Life insurance is a contract between a life insurance company and a policy owner to insure the life of an individual. In many cases, the individual being insured is also the policy owner (though the insured individual doesn't have to be the policy owner - it could be the spouse, child, or even a business partner of the insured).
The life insurance policy pays a death benefit to a beneficiary who is named in the contract by the policy owner upon the death of the insured. In other words, when the person insured by the insurance contract dies, the contract terminates and the beneficiary gets the money stipulated in the insurance policy.
Life insurance was originally designed as a way to help pay for burial costs. However, today, life insurance is used for a wide variety of purposes both personal and business including insuring the life of business owners (to keep the business operating after the owner's death), key employees, supplemental retirement income, defined benefit plans, to protect an individual's pension benefits (i.e. "pension max"), and traditional income replacement (in the event of the death of either spouse).
Today's life insurance contracts also include suicide provisions to prevent insurance companies from having to pay claims on policies where the insured has committed suicide within the first two years of the policy. Insurance companies also require that there be an "insurable interest" between the policy owner and the insured (to help prevent a conflict of interest between the owner of a policy and the person being insured).
An "insurable interest" just means that the person buying insurance (the policy owner) has a personal and economic interest on the life of the person he is insuring. So, for example, you could buy insurance on the life of your spouse but not the life of some random stranger. You have a personal interest in the life of your spouse (presumably) but you don't have a personal or economic interest in the life of a stranger.
While not technically accurate, financial advisers and insurance agents tend to divide insurance contracts into two different "types": term insurance (temporary) and cash value insurance (permanent).
Term Life Insurance
Term insurance is temporary or "pure" insurance. The policy owner pays a defined amount of money for a specific amount of death benefit. When payments stop, the insurance ends. Term policies tend to be very inexpensive when the insured is very young, and are guaranteed to get more expensive as the insured becomes older. Due to expected mortality rates, term policies also tend to have a very low payout ratio which is estimated to be about 1 percent. In other words, only 1 percent of term policies every really pay a claim. For the most part, people simply outlive the term of the contract so the beneficiary never collects the death benefit.
A defining characteristic of term life is the fact that term policies only remain in force for a set number of years.
One-Year Renewable
This term contract gives you one year's worth of death benefit protection for a set premium which does not change for the entire year. That premium is just enough to cover one year's worth of insurance charges. At the end of the year, you must renew this policy. Upon renewal, your premium is guaranteed to increase since your risk of death increases with age.
Level Premium Term Policies
Level premium policies have the benefit of level premiums for an extended period of time. When you purchase the policy, you choose the number of years you want to keep the term insurance in force for. The insurance company collects an amount of money from you which exceeds the actual cost to provide death benefit protection. The excess premium collected is invested in the insurance company's general investment account. In the later years of the policy, this excess premium, plus investment interest, is used to hold down the rising cost of insurance thus keeping the premium level for the duration of the contract term.
Permanent Life Insurance
Permanent life insurance is sometimes known as "cash value insurance." These policies are often defined by insurance companies as "a death benefit with a savings component." This "savings component" is actually a cash reserve that is designed to grow in value until the reserve equals the death benefit.
Like level premium policies, the insurance company collects premium payments which are more than enough to pay for the cost of insurance. The excess premium is invested to hold down the future, rising, cost of insurance.
Unlike with level term policies, an insurer uses the excess premium to establish a cash value reserve associated with the policy. With each premium payment, the costs associated with mortality and other expenses are either guaranteed to decrease every year (i.e. whole life insurance), or are expected to decrease every year (i.e. universal life with a level death benefit option selected) .
A unique feature of cash value policies is that the cash value is allowed to grow income tax deferred. The money can then be withdrawn or a loan can be taken against the cash value if it is ever needed during your lifetime. The interest credited to a cash value policy is normally comparable to other competing savings instruments such as bonds, bank CDs, or high yield savings accounts. The major difference is that life insurance cash values grow tax deferred inside the policy and can be accessed on a tax-free basis unlike other savings options.
Whole Life
Whole life is the most basic form of permanent life insurance. Premiums are collected and invested in the insurer's general investment account. While not all of the investments in the general account are bonds, many of them are. Insurers attempt to diversify investment holdings so that policyholders can be guaranteed a minimum interest rate on policy cash values. This also ensures that the insurer meets its contractual obligation to provide for a cash value that equals the death benefit amount at the policyholder's age 100.
Whole life may pay excess interest through one of several methods. First, a whole life may credit dividends based on the policy's death benefit. Dividends may be used to increase the amount of death benefit, they may be paid out as cash, they may be invested with the insurer, or they may be used to pay premiums due on the policy.
