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Life Insurance Protects the Ones You Love & Enriches Your Estate

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Introduction

Everyone should have life insurance.  The questions are:

  • How Much
  • What kind
  • For What Purpose

 This section will answer these questions as well as provide a general understanding of the way that life insurance works and the various options available.

Definition

Life insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money (the "benefits") upon the death of the insured person.  Depending on the contract, other events such as terminal illness or critical illness may also trigger payment.  The policy holder typically pays a premium, either regularly or as a lump sum.

The advantage for the policy owner is "peace of mind", in knowing that the death of the insured person will not result in financial hardship for loved ones and lenders.

Life insurance 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; common examples are claims relating to suicide, fraud, war, riot and civil commotion.

You can purchase life insurance for yourself or someone else.  If you purchase it for yourself, you are both the policy owner and the insured.  You would typically purchase life insurance for others besides yourself including your spouse and children, but you can also purchase a policy for someone else for which you have an “insurable interest” (such as a business partner).  The policy owner can change the beneficiary unless the policy has an irrevocable beneficiary designation, in which case the original beneficiary would need to agree.

Policy prices are determined by life insurance companies based on mortality tables.  Common factors considered in determining price include: age, gender, use of tobacco, health, and family history.  The health of the insured is often determined by a questionnaire and a brief physical exam conducted by a licensed medical professional.

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).

Types of Life Insurance

Life insurance may be divided into two basic classes: temporary and permanent:

  • Temporary (Term) Insurance – Provides life insurance coverage for a specified term.

  • Permanent Insurance – Provides life insurance that remains active until the policy matures.

I.  Term Insurance

Term assurance provides life insurance coverage (protection) for a fixed term of 5, 10, 15, 20, 25, 30, and even 35 years.  The policy also has a fixed face value (payout) amount, except for mortgage insurance, and does not accumulate cash value.  Mortgage life insurance usually has a declining face value.

Three factors are considered in term insurance:

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

Under term insurance, if the insured individual dies before the 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 ends, the insured and beneficiary receive nothing.

At the end of the term, the policy owner has the option of renewing the policy for an additional term (and at a higher premium).  Some term policies come with a “guaranteed renewal option” that has no insurability test.


Purpose, Amount & Type of Insurance Needed (Examples):

Purpose

Amount

Type

Provide income protection for spouse.  This is especially important if the partner who died had a substantial pension with no (or limited) spousal benefits.

Sufficient to provide at least 50% of the lost pension income.

Permanent Life Insurance (Preferably Universal Life Insurance)

Provide coverage to protect final years of employment (when salary is highest) or to assure ability to cover a significant future financial demand – e.g., college tuition for children.

Coverage for remaining earning years or for the amount of the future financial requirement.

Term Life Insurance or a Permanent Life Endowment

Pay off the mortgage on your home if the borrower dies.

Amount of mortgage principal

Term Life Insurance with declining face value

Pass an estate, or part of an estate, on to your heirs tax free.

Based on estate value and amount of disposable income available.

Term Life Insurance

Provide life insurance in retirement but don’t want to be saddled with the future expense of insurance premiums.  (This insurance is ideal for those who have the discretionary income to pay insurance premiums pre-retirement, but want to protect their retirement income.)

Sufficient to provide protection for the surviving spouse or to provide heirs with a portion of your estate.

Limited-Pay Life Insurance

Parents insuring their children.  Insurance is relatively inexpensive at that time due to the young age of the insured.  The paid-up policy can guarantee the child’s insurability, and the face value can be increased later in life.

Generally, $10,000 to $20,000 per child.

Limited-Pay Life Insurance


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II.  Permanent Life Insurance

Permanent life insurance is life insurance that remains active until the policy matures, unless the owner fails to pay the premiums when due.  A permanent insurance policy accumulates a cash value.  This characteristic:

  • Allows the policy owner to withdraw money from the cash value, borrow the cash value, or surrender the policy and receive the surrender value, and
  • Reduces the insurance company’s risk and expense over time.

