baseline for the cost of insurance. In practice, these mortality tables are used in conjunction with the health and family history of the individual applying for a policy in order to determine premiums and insurability. Mortality tables currently in use by life insurance companies in the United States are individually modified by each company using pooled industry experience studies as a starting point. In the 1980s and 90's the SOA 1975-80 Basic Select & Ultimate tables were the typical reference points, while the 2001 VBT and 2001 CSO tables were published more recently. The newer tables include separate mortality tables for smokers and non-smokers and the CSO tables include separate tables for preferred classes. [3]
Recent US select mortality tables predict that roughly 0.35 in 1,000 non-smoking males aged 25 will die during the first year of coverage after underwriting.[2] Mortality approximately doubles for every extra ten years of age so that the mortality rate in the first year for underwritten non-smoking men is about 2.5 in 1,000 people at age 65.[3] Compare this with the US population male mortality rates of 1.3 per 1,000 at age 25 and 19.3 at age 65 (without regard to health or smoking status).[4]
The mortality of underwritten persons rises much more quickly than the general population. At the end of 10 years the mortality of that 25 year-old, non-smoking male is 0.66/1000/year. Consequently, in a group of one thousand 25 year old males with a $100,000 policy, all of average health, a life insurance company would have to collect approximately $50 a year from each of a large group to cover the relatively few expected claims. (0.35 to 0.66 expected deaths in each year x $100,000 payout per death = $35 per policy). Administrative and sales commissions need to be accounted for in order for this to make business sense. A 10 year policy for a 25 year old non-smoking male person with preferred medical history may get offers as low as $90 per year for a $100,000 policy in the competitive US life insurance market.
The insurance company receives the premiums from the policy owner and invests them to create a pool of money from which it can pay claims and finance the insurance company's operations. Contrary to popular belief, the majority of the money that insurance companies make comes directly from premiums paid, as money gained through investment of premiums can never, in even the most ideal market conditions, vest enough money per year to pay out claims.[citation needed] Rates charged for life insurance increase with the insured's age because, statistically, people are more likely to die as they get older.
Given that adverse selection can have a negative impact on the insurer's financial situation, the insurer investigates each proposed insured individual unless the policy is below a company-established minimum amount, beginning with the application process. Group Insurance policies are an exception.
This investigation and resulting evaluation of the risk is termed underwriting. Health and lifestyle questions are asked. Certain responses or information received may merit further investigation. Life insurance companies in the United States support the Medical Information Bureau (MIB) [4], which is a clearinghouse of information on persons who have applied for life insurance with participating companies in the last seven years. As part of the application, the insurer receives permission to obtain information from the proposed insured's physicians.[5]
Underwriters will determine the purpose of insurance. The most common is to protect the owner's family or financial interests in the event of the insured's demise. Other purposes include estate planning or, in the case of cash-value contracts, investment for retirement planning. Bank loans or buy-sell provisions of business agreements are another acceptable purpose.
Life insurance companies are never required by law to underwrite or to provide coverage to anyone, with the exception of Civil Rights Act compliance requirements. Insurance companies alone determine insurability, and some people, for their own health or lifestyle reasons, are deemed uninsurable. The policy can be declined (turned down) or rated.[citation needed] Rating increases the premiums to provide for additional risks relative to the particular insured.[citation needed]
Many companies use four general health categories for those evaluated for a life insurance policy. These categories are Preferred Best, Preferred, Standard, and Tobacco.[citation needed] Preferred Best is reserved only for the healthiest individuals in the general population. This means, for instance, that the proposed insured has no adverse medical history, is not under medication for any condition, and his family (immediate and extended) have no history of early cancer, diabetes, or other conditions.[citation needed] Preferred means that the proposed insured is currently under medication for a medical condition and has a family history of particular illnesses.[citation needed] Most people are in the Standard category.[citation needed] Profession, travel, and lifestyle factor into whether the proposed insured will be granted a policy, and which category the insured falls. For example, a person who would otherwise be classified as Preferred Best may be denied a policy if he or she travels to a high risk country.[citation needed] Underwriting practices can vary from insurer to insurer which provide for more competitive offers in certain circumstances.
Life insurance contracts are written on the basis of utmost good faith. That is, the proposer and the insurer both accept that the other is acting in good faith. This means that the proposer can assume the contract offers what it represents without having to fine comb the small print and the insurer assumes the proposer is being honest when providing details to underwriter.[citation needed]
Death proceeds
Upon the insured's death, the insurer requires acceptable proof of death before it pays the claim. The normal minimum proof required is a death certificate and the insurer's claim form completed, signed (and typically notarized).[citation needed] If the insured's death is suspicious and the policy amount is large, the insurer may investigate the circumstances surrounding the death before deciding whether it has an obligation to pay the claim.
Proceeds from the policy may be paid as a lump sum or as an annuity, which is paid over time in regular recurring payments for either a specified period or for a beneficiary's lifetime.[citation needed]
Insurance vs. assurance
Outside the United States, the specific uses of the terms "insurance" and "assurance" are sometimes confused. In general, in these jurisdictions "insurance" refers to providing cover for an event that might happen, while "assurance" is the provision of cover for an event that is certain to happen. However, in the United States both forms of coverage are called "insurance".
When a person insures the contents of their home they do so because of events that might happen (fire, theft, flood, etc.) They hope their home will never be burglarized, or burn down, but they want to ensure that they are financially protected if the worst happens. This example of insurance shows how it is a way of spending a little money to protect against the risk of having to spend a lot of money.
