Life Insurance

Life Insurance

Term Life Insurance

Term assurance provides life insurance coverage for a specified term. 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.

There are three key factors to be considered in term insurance:

1. Face amount (protection or death benefit),
2. Premium to be paid (cost to the insured), and
3. Length of coverage (term).

Various 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. Common types of term insurance include level, annual renewable and mortgage insurance.

Level term policy features a premium fixed for a period longer than a year. These terms are commonly 5, 10, 15, 20, 25, 30 and even 35 years. Level term is often used for long-term planning and asset management as premiums remain constant year to year, allowing for long-term budgeting. At the end of the term, some policies contain a renewal or conversion option. With guaranteed renewal, the insurance company guarantees it will issue a policy of an 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. Some companies however do not guarantee renewal, and require proof of insurability at the time of renewal. Renewal that requires proof of insurability often includes a conversion option that allows the insured to convert the term policy to a permanent one, possibly compelling the applicant to agree to higher premiums. Renewal and conversion options can be very important when selecting a policy.

Annual renewable term is a one-year policy, but the insurance company guarantees it will issue a policy of an equal or lesser amount regardless of the insurability of the applicant, and with a premium set for the applicant’s age at that time.

Another common type of term insurance is mortgage life insurance, which usually involves a level-premium, declining face value policy. The face amount is intended to equal the amount of the mortgage on the policy owner’s property, such that any outstanding amount on the applicant’s mortgage will be paid should the applicant die.

A policy holder insures his life for a specified term. If he dies before that specified term is up (with the exception of suicide), his estate or named beneficiary receives a payout. If he does not die before the term is up, he receives nothing. However, in some European countries (notably Serbia), insurance policy is such that the policy holder receives the amount he has insured himself to, or the amount he has paid to the insurance company in total. Suicide used to be excluded from all insurance policies. However, after a number of court judgements, many insurers began awarding payouts in the event of suicide (except for cases where it can be demonstrated that the insured committed suicide solely to access the policy payout). Generally, if an insured person commits suicide within the first two policy years, the insurer will simply return the premiums paid as a compromise. After this period, the full death benefit may be paid in the event of suicide.

Permanent Life Insurance

Permanent life insurance is life insurance that remains active until the policy matures, unless the owner fails to pay the premium when due. The policy cannot be cancelled by the insurer for any reason except fraudulent application, and any such cancellation must occur within a period of time defined by law (usually two years). A permanent insurance policy accumulates a cash value, reducing the risk to which the insurance company is exposed, and thus the insurance expense over time. This means that a policy with a million dollar face value can be relatively expensive to a 70-year-old. 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 four basic types of permanent insurance are whole life, universal life, limited pay and endowment.

Whole Life Insurance

Whole life insurance provides lifetime death benefit coverage for a level premium in most cases. Premiums are much higher than term insurance at younger ages, but as term insurance premiums rise with age at each renewal, the cumulative value of all premiums paid across a lifetime are roughly equal if policies are maintained until average life expectancy. Part of the insurance contract stipulates that the policyholder is entitled to a cash value reserve, which is part of the policy and guaranteed by the company. This cash value can be accessed at any time through policy loansand are received income tax free. Policy loans are available until the insured’s death. If there are any unpaid loans upon death, the insurer subtracts the loan amount from the death benefit and pays the remainder to the beneficiary named in the policy.

While the marketing divisions of some life insurance companies often explain whole life as a “death benefit with a savings component”, this distinction is artificial according to life insurance actuaries Albert E. Easton and Timothy F. Harris. The cash value reserve builds up against the death benefit of the policy and reduces the net amount at risk. The net amount at risk is the amount the insurer must pay to the beneficiary should the insured die before the policy has accumulated an amount equal to the death benefit. It is the difference between the current cash value amount and the total death benefit amount. Because of this relationship between the cash value and death benefit, it may be more accurate to describe the policy as a single, indivisible product, as no actual separation of the cash value and death benefit is possible. The insurer is actually setting aside money as a cash reserve to pay the future death benefit claim. This suggests that the cash value is technically part of the death benefit, which is “earned” as cash over time. The lack of separation between the cash value and death benefit also explains why insurers do not pay both the death benefit and the cash value to the beneficiary.

The advantages of whole life insurance are guaranteed death benefits, guaranteed cash values, fixed, predictable annual premiums and mortality and expense charges that will not reduce the cash value of the policy. The disadvantages of whole life are inflexibility of premiums and the fact that 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. One such rider is a paid-up additions rider.

The death benefit can also be increased through the use of policy dividends, though these dividends cannot be guaranteed and may be higher or lower than historical rates over time. According to internal documents from some life insurance companies, like Massachusetts Mutual, the internal rate of return and dividend payment realized by the policyholder is often a function of when the policyholder buys the policy and how long that policy remains in force. Dividends paid on a whole life policy can be utilized in many ways. First, if “paid-up additions” is elected, dividends will purchase additional death benefit which will increase the death benefit of the policy to the named beneficiary. Since this additional death benefit generates cash value, it also increases the cash value of the policy. Another alternative is to opt in for ‘reduced premiums’ on some policies. This reduces the owed premiums by the non-guaranteed dividends amount. A third option allows the owner to take the dividends as they are paid out (although some policies provide other/different/less options than these – it depends on the company for some cases). A final option is to invest the dividends in the insurance company’s general or separate account.

Universal Life Insurance

Universal life insurance (UL) is a relatively new insurance product, intended to combine permanent insurance coverage with greater flexibility in premium payment, along with the potential for greater growth of cash values. There are several types of universal life insurance policies which include interest sensitive (also known as “traditional fixed universal life insurance”), variable universal life (VUL), guaranteed death benefit, and equity indexed universal life insurance.

A universal life insurance policy includes a cash value. Premiums increase the cash values, but the cost of insurance (along with any other charges assessed by the insurance company) reduces cash values. However, with the exception of VUL, interest is paid at a rate specified by the company, further increasing cash values. With VUL, cash values will ebb and flow relative to the performance of the investment sub-accounts the policy owner has chosen. The surrender value of the policy is the amount payable to the policy owner after applicable surrender charges, if any.

Universal life insurance addresses the perceived disadvantages of whole life – namely that premiums and death benefit are fixed. With universal life, both the premiums and death benefit are flexible. Except with regards to guaranteed death benefit universal life, this flexibility comes with the disadvantage of reduced guarantees.

Depending on how interest is credited, the internal rate of return can be higher as it moves with prevailing interest rates (interest-sensitive) or the financial markets (equity indexed universal life and variable universal life). 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 this.

Flexible death benefit means the policy owner can choose to decrease the death benefit. The death benefit could also be increased by the policy owner, but that would typically require the insured to go through a new underwriting. Another feature of flexible death benefit is the ability to choose from option A or option B death benefits, and to change those options during the life of the insured. Option A is often referred to as a level death benefit. Generally speaking, the death benefit will remain level for the life of the insured and premiums are expected to be lower than policies with an Option B death benefit. Option B pays the face amount plus the cash value. If cash values grow over time, so would the death benefit which is payable to the insured’s beneficiaries. If cash values decline, the death benefit would also decline. Presumably, option B death benefit policies would require higher premiums than option A policies.

Limited-Pay Life Insurance

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 the policy in force. Common limited pay periods include 10-year, 20-year, and are paid out at the age of 65.

Endowments

Endowments are policies in which the cumulative cash value of the policy equals the death benefit at a certain age. The age at which this condition is reached 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 in the same manner as annuities and IRAs.

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).

  

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