The four basic types of permanent insurance are 1) whole life, 2) universal life, 3) limited-pay and 4) endowment.

1.  Whole Life Insurance

The simplest (traditional) form of permanent life insurance is whole life.  Whole life insurance provides lifetime death benefit coverage for a level premium in most cases.  The cash value of a whole life policy increases over time based on “excess” premiums plus earnings.  Cash value is calculated from insurance company charts based on the age of the insured and the number of years that the policy has been in effect.

This cash value can be accessed at any time until the insurer’s death through “policy loans” which are received income tax free.  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.

The advantages of whole life insurance are:

  • Guaranteed death benefits;
  • Guaranteed cash values;
  • Fixed, predictable annual premiums; and
  • No cash value reduction from mortality and expense charges. 

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.

2.  Universal Life Insurance

Universal life insurance (UL) is a relatively new insurance product that combines permanent insurance coverage with greater flexibility in premium payment, along with the potential for greater growth of cash value.

With universal life insurance, the cash value grows through the addition of insurance premium payments and investment income.  The policy’s cash value decreases as the insurance company subtracts (from the cash value) the cost of insurance, cost of insurance riders and sales/administrative expense.

Investment income is determined by the type of policy:

  • Interest Sensitive (Traditional Fixed Universal Life) – Income is based on the interest rate set by the insurance company.
  • Variable Universal Life (VUL) – Income is based on the performance of investment sub-accounts chosen by the policy owner.
  • Equity Indexed – Income is based on the upward movement of a stock market index.

Unlike whole life, universal life has a flexible death benefit (unless it is a guaranteed death benefit policy).  Flexible death benefit means the death benefit can change based on investment growth, or the policy owner’s decision to increase (with new underwriting) or decrease the death benefit.

The flexible premium feature allows:

  • A lump sum initial premium payment to be made to reduce future payment amounts.
  • The policy owner to discontinue paying premiums if there is sufficient cash value to cover the required payments.

Upon the death of the insured, the policy pays the death benefit exclusive of the cash value.  The surrender value of the policy is the amount of cash value payable to the policy owner after applicable surrender charges, if any.

3.  Limited-Pay Life Insurance

Limited-Pay life insurance is a type of permanent insurance in which all the premiums are paid over a specified period (e.g., 10-20 years) after which no additional premiums are due.  At policy maturity you have paid-up insurance for the rest of your life.

This policy has a death benefit that is guaranteed to stay level for as long as you own it even if you choose to keep it until age 100.  The face amount is usually paid out income tax free to the beneficiary of your choice.  It can be paid in one lump sum or in the form of a monthly income.

4.  Endowments

Endowments are permanent insurance policies in which the cumulative cash value of the policy equals the death benefit at a certain age (the endowment age).  You choose how much you want to save each month and when you want the policy to mature.  These policies provide a risk-free, guaranteed return on a guaranteed date, which make them appealing as college savings plans.

If you should die before the policy matures, your child will receive the payout as your death benefit, still providing them the anticipated money for college.  What's more, the payout isn't counted against your child's financial aid eligibility.

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 maturity date is earlier.

Summary

Based on the above, I’m sure that you see several areas where life insurance can play a significant role in your retirement and estate plans.  Below is a table showing examples of these.  Keep in mind that these represent only a few of the many ways of utilizing life insurance, and many other opportunities are possible.

As you relate these life insurance alternatives to your specific situation, keep in mind that one of the major advantages of life insurance is that death benefits are generally excluded from income tax to the beneficiary.  However, they are included as part of the estate of the deceased if the deceased was the owner of the policy at the time of death.

This inclusion as part of the estate may subject the benefit paid to estate taxes both at the federal and state levels.  Estate inclusion can be avoided if the owner of the life insurance policy is someone other than the deceased, however; this assignment must have occurred more than three years prior to the date of death, or the IRS will still consider the deceased as the policy owner for estate tax purposes.