When a person insures their life they do so knowing that one day they will die. Therefore a policy that covers death is assured to make a payment. The policy offers assurance on death; even if the policy has a prescribed termination date the policy is still assured to pay on death and therefore is an assurance policy. Examples include Term Assurance and Whole Life Assurance. An accidental death policy is not assured to pay on death as the life insured may not die through an accident, therefore it is an insurance policy.
A policy might also be assured for other reasons. For example an endowment policy is designed to provide a lump sum on maturity. Under certain types of policy the lump sum is guaranteed. Therefore, this may also be called an assurance policy.
The test of whether a policy is assurance or insurance is that with an assurance policy the insured event will definitely occur (at some point) whereas with an insurance policy there is a risk the insured event might occur.
With regard to Whole Life policies, the question is not whether the insured event (in this case death) will occur, but simply when. If the policy has nonforfeiture values (or cash values) then the policy is assured to pay.
During recent years, the distinction between the two terms has become largely blurred. This is principally due to many companies offering both types of policy, and rather than refer to themselves using both insurance and assurance titles, they instead use just one.
Types of life insurance
Life insurance may be divided into two basic classes – temporary and permanent or following subclasses - term, universal, whole life, variable, variable universal and endowment life insurance.
Temporary (Term)
Term life insurance or 'term assurance' provides for life insurance coverage for a specified term of years for a specified premium. The policy does not accumulate cash value. Term is generally considered "pure" insurance, where the premium buys protection in the event of death and nothing else. (See Theory of Decreasing Responsibility and buy term and invest the difference.)
The three key factors to be considered in term insurance are: face amount (protection or death benefit), premium to be paid (cost to the insured), and length of coverage (term).
Various (U.S.) insurance companies sell term insurance with many different combinations of these three parameters. The face amount can remain constant or decline. The term can be for one or more years. The premium can remain level or increase. A common type of term is called annual renewable term. It is a one year policy but the insurance company guarantees it will issue a policy of equal or lesser amount without regard to the insurability of the insured and with a premium set for the insured's age at that time. Another common type of term insurance is mortgage insurance, which is usually a level premium, declining face value policy. The face amount is intended to equal the amount of the mortgage on the policy owner’s residence so the mortgage will be paid if the insured dies.
A policy holder insures his life for a specified term. If he dies before that specified term is up, his estate or named beneficiary(ies) receive(s) a payout. If he does not die before the term is up, he receives nothing. In the past these policies would almost always exclude suicide. However, after a number of court judgments against the industry, payouts do occur on death by suicide (presumably except for in the unlikely case that it can be shown that the suicide was just to benefit from the policy). Generally, if an insured person commits suicide within the first two policy years, the insurer will return the premiums paid. However, a death benefit will usually be paid if the suicide occurs after the two year period.
Permanent
Permanent life insurance is life insurance that remains in force (in-line) until the policy matures (pays out), unless the owner fails to pay the premium when due (the policy expires OR policies lapse). The policy cannot be canceled by the insurer for any reason except fraud in the application, and that cancellation must occur within a period of time defined by law (usually two years). Permanent insurance builds a cash value that reduces the amount at risk to the insurance company and thus the insurance expense over time. This means that a policy with a million dollars face value can be relatively inexpensive to a 70 year old because the actual amount of insurance purchased is much less than one million dollars. The owner can access the money in the cash value by withdrawing money, borrowing the cash value, or surrendering the policy and receiving the surrender value.
The three basic types of permanent insurance are whole life, universal life, and endowment.
Whole life coverage
Whole life insurance provides for a level premium, and a cash value table included in the policy guaranteed by the company. The primary advantages of whole life are guaranteed death benefits, guaranteed cash values, fixed and known annual premiums, and mortality and expense charges will not reduce the cash value shown in the policy. The primary disadvantages of whole life are premium inflexibility, and the internal rate of return in the policy may not be competitive with other savings alternatives. Riders are available that can allow one to increase the death benefit by paying additional premium. The death benefit can also be increased through the use of policy dividends. Dividends cannot be guaranteed and may be higher or lower than historical rates over time. Premiums are much higher than term insurance in the short-term, but cumulative premiums are roughly equal if policies are kept in force until average life expectancy.
Cash value can be accessed at any time through policy "loans". Since these loans decrease the death benefit if not paid back, payback is optional. Cash values are not paid to the beneficiary upon the death of the insured; the beneficiary receives the death benefit only. If the dividend option: Paid up additions is elected, dividend cash values will purchase additional death benefit which will increase the death benefit of the policy to the named beneficiary.
Universal life coverage
Universal life insurance (UL) is a relatively new insurance product intended to provide permanent insurance coverage with greater flexibility in premium payment and the potential for a higher internal rate of return. A universal life policy includes a cash account. Premiums increase the cash account. Interest is paid within the policy (credited) on the account at a rate specified by the company. This rate has a guaranteed minimum but usually is higher than that minimum. Mortality charges and administrative costs are charged against (reduce) the cash account. The surrender value of the policy is the amount remaining in the cash account less applicable surrender charges, if any.
With all life insurance, there are basically two functions that make it work. There's a mortality function and a cash function. The mortality function would be the classical notion of pooling risk where the premiums paid by everybody else would cover the death benefit for the one or two who will die for a given period of time. The cash function inherent in all life insurance says that if a person is to reach age 95 to 100 (the age varies depending on state and company), then the policy matures and endows the face value of the policy.
Actuarially, it is reasoned that out of a group of 1000 people, if even 10 of them live to age 95, then the mortality function alone will not be able to cover the cash function. So in order to cover the cash function, a minimum rate of investment return on the premiums will be required in the event that a policy matures.
