Life insurance
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Life insurance is a type of insurance. As in all insurance, the insured transfers a risk to the insurer, receiving a policy and paying a premium in exchange. The risk assumed by the insurer is the risk of death of the insured.
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How Life Insurance Works
There are three parties in a life insurance transaction: the insurer, the insured, and the owner of the policy, although the owner and the insured are often the same person. For example, if John Smith buys a policy on his own life, he is both the owner and the insured. But if Mary Smith, his wife, buys a policy on John’s life, she is the owner and he is the insured.
Another important person involved is the beneficiary. The beneficiary is the person or persons who will receive the policy proceeds upon the death of the insured. The beneficiary is not a party to the policy, but is designated by the owner, who may change the beneficiary unless the policy has an irrevocable beneficiary designation. With an irrevocable beneficiary, that beneficiary must agree to changes in beneficiary, policy assignment, or borrowing of cash value.
The policy, like all insurance policies, is a legal contract specifying the terms and conditions of the risk assumed. Special provisions apply, including a suicide clause wherein the policy becomes null if the insured commits suicide within a specified time for the policy date (usually two years). Any misrepresentation by the owner or insured on the application is also grounds for nullification.
The face amount of the policy is normally the amount paid when the policy matures, although policies can provide for greater or lesser amounts. The policy matures when the insured dies or reaches a specified age. The most common reason to buy a life insurance policy is to protect the financial interests of the owner of the policy is the event of the insured’s demise. The insurance proceeds would pay for funeral and other death costs or be invested to provide income replacing the deceased’s wages. Other reasons include estate planning and retirement. Because the insured’s death will be to the financial betterment of the policy owner, the owner, by law, must have an insurable interest (i.e., a legitimate reason for insuring another person’s life.)
The insurer (i.e., life insurance company) prices the policies with an intent to recover claims to be paid and administrative costs, and to make a profit.
Claims to be paid are determined by actuaries using mortality tables. Actuaries are professionals who use actuarial science which is based in mathematics (primarily probability and statistics). Mortality tables are statistically based tables showing average life expectancies. Normally, the only three considerations in a mortality table are the insured’s age, gender, and whether or not they use tobacco.
The insurance company receives the premiums from the policy owner and invests them, using the time value of money and compound return principles to create a pool of money from which claims are paid. Therefore, rates charged for life insurance are sensitive to the insured’s age because the insurer will have less premium dollars to invest and less time to invest them for an older person.
Since adverse selection can have a negative impact on the financial results of the insurer, the insurer investigates each insured (unless the policy is below a company-established de minimis amount) beginning with the application, which becomes part of the policy.
This investigation and resulting evaluation of the risk is called underwriting. Health and life style questions are asked, answered, and dutifully recorded. Certain responses by the insured will be given further investigation. Life insurance companies support The Medical Information Bureau, which is a clearinghouse of medical information on all persons who have ever applied for life insurance. As part of the application, the insurer receives permission to obtain information from the insured’s physicians.
Life insurance companies are not required by law to underwrite coverage on anyone. They alone determine insurability, and some people, for their own health or lifestyle reasons, are uninsurable. The policy can be declined (turned down) or rated. Rating means increasing the premiums to provide for additional risks relative to that particular insured discovered in the underwriting process.
Upon the death of the insured, the insured will require acceptable proof of death before paying the claim. The normal minimum proof is a death certificate and the insurer’s claim form completed, signed, and often notarized. If the insured’s death was suspicious and the policy amount warrants it, the insurer may investigate until it is assured the policy should be paid.
Proceeds from the policy may be paid in a lump sum or paid over time as regular recurring payments for either for the life of a specified person or a specified time period.
Insurance vs. assurance
The world of finance is extremely complicated, and there are many factors to consider when choosing any financial protection product.
When looking for a policy you need to know what you are looking for and what is on offer in order that you get the right cover for your needs.
One thing that many people find confusing is the specific use of the term “insurance” and the use of “assurance”. What are the differences between them?
In general, the term 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.
For the purposes of financial provisions, a life insurance policy provides cover for a set period of time. If the worst were to happen during that time (and there are no complications), then the insurance company will be required to pay out the agreed sum to the beneficiary. The only time the policy has any real monetary value, is if there is a claim made for payment as a result of an event triggering that claim, such as the death of the person covered. If the person outlives the term of the policy, then the insurance policy will cease and no payment will be made.
Life assurance is different from insurance, and will always result in a payment. This is achieved by combining an investment element along with and an insured sum. This means that over time the value of the policy can increase as the investment bonuses are added. If the life covered were to die, then the insured sum would be paid out, along with the investment bonuses that have accrued over time. If it is necessary to cancel the policy prior to the end of any designated term period, or the death of the life being covered, then once an investment bonus has been added, the life assurance policy will have an encashment value. It is therefore possible to cash in a policy earlier than its usual termination date, in order to collect on the investment portion. It should be noted that many insurance companies place penalties for cashing in policies early.
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 the one.
“Most life insurance companies offer a wide range of insurance and investment services – for example pension, investment funds, investment bonds, car insurance, home & contents insurance, life assurance, and even loans. Sometimes a life insurance company will call itself a life assurance company but they mean one and the same.” (Reference: Richard Brown CEO of Moneynet, a UK financial information site.) Further information about life insurance in the UK (http://www.moneynet.co.uk/life-insurance-guide/index.shtml)
Types of Life Insurance
Life insurance may be divided into two basic classes – term and permanent.
Term
Term life insurance 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.
The three key factors to be considered in term insurance are: face amount (protection), premium to be paid (cost to the insured), and 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. 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.
Guaranteed renewability is an important policy feature for any prospective owner or insured to consider because it allows the insured to acquire life insurance even if they become uninsurable.
Permanent
Permanent life insurance is life insurance that remains in force 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 fraud in the application, and that cancellation must occur within a period of time defined by law (usually two years). Permanent insurance builds cash value, providing a type of savings account that the policy owner can access if needed either by borrowing against the policy or surrendering the policy and receiving the surrender value.
The three basic types of permanent insurance are whole life, universal life, and endowment.
Whole
Whole life insurance provides for a set face amount, 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, death benefit inflexibility, cash value accessibility is limited, and the internal rate of return in the policy may not be competitive in with other savings alternatives.
Universal
Universal life insurance 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.
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 pays the face amount at death and Option B pays the face amount plus the cash value.
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.
A type of universal life is called variable universal life in which the rate of return on the cash account is related to stock or bond market fluctuations.
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. The most common kind of limited pay is twenty-year limited pay. Another kind is paid-up when the insured is sixty-five.
Endowments
Endowments are policies which mature (endow) before the normal endowment age. Endowments are considerably more expensive (in terms of annual premiums) than either whole life or universal life because the premium paying period in shortened and the endowment date is earlier. Annuities are a financial product issued by life insurance companies but are not life insurance policies. They are discussed in annuities.
Accidental death
Accidental death is a limited life insurance that is designed to cover the insured if 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. These policies are much less expensive than other life insurances because they only cover accidents. 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). To be aware of what coverage they have, an insured should always review their policy for what it covers and what it excludes. It is also very commonly offered as a accidental death and dismemberment policy, 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 ever pay a benefit because either the cause of death is not covered, or the coverage is not maintained until death occurs.
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 includable in taxable income for federal and state income tax purposes but may be includable in the estate of the deceased and, therefore, subject to federal and state estate and inheritance (death) 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.
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.
Other
Riders are modifications to the insurance policy added at the same the policy is issued. These riders change the basic policy to provide some feature desired by the policy owner. A common rider is 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 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.