Another method to credit excess interest to a whole life policy is to tie the cash value performance, in part, to current market interest rates. As these rates fluctuate, the whole life policy's cash value may be credited with more or less interest.
Finally, whole life may be credited with interest tied to the performance of a stock market index. The insurer may allow part or all of the premium to be invested either directly into the stock or into a proprietary equity-indexed strategy.
The direct investment in the market typically allows some of the premium to be invested in the insurer's separate account consisting of mutual funds. An equity-indexed strategy requires the insurer to take full control over the investment strategy. Policyholders are paid based only on the upward movement of a stock market index. All market losses are ignored. The insurer is able to do this by using a very precise mix of bonds and index call options.
Universal Life
Universal life consists of a one-year annual renewable policy and an investment account. The insurer collects deposits and allocates them to a cash value account. The company then subtracts all costs associated with the policy. Finally, the it credits interest to the cash value account based on one of several methods you select at the onset of the policy. If or when the policy's cash value account reaches $0, your policy terminates and you lose your life insurance.
Your investment choices for a universal life policy vary. In general, you may choose between an interest rate tied to current interest rates, investment returns derived from the insurer's separate account, or an equity-indexed investment strategy managed by the company.
Universal life is arguably the most complex insurance option on the market. This is because of the fact that the insurance company requires that you share the risk associated with the operation of the policy. The insurer provides a guaranteed minimum interest rate that it will pay to the policy. It also provides you with a guaranteed maximum insurance charge it will assess on the cash value account. However, these policies are designed to function optimally at interest rates above the minimum guaranteed rate and insurance charges which are lower than the guaranteed maximum.
You may change your premium payments, death benefit face amount, and death benefit schedule at any time. The premium payments may be increased, decreased, skipped or stopped altogether. As long as there is enough money in the cash value account to pay for insurance charges, then there are no "required" premiums.
You may change the face amount of insurance you purchase at any time. For example, you may elect $100,000 when you start the policy. However, if you decide you only want $75,000 later on in life, you may reduce your face amount to this level. You may also increase the face amount above the original face amount, but you'll often need to undergo additional health exams to ensure that you are still insurable.
Finally, the death benefit schedule options for universal life consist of a level death benefit and an increasing death benefit. A level death benefit means that your beneficiary receives just the death benefit amount when you die. The increasing death benefit option allows your beneficiaries to collect the death benefit plus the cash value that builds up over your lifetime.
The benefit of the level death benefit option is that the cost of insurance will decrease over time as the cash value builds up against the death benefit. The difference between the cash value and the death benefit, called the "net amount at risk" is decreasing, forcing the policy's costs lower over time (assuming all investment return and insurance charge projections are accurate). The benefit of the increasing death benefit option is that your beneficiary may receive far more than the face amount of insurance if the underlying investments of the policy perform well.
Variable Life
Variable life insurance works by allowing you invest some or all of your premiums into the insurance company's separate account. Premium payments are fixed, but there are no explicit guarantees on the performance of your policy. Your policy's death benefit and cash value is driven entirely by the underlying mutual fund investments. If your policy's cash value reaches $0, your policy terminates and you lose your life insurance.
A Word About Buying Life Insurance
The amount and type of life insurance you should buy really depends on several factors like age, health, and how many financial liabilities you have now versus how many you expect to have in the future.
You can try to use an online calculator, quoting software, or simply pick an arbitrary amount of life insurance that you "feel" is the right amount. However, risk with taking such a slap-dash approach is that you could be purchasing too much or too little insurance.
For example, such factors as personal financial goals, age, annual income, if you plan on retireing and if so when, total debt (including mortgage debt), number of children, your investment experience, your expected pension benefits, expected social security benefits, and so on must all be taken into account when purchasing life insurance. Even after all of this analyzing is done, the advice of a good financial professional can be invaluable in helping you figure out how to comfortably afford a new policy.
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References for this post:
Mittra, S., Anandi, S.P., & Crane, R.A. (2007). "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition". Holly, MI: Rochester Hills Publishing
Black, K. Jr., & Skipper, H.D. Jr. (1994). "Life Insurance". Englewood Cliffs, NJ: Prentice-Hall, Inc.
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_________________________This entry was posted on December 1st, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · 1 Comment · Insurance & Savings
Few people really understand the importance of Whole Life insurance as a part of their overall financial plan. This article is a plesant introduction without even mentioning the advantage W.L has for Disability, Liability, inflation, creditor protected, and income engineering. Good article, if more people understood the value of W.L in their plan they would be much better off.