Universal life policies guarantee, to some extent, the death proceeds, but not the cash function - thus the flexible premiums and interest returns. If interest rates are high, then the investment returns help reduce premiums. If interest rates are low, then the customer would have to pay additional premiums in order to keep the policy in force. When interest rates are above the minimum required, then the customer has the flexibility to pay less as investment returns cover the remainder to keep the policy in force.
The universal life policy addresses the perceived disadvantages of whole life. Premiums are flexible. The internal rate of return is usually higher because it moves with the financial markets. Mortality costs and administrative charges are known. And cash value may be considered more easily attainable because the owner can discontinue premiums if the cash value allows it. And universal life has a more flexible death benefit because the owner can select one of two death benefit options, Option A and Option B.
Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at age 95. Option B pays the face amount plus the cash value, as it's designed to increase the net death benefit as cash values accumulate. Option B does carry with it a caveat. This caveat is that in order for the policy to keep its tax favored life insurance status, it must stay within a corridor specified by state and federal laws that prevent abuses such as attaching a million dollars in cash value to a two dollar insurance policy. The interesting part about this corridor is that for those people who can make it to age 95-100, this corridor requirement goes away and your cash value can equal exactly the face amount of insurance. If this corridor is ever violated, then the universal life policy will be treated as, and in effect turn into, a Modified Endowment Contract (or more commonly referred to as a MEC).
But universal life has its own disadvantages which stem primarily from this flexibility. The policy lacks the fundamental guarantee that the policy will be in force unless sufficient premiums have been paid and cash values are not guaranteed.
Universal life policies are sometimes erroneously referred to as self-sustaining policies. In the 1980s, when interest rates were high, the cash value accumulated at a more accelerated rate, and universal life coverage was often sold by agents as a policy that could be self-paying. Many policies did sustain themselves for a prolonged period, but the combination of lower interest rates and an increasing cost of insurance as the insured ages meant that for many policies, the cash option was diminished or depleted.
Variable universal life Insurance (VUL) is not the same as universal life, even though they both have cash values attached to them. These differences are in how the cash accounts are managed. The cash account within a VUL is held in the insurer's "separate account" (generally in mutual funds, managed by a fund manager).
Limited-pay
Another type of permanent insurance is Limited-pay life insurance, in which all the premiums are paid over a specified period after which no additional premiums are due to keep the policy in force. Common limited pay periods include 10-year, 20-year, and paid-up at age 65.
Endowments
Main article: Endowment policy
Endowments are policies in which the cash value built up inside the policy, equals the death benefit (face amount) at a certain age. The age this commences is known as the endowment age. Endowments are considerably more expensive (in terms of annual premiums) than either whole life or universal life because the premium paying period is shortened and the endowment date is earlier.
In the United States, the Technical Corrections Act of 1988 tightened the rules on tax shelters (creating modified endowments). These follow tax rules as annuities and IRAs do.
Endowment Insurance is paid out whether the insured lives or dies, after a specific period (e.g. 15 years) or a specific age (e.g. 65).
Accidental death
Accidental death is a limited life insurance that is designed to cover the insured when they pass away due to an accident. Accidents include anything from an injury, but do not typically cover any deaths resulting from health problems or suicide. Because they only cover accidents, these policies are much less expensive than other life insurances.
It is also very commonly offered as "accidental death and dismemberment insurance", also known as an AD&D policy. In an AD&D policy, benefits are available not only for accidental death, but also for loss of limbs or bodily functions such as sight and hearing, etc.
Accidental death and AD&D policies very rarely pay a benefit; either the cause of death is not covered, or the coverage is not maintained after the accident until death occurs. To be aware of what coverage they have, an insured should always review their policy for what it covers and what it excludes. Often, it does not cover an insured who puts themselves at risk in activities such as: parachuting, flying an airplane, professional sports, or involvement in a war (military or not). Also, some insurers will exclude death and injury caused by proximate causes due to (but not limited to) racing on wheels and mountaineering.
Accidental death benefits can also be added to a standard life insurance policy as a rider. If this rider is purchased, the policy will generally pay double the face amount if the insured dies due to an accident. This used to be commonly referred to as a double indemnity coverage. In some cases, some companies may even offer a triple indemnity cover.
Related life insurance products
Riders are modifications to the insurance policy added at the same time the policy is issued. These riders change the basic policy to provide some feature desired by the policy owner. A common rider is accidental death, which used to be commonly referred to as "double indemnity", which pays twice the amount of the policy face value if death results from accidental causes, as if both a full coverage policy and an accidental death policy were in effect on the insured. Another common rider is premium waiver, which waives future premiums if the insured becomes disabled.
Joint life insurance is either a term or permanent policy insuring two or more lives with the proceeds payable on the first death.
Survivorship life or second-to-die life is a whole life policy insuring two lives with the proceeds payable on the second (later) death.
Single premium whole life is a policy with only one premium which is payable at the time the policy is issued.
Modified whole life is a whole life policy that charges smaller premiums for a specified period of time after which the premiums increase for the remainder of the policy.
Group life insurance is term insurance covering a group of people, usually employees of a company or members of a union or association. Individual proof of insurability is not normally a consideration in the underwriting. Rather, the underwriter considers the size and turnover of the group, and the financial strength of the group. Contract provisions will attempt to exclude the possibility of adverse selection. Group life insurance often has a provision that a member exiting the group has the right to buy individual insurance coverage.
Senior and preneed products
Insurance companies have in recent years developed products to offer to niche markets, most notably targeting the senior market to address needs of an aging population. Many companies offer policies tailored to the needs of senior applicants. These are often low to moderate face value whole life insurance policies, to allow a senior citizen purchasing insurance at an older issue age an opportunity to buy affordable insurance. This may also be marketed as final expense insurance, and an agent or company may suggest (but not require) that the policy proceeds could be used for end-of-life expenses.
Preneed (or prepaid) insurance policies are whole life policies that, although available at any age, are usually offered to older applicants as well. This type of insurance is designed specifically to cover funeral expenses when the insured person dies. In many cases, the applicant signs a prefunded funeral arrangement with a funeral home at the time the policy is applied for. The death proceeds are then guaranteed to be directed first to the funeral services provider for payment of services rendered. Most contracts dictate that any excess proceeds will go either to the insured's estate or a designated beneficiary.
These products are sometimes assigned into a trust at the time of issue, or shortly after issue. The policies are irrevocably assigned to the trust, and the trust becomes the owner. Since a whole life policy has a cash value component, and a loan provision, it may be considered an asset; assigning the policy to a trust means that it can no longer be considered an asset for that individual. This can impact an individual's ability to qualify for Medicare or Medicaid.
Investment policies
With-profits policies
Main article: With-profits policy
Some policies allow the policyholder to participate in the profits of the insurance company these are with-profits policies. Other policies have no rights to participate in the profits of the company, these are non-profit policies.
With-profits policies are used as a form of collective investment to achieve capital growth. Other policies offer a guaranteed return not dependent on the company's underlying investment performance; these are often referred to as without-profit policies which may be construed as a misnomer.
Insurance/Investment Bonds
Main article: Insurance bond
Pensions
Pensions are a form of life assurance. However, whilst basic life assurance, permanent health insurance and non-pensions annuity business includes an amount of mortality or morbidity risk for the insurer, for pensions there is a longevity risk.
A pension fund will be built up throughout a person's working life. When the person retires, the pension will become in payment, and at some stage the pensioner will buy an annuity contract, which will guarantee a certain pay-out each month until death.
Annuities
Main article: annuity
An annuity is a contract with an insurance company whereby the purchaser pays an initial premium or premiums into a tax-deferred account, which pays out a sum at pre-determined intervals. There are two periods: the accumulation (when payments are paid into the account) and the annuitization (when the insurance company pays out). For example, a policy holder may pay £10,000, and in return receive £150 each month until he dies; or £1,000 for each of 14 years or death benefits if he dies before the full term of the annuity has elapsed. Tax penalties and insurance company surrender charges may apply to premature withdrawals (if indeed these are allowed; in most markets outside the U.S. the policy owner has no right to end the contract prematurely).
Tax and life insurance
Taxation of life insurance in the United States
Premiums paid by the policy owner are normally not deductible for federal and state income tax purposes.
Proceeds paid by the insurer upon death of the insured are not includible in taxable income for federal and state income tax purposes; however, if the proceeds are included in the "estate" of the deceased, it is likely they will be subject to federal and state estate and inheritance tax.
Cash value increases within the policy are not subject to income taxes unless certain events occur. For this reason, insurance policies can be a legal and legitimate tax shelter wherein savings can increase without taxation until the owner withdraws the money from the policy. On flexible-premium policies, large deposits of premium could cause the contract to be considered a "Modified Endowment Contract" by the IRS, which negates many of the tax advantages associated with life insurance. The insurance company, in most cases, will inform the policy owner of this danger before applying their premium.
Tax deferred benefit from a life insurance policy may be offset by its low return or high cost in some cases. This depends upon the insuring company, type of policy and other variables (mortality, market return, etc.). Also, other income tax saving vehicles (i.e. IRA, 401K or Roth IRA) appear to be better alternatives for value accumulation, at least for more sophisticated investors who can keep track of multiple financial vehicles. The combination of low-cost term life insurance and higher return tax-efficient retirement accounts can achieve better performance, assuming that the insurance itself is only needed for a limited amount of time.
The tax ramifications of life insurance are complex. The policy owner would be well advised to carefully consider them. As always, Congress or the state legislatures can change the tax laws at any time.
As with most insurance policies, life insurance is a contract between the insurer and the policy owner (policyholder) whereby a benefit is paid to the designated Beneficiary (or Beneficiaries) if an insured event occurs which is covered by the policy. To be a life policy the insured event must be based upon life (or lives) of the people named in the policy.
Insured events that may be covered include:
Serious illness
Life policies are legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; for example claims relating to suicide, fraud, war, riot and civil commotion.
Life based contracts tend to fall into two major categories:
Protection policies - designed to provide a benefit in the event of specified event, typically a lump sum payment. A common form of this design is term insurance.
Investment policies - where the main objective is to facilitate the growth of capital by regular or single premiums. Common forms (in the US anyway) are whole life, universal life and variable life policies.
Parties to contract
There is a difference between the insured and the policy owner (policy holder), although the owner and the insured are often the same person. For example, if Joe buys a policy on his own life, he is both the owner and the insured. But if Jane, his wife, buys a policy on Joe's life, she is the owner and he is the insured. The policy owner is the guarantee and he or she will be the person who will pay for the policy. The insured is a participant in the contract, but not necessarily a party to it.
The beneficiary receives policy proceeds upon the insured's death. The owner designates the beneficiary, but the beneficiary is not a party to the policy. The owner can change the beneficiary unless the policy has an irrevocable beneficiary designation. With an irrevocable beneficiary, that beneficiary must agree to any beneficiary changes, policy assignments, or cash value borrowing.
In cases where the policy owner is not the insured (also referred to as the cestui qui vit or CQV), insurance companies have sought to limit policy purchases to those with an "insurable interest" in the CQV. For life insurance policies, close family members and business partners will usually be found to have an insurable interest. The "insurable interest" requirement usually demonstrates that the purchaser will actually suffer some kind of loss if the CQV dies. Such a requirement prevents people from benefiting from the purchase of purely speculative policies on people they expect to die. With no insurable interest requirement, the risk that a purchaser would murder the CQV for insurance proceeds would be great. In at least one case, an insurance company which sold a policy to a purchaser with no insurable interest (who later murdered the CQV for the proceeds), was found liable in court for contributing to the wrongful death of the victim (Liberty National Life v. Weldon, 267 Ala.171 (1957)).
Contract terms
Special provisions may apply, such as suicide clauses wherein the policy becomes null if the insured commits suicide within a specified time (usually two years after the purchase date; some states provide a statutory one-year suicide clause). Any misrepresentations by the insured on the application is also grounds for nullification. Most US states specify that the contestability period cannot be longer than two years; only if the insured dies within this period will the insurer have a legal right to contest the claim on the basis of misrepresentation and request additional information before deciding to pay or deny the claim.
The face amount on the policy is the initial amount that the policy will pay at the death of the insured or when the policy matures, although the actual death benefit can provide for greater or lesser than the face amount. The policy matures when the insured dies or reaches a specified age (such as 100 years old).
Costs, insurability, and underwriting
The insurer (the life insurance company) calculates the policy prices with intent to fund claims to be paid and administrative costs, and to make a profit. The cost of insurance is determined using mortality tables calculated by actuaries. Actuaries are professionals who employ actuarial science, which is based in mathematics (primarily probability and statistics). Mortality tables are statistically-based tables showing expected annual mortality rates. It is possible to derive life expectancy estimates from these mortality assumptions. Such estimates can be important in taxation regulation.[1] [2]
The three main variables in a mortality table have been age, gender, and use of tobacco. More recently in the US, preferred class specific tables were introduced. The mortality tables provide a baseline for the cost of insurance. In practice, these mortality tables are used in conjunction with the health and family history of the individual applying for a policy in order to determine premiums and insurability. Mortality tables currently in use by life insurance companies in the United States are individually modified by each company using pooled industry experience studies as a starting point. In the 1980s and 90's the SOA 1975-80 Basic Select & Ultimate tables were the typical reference points, while the 2001 VBT and 2001 CSO tables were published more recently. The newer tables include separate mortality tables for smokers and non-smokers and the CSO tables include separate tables for preferred classes. [3]
Recent US select mortality tables predict that roughly 0.35 in 1,000 non-smoking males aged 25 will die during the first year of coverage after underwriting.[2] Mortality approximately doubles for every extra ten years of age so that the mortality rate in the first year for underwritten non-smoking men is about 2.5 in 1,000 people at age 65.[3] Compare this with the US population male mortality rates of 1.3 per 1,000 at age 25 and 19.3 at age 65 (without regard to health or smoking status).[4]
The mortality of underwritten persons rises much more quickly than the general population. At the end of 10 years the mortality of that 25 year-old, non-smoking male is 0.66/1000/year. Consequently, in a group of one thousand 25 year old males with a $100,000 policy, all of average health, a life insurance company would have to collect approximately $50 a year from each of a large group to cover the relatively few expected claims. (0.35 to 0.66 expected deaths in each year x $100,000 payout per death = $35 per policy). Administrative and sales commissions need to be accounted for in order for this to make business sense. A 10 year policy for a 25 year old non-smoking male person with preferred medical history may get offers as low as $90 per year for a $100,000 policy in the competitive US life insurance market.
The insurance company receives the premiums from the policy owner and invests them to create a pool of money from which it can pay claims and finance the insurance company's operations. Contrary to popular belief, the majority of the money that insurance companies make comes directly from premiums paid, as money gained through investment of premiums can never, in even the most ideal market conditions, vest enough money per year to pay out claims.[citation needed] Rates charged for life insurance increase with the insured's age because, statistically, people are more likely to die as they get older.
Given that adverse selection can have a negative impact on the insurer's financial situation, the insurer investigates each proposed insured individual unless the policy is below a company-established minimum amount, beginning with the application process. Group Insurance policies are an exception.
This investigation and resulting evaluation of the risk is termed underwriting. Health and lifestyle questions are asked. Certain responses or information received may merit further investigation. Life insurance companies in the United States support the Medical Information Bureau (MIB) [4], which is a clearinghouse of information on persons who have applied for life insurance with participating companies in the last seven years. As part of the application, the insurer receives permission to obtain information from the proposed insured's physicians.[5]
Underwriters will determine the purpose of insurance. The most common is to protect the owner's family or financial interests in the event of the insured's demise. Other purposes include estate planning or, in the case of cash-value contracts, investment for retirement planning. Bank loans or buy-sell provisions of business agreements are another acceptable purpose.
Life insurance companies are never required by law to underwrite or to provide coverage to anyone, with the exception of Civil Rights Act compliance requirements. Insurance companies alone determine insurability, and some people, for their own health or lifestyle reasons, are deemed uninsurable. The policy can be declined (turned down) or rated.[citation needed] Rating increases the premiums to provide for additional risks relative to the particular insured.[citation needed]
Many companies use four general health categories for those evaluated for a life insurance policy. These categories are Preferred Best, Preferred, Standard, and Tobacco.[citation needed] Preferred Best is reserved only for the healthiest individuals in the general population. This means, for instance, that the proposed insured has no adverse medical history, is not under medication for any condition, and his family (immediate and extended) have no history of early cancer, diabetes, or other conditions.[citation needed] Preferred means that the proposed insured is currently under medication for a medical condition and has a family history of particular illnesses.[citation needed] Most people are in the Standard category.[citation needed] Profession, travel, and lifestyle factor into whether the proposed insured will be granted a policy, and which category the insured falls. For example, a person who would otherwise be classified as Preferred Best may be denied a policy if he or she travels to a high risk country.[citation needed] Underwriting practices can vary from insurer to insurer which provide for more competitive offers in certain circumstances.
Life insurance contracts are written on the basis of utmost good faith. That is, the proposer and the insurer both accept that the other is acting in good faith. This means that the proposer can assume the contract offers what it represents without having to fine comb the small print and the insurer assumes the proposer is being honest when providing details to underwriter.[citation needed]
Death proceeds
Upon the insured's death, the insurer requires acceptable proof of death before it pays the claim. The normal minimum proof required is a death certificate and the insurer's claim form completed, signed (and typically notarized).[citation needed] If the insured's death is suspicious and the policy amount is large, the insurer may investigate the circumstances surrounding the death before deciding whether it has an obligation to pay the claim.
Proceeds from the policy may be paid as a lump sum or as an annuity, which is paid over time in regular recurring payments for either a specified period or for a beneficiary's lifetime.[citation needed]
Insurance vs. assurance
Outside the United States, the specific uses of the terms "insurance" and "assurance" are sometimes confused. In general, in these jurisdictions "insurance" refers to providing cover for an event that might happen, while "assurance" is the provision of cover for an event that is certain to happen. However, in the United States both forms of coverage are called "insurance".
When a person insures the contents of their home they do so because of events that might happen (fire, theft, flood, etc.) They hope their home will never be burglarized, or burn down, but they want to ensure that they are financially protected if the worst happens. This example of insurance shows how it is a way of spending a little money to protect against the risk of having to spend a lot of money.
When a person insures their life they do so knowing that one day they will die. Therefore a policy that covers death is assured to make a payment. The policy offers assurance on death; even if the policy has a prescribed termination date the policy is still assured to pay on death and therefore is an assurance policy. Examples include Term Assurance and Whole Life Assurance. An accidental death policy is not assured to pay on death as the life insured may not die through an accident, therefore it is an insurance policy.
A policy might also be assured for other reasons. For example an endowment policy is designed to provide a lump sum on maturity. Under certain types of policy the lump sum is guaranteed. Therefore, this may also be called an assurance policy.
The test of whether a policy is assurance or insurance is that with an assurance policy the insured event will definitely occur (at some point) whereas with an insurance policy there is a risk the insured event might occur.
With regard to Whole Life policies, the question is not whether the insured event (in this case death) will occur, but simply when. If the policy has nonforfeiture values (or cash values) then the policy is assured to pay.
During recent years, the distinction between the two terms has become largely blurred. This is principally due to many companies offering both types of policy, and rather than refer to themselves using both insurance and assurance titles, they instead use just one.
Types of life insurance
Life insurance may be divided into two basic classes – temporary and permanent or following subclasses - term, universal, whole life, variable, variable universal and endowment life insurance.
Temporary (Term)
Term life insurance or 'term assurance' provides for life insurance coverage for a specified term of years for a specified premium. The policy does not accumulate cash value. Term is generally considered "pure" insurance, where the premium buys protection in the event of death and nothing else. (See Theory of Decreasing Responsibility and buy term and invest the difference.)
The three key factors to be considered in term insurance are: face amount (protection or death benefit), premium to be paid (cost to the insured), and length of coverage (term).
Various (U.S.) insurance companies sell term insurance with many different combinations of these three parameters. The face amount can remain constant or decline. The term can be for one or more years. The premium can remain level or increase. A common type of term is called annual renewable term. It is a one year policy but the insurance company guarantees it will issue a policy of equal or lesser amount without regard to the insurability of the insured and with a premium set for the insured's age at that time. Another common type of term insurance is mortgage insurance, which is usually a level premium, declining face value policy. The face amount is intended to equal the amount of the mortgage on the policy owner’s residence so the mortgage will be paid if the insured dies.
A policy holder insures his life for a specified term. If he dies before that specified term is up, his estate or named beneficiary(ies) receive(s) a payout. If he does not die before the term is up, he receives nothing. In the past these policies would almost always exclude suicide. However, after a number of court judgments against the industry, payouts do occur on death by suicide (presumably except for in the unlikely case that it can be shown that the suicide was just to benefit from the policy). Generally, if an insured person commits suicide within the first two policy years, the insurer will return the premiums paid. However, a death benefit will usually be paid if the suicide occurs after the two year period.
Permanent
Permanent life insurance is life insurance that remains in force (in-line) until the policy matures (pays out), unless the owner fails to pay the premium when due (the policy expires OR policies lapse). The policy cannot be canceled by the insurer for any reason except fraud in the application, and that cancellation must occur within a period of time defined by law (usually two years). Permanent insurance builds a cash value that reduces the amount at risk to the insurance company and thus the insurance expense over time. This means that a policy with a million dollars face value can be relatively inexpensive to a 70 year old because the actual amount of insurance purchased is much less than one million dollars. The owner can access the money in the cash value by withdrawing money, borrowing the cash value, or surrendering the policy and receiving the surrender value.
The three basic types of permanent insurance are whole life, universal life, and endowment.
Whole life coverage
Whole life insurance provides for a level premium, and a cash value table included in the policy guaranteed by the company. The primary advantages of whole life are guaranteed death benefits, guaranteed cash values, fixed and known annual premiums, and mortality and expense charges will not reduce the cash value shown in the policy. The primary disadvantages of whole life are premium inflexibility, and the internal rate of return in the policy may not be competitive with other savings alternatives. Riders are available that can allow one to increase the death benefit by paying additional premium. The death benefit can also be increased through the use of policy dividends. Dividends cannot be guaranteed and may be higher or lower than historical rates over time. Premiums are much higher than term insurance in the short-term, but cumulative premiums are roughly equal if policies are kept in force until average life expectancy.
Cash value can be accessed at any time through policy "loans". Since these loans decrease the death benefit if not paid back, payback is optional. Cash values are not paid to the beneficiary upon the death of the insured; the beneficiary receives the death benefit only. If the dividend option: Paid up additions is elected, dividend cash values will purchase additional death benefit which will increase the death benefit of the policy to the named beneficiary.
Universal life coverage
Universal life insurance (UL) is a relatively new insurance product intended to provide permanent insurance coverage with greater flexibility in premium payment and the potential for a higher internal rate of return. A universal life policy includes a cash account. Premiums increase the cash account. Interest is paid within the policy (credited) on the account at a rate specified by the company. This rate has a guaranteed minimum but usually is higher than that minimum. Mortality charges and administrative costs are charged against (reduce) the cash account. The surrender value of the policy is the amount remaining in the cash account less applicable surrender charges, if any.
With all life insurance, there are basically two functions that make it work. There's a mortality function and a cash function. The mortality function would be the classical notion of pooling risk where the premiums paid by everybody else would cover the death benefit for the one or two who will die for a given period of time. The cash function inherent in all life insurance says that if a person is to reach age 95 to 100 (the age varies depending on state and company), then the policy matures and endows the face value of the policy.
Actuarially, it is reasoned that out of a group of 1000 people, if even 10 of them live to age 95, then the mortality function alone will not be able to cover the cash function. So in order to cover the cash function, a minimum rate of investment return on the premiums will be required in the event that a policy matures.
Universal life policies guarantee, to some extent, the death proceeds, but not the cash function - thus the flexible premiums and interest returns. If interest rates are high, then the investment returns help reduce premiums. If interest rates are low, then the customer would have to pay additional premiums in order to keep the policy in force. When interest rates are above the minimum required, then the customer has the flexibility to pay less as investment returns cover the remainder to keep the policy in force.
The universal life policy addresses the perceived disadvantages of whole life. Premiums are flexible. The internal rate of return is usually higher because it moves with the financial markets. Mortality costs and administrative charges are known. And cash value may be considered more easily attainable because the owner can discontinue premiums if the cash value allows it. And universal life has a more flexible death benefit because the owner can select one of two death benefit options, Option A and Option B.
Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at age 95. Option B pays the face amount plus the cash value, as it's designed to increase the net death benefit as cash values accumulate. Option B does carry with it a caveat. This caveat is that in order for the policy to keep its tax favored life insurance status, it must stay within a corridor specified by state and federal laws that prevent abuses such as attaching a million dollars in cash value to a two dollar insurance policy. The interesting part about this corridor is that for those people who can make it to age 95-100, this corridor requirement goes away and your cash value can equal exactly the face amount of insurance. If this corridor is ever violated, then the universal life policy will be treated as, and in effect turn into, a Modified Endowment Contract (or more commonly referred to as a MEC).
But universal life has its own disadvantages which stem primarily from this flexibility. The policy lacks the fundamental guarantee that the policy will be in force unless sufficient premiums have been paid and cash values are not guaranteed.
Universal life policies are sometimes erroneously referred to as self-sustaining policies. In the 1980s, when interest rates were high, the cash value accumulated at a more accelerated rate, and universal life coverage was often sold by agents as a policy that could be self-paying. Many policies did sustain themselves for a prolonged period, but the combination of lower interest rates and an increasing cost of insurance as the insured ages meant that for many policies, the cash option was diminished or depleted.
Variable universal life Insurance (VUL) is not the same as universal life, even though they both have cash values attached to them. These differences are in how the cash accounts are managed. The cash account within a VUL is held in the insurer's "separate account" (generally in mutual funds, managed by a fund manager).
Limited-pay
Another type of permanent insurance is Limited-pay life insurance, in which all the premiums are paid over a specified period after which no additional premiums are due to keep the policy in force. Common limited pay periods include 10-year, 20-year, and paid-up at age 65.
Endowments
Main article: Endowment policy
Endowments are policies in which the cash value built up inside the policy, equals the death benefit (face amount) at a certain age. The age this commences is known as the endowment age. Endowments are considerably more expensive (in terms of annual premiums) than either whole life or universal life because the premium paying period is shortened and the endowment date is earlier.
In the United States, the Technical Corrections Act of 1988 tightened the rules on tax shelters (creating modified endowments). These follow tax rules as annuities and IRAs do.
Endowment Insurance is paid out whether the insured lives or dies, after a specific period (e.g. 15 years) or a specific age (e.g. 65).
Accidental death
Accidental death is a limited life insurance that is designed to cover the insured when they pass away due to an accident. Accidents include anything from an injury, but do not typically cover any deaths resulting from health problems or suicide. Because they only cover accidents, these policies are much less expensive than other life insurances.
It is also very commonly offered as "accidental death and dismemberment insurance", also known as an AD&D policy. In an AD&D policy, benefits are available not only for accidental death, but also for loss of limbs or bodily functions such as sight and hearing, etc.
Accidental death and AD&D policies very rarely pay a benefit; either the cause of death is not covered, or the coverage is not maintained after the accident until death occurs. To be aware of what coverage they have, an insured should always review their policy for what it covers and what it excludes. Often, it does not cover an insured who puts themselves at risk in activities such as: parachuting, flying an airplane, professional sports, or involvement in a war (military or not). Also, some insurers will exclude death and injury caused by proximate causes due to (but not limited to) racing on wheels and mountaineering.
Accidental death benefits can also be added to a standard life insurance policy as a rider. If this rider is purchased, the policy will generally pay double the face amount if the insured dies due to an accident. This used to be commonly referred to as a double indemnity coverage. In some cases, some companies may even offer a triple indemnity cover.
Related life insurance products
Riders are modifications to the insurance policy added at the same time the policy is issued. These riders change the basic policy to provide some feature desired by the policy owner. A common rider is accidental death, which used to be commonly referred to as "double indemnity", which pays twice the amount of the policy face value if death results from accidental causes, as if both a full coverage policy and an accidental death policy were in effect on the insured. Another common rider is premium waiver, which waives future premiums if the insured becomes disabled.
Joint life insurance is either a term or permanent policy insuring two or more lives with the proceeds payable on the first death.
Survivorship life or second-to-die life is a whole life policy insuring two lives with the proceeds payable on the second (later) death.
Single premium whole life is a policy with only one premium which is payable at the time the policy is issued.
Modified whole life is a whole life policy that charges smaller premiums for a specified period of time after which the premiums increase for the remainder of the policy.
Group life insurance is term insurance covering a group of people, usually employees of a company or members of a union or association. Individual proof of insurability is not normally a consideration in the underwriting. Rather, the underwriter considers the size and turnover of the group, and the financial strength of the group. Contract provisions will attempt to exclude the possibility of adverse selection. Group life insurance often has a provision that a member exiting the group has the right to buy individual insurance coverage.
Senior and preneed products
Insurance companies have in recent years developed products to offer to niche markets, most notably targeting the senior market to address needs of an aging population. Many companies offer policies tailored to the needs of senior applicants. These are often low to moderate face value whole life insurance policies, to allow a senior citizen purchasing insurance at an older issue age an opportunity to buy affordable insurance. This may also be marketed as final expense insurance, and an agent or company may suggest (but not require) that the policy proceeds could be used for end-of-life expenses.
Preneed (or prepaid) insurance policies are whole life policies that, although available at any age, are usually offered to older applicants as well. This type of insurance is designed specifically to cover funeral expenses when the insured person dies. In many cases, the applicant signs a prefunded funeral arrangement with a funeral home at the time the policy is applied for. The death proceeds are then guaranteed to be directed first to the funeral services provider for payment of services rendered. Most contracts dictate that any excess proceeds will go either to the insured's estate or a designated beneficiary.
These products are sometimes assigned into a trust at the time of issue, or shortly after issue. The policies are irrevocably assigned to the trust, and the trust becomes the owner. Since a whole life policy has a cash value component, and a loan provision, it may be considered an asset; assigning the policy to a trust means that it can no longer be considered an asset for that individual. This can impact an individual's ability to qualify for Medicare or Medicaid.
Investment policies
With-profits policies
Main article: With-profits policy
Some policies allow the policyholder to participate in the profits of the insurance company these are with-profits policies. Other policies have no rights to participate in the profits of the company, these are non-profit policies.
With-profits policies are used as a form of collective investment to achieve capital growth. Other policies offer a guaranteed return not dependent on the company's underlying investment performance; these are often referred to as without-profit policies which may be construed as a misnomer.
Insurance/Investment Bonds
Main article: Insurance bond
Pensions
Pensions are a form of life assurance. However, whilst basic life assurance, permanent health insurance and non-pensions annuity business includes an amount of mortality or morbidity risk for the insurer, for pensions there is a longevity risk.
A pension fund will be built up throughout a person's working life. When the person retires, the pension will become in payment, and at some stage the pensioner will buy an annuity contract, which will guarantee a certain pay-out each month until death.
Annuities
Main article: annuity
An annuity is a contract with an insurance company whereby the purchaser pays an initial premium or premiums into a tax-deferred account, which pays out a sum at pre-determined intervals. There are two periods: the accumulation (when payments are paid into the account) and the annuitization (when the insurance company pays out). For example, a policy holder may pay £10,000, and in return receive £150 each month until he dies; or £1,000 for each of 14 years or death benefits if he dies before the full term of the annuity has elapsed. Tax penalties and insurance company surrender charges may apply to premature withdrawals (if indeed these are allowed; in most markets outside the U.S. the policy owner has no right to end the contract prematurely).
Tax and life insurance
Taxation of life insurance in the United States
Premiums paid by the policy owner are normally not deductible for federal and state income tax purposes.
Proceeds paid by the insurer upon death of the insured are not includible in taxable income for federal and state income tax purposes; however, if the proceeds are included in the "estate" of the deceased, it is likely they will be subject to federal and state estate and inheritance tax.
Cash value increases within the policy are not subject to income taxes unless certain events occur. For this reason, insurance policies can be a legal and legitimate tax shelter wherein savings can increase without taxation until the owner withdraws the money from the policy. On flexible-premium policies, large deposits of premium could cause the contract to be considered a "Modified Endowment Contract" by the IRS, which negates many of the tax advantages associated with life insurance. The insurance company, in most cases, will inform the policy owner of this danger before applying their premium.
Tax deferred benefit from a life insurance policy may be offset by its low return or high cost in some cases. This depends upon the insuring company, type of policy and other variables (mortality, market return, etc.). Also, other income tax saving vehicles (i.e. IRA, 401K or Roth IRA) appear to be better alternatives for value accumulation, at least for more sophisticated investors who can keep track of multiple financial vehicles. The combination of low-cost term life insurance and higher return tax-efficient retirement accounts can achieve better performance, assuming that the insurance itself is only needed for a limited amount of time.
The tax ramifications of life insurance are complex. The policy owner would be well advised to carefully consider them. As always, Congress or the state legislatures can change the tax laws at any time.
Subscribe to:
Posts (Atom)