What is Life Insurance
Life Insurance is a contract between an insurance policy holder and an insurer or assurer, where the insurer promises to pay a designated beneficiary a sum of money (the benefit) in exchange for a premium, upon the death of an insured person (often the policy holder). Depending on the contract, other events such as terminal illness or critical illness can also trigger payment. The policy holder typically pays a premium, either regularly or as one lump sum. Other expenses (such as funeral expenses) can also be included in the benefits.
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; common examples are 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, typically a lump sum payment, in the event of specified event. A common form of a protection policy 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 U.S.) are whole life, universal life, and variable life policies.
Types of Life Insurance
Term Life Insurance 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.
Term insurance is significantly less expensive than an equivalent permanent policy. Term allows individuals with limited income to provide sufficient coverage for their family. Purchasers of term insurance should be aware that premiums for new insurance beyond the policy term will be higher because of advanced age. Future insurance needs beyond the policy term may be provided for by saving to provide for increased term premiums or by decreasing insurance needs (by paying off debts or saving to provide for survivor needs).
There are three key factors to be considered in term insurance:
- Face amount (protection or death benefit),
- Premium to be paid (cost to the insured), and
- Length of coverage (term).
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. Level premium term can be purchased in 5, 10, 15, 20, 25, 30 or 35 year terms. The premium and death benefit stays level during these terms.
Businesses may also have legitimate and compelling needs, including funding of:
- Buy-sell agreements
- Death of key person
- Supplemental executive retirement plans (S.E.R.P.)
- Deferred compensation
While Term life may be suitable for Buy-Sell agreements and Key Person indemnification, cash value insurance is almost exclusively for Deferred Comp and S.E.R.P.'s.
Mortgage Protection Insurance insures a loan secured by real property and usually features a level premium amount for a declining policy face value because what is insured is the principal and interest outstanding on a mortgage that is constantly being reduced by mortgage payments. The face amount of the policy is always the amount of the principal and interest outstanding that are paid should the applicant die before the final installment is paid.
Whole Life insurance sometimes called "straight life" or "ordinary life," is a life insurance policy which is guaranteed to remain in force for the insured's entire lifetime, provided required premiums are paid, or to the maturity date. Premiums are fixed, based on the age of issue, and usually do not increase with age. The insured party normally pays premiums until death, except for limited pay policies which may be paid-up in 10 years, 20 years, or at age 65. Whole life insurance belongs to the cash value category of life insurance, which also includes universal life, variable life, and endowment policies. Individuals may find whole life attractive because it offers coverage for an indeterminate length of time. Cash values are an integral part of a whole life policy, and reflect the reserves necessary to assure payment of the guaranteed death benefit. Thus, "cash surrender" (and "loan") values arise from the policyholder's rights to quit the contract and reclaim a share of the reserve fund attributable to his policy.
Although life insurance is often sold with a view toward the "living benefits" (accumulated cash and dividend values), this feature is a byproduct of the level premium nature of the contract. The original intent was not to "sugar coat" the product; rather it is a necessary part of the design. However, prospective purchasers are often more motivated by the thought of being able to "count my money in the future." Policies purchased at younger ages will usually have guaranteed cash values greater than the sum of all premiums paid after a number of years. Sales tactics frequently appeal to this self-interest (sometimes called "the greed motive"). It is a reflection of human behavior that people are often more willing to talk about money for their own future than to discuss provisions for the family in case of premature death (the "fear motive"). On the other hand, many policies purchased due to selfish motives will become vital family resources later in a time of need.
The marketing of whole life (and other cash value policies) as a substitute for savings and investments is considered controversial in some circles. Sometimes the regulatory agencies forbid the use of the words "savings" or "investment" by sales people when describing life insurance, insisting that life insurance should only be for "protection" against the economic hazard of death.
When discontinuing a policy, according to Standard Non-forfeiture Law, a policyholder is entitled to receive his share of the reserves, or cash values, in one of three ways (1) Cash, (2) Reduced Paid-up Insurance, or (3) Extended term insurance.
It is the dominant choice for insuring so-called "permanent" insurance needs, including:
- Funeral expenses,
- Estate planning,
- Surviving spouse income, and
- Supplemental retirement income.
Individuals may find whole life less attractive, due to the relatively high premiums, for insuring:
- Large debts,
- Temporary needs, such as children's dependency years,
- Young families with large needs and limited income.
Universal Life Insurance (UL) is a relatively new insurance product, intended to combine permanent insurance coverage with greater flexibility in premium payments, along with the potential for greater growth of cash values. There are several types of universal life insurance policies, including interest- sensitive (also known as "traditional fixed universal life insurance"), variable universal life (VUL), guaranteed death benefit, and equity-indexed universal life insurance. Universal life insurance policies have cash values. Paid-in premiums increase their cash values; administrative and other costs reduce their cash values.
Universal life insurance addresses the perceived disadvantages of whole life – namely that premiums and death benefits are fixed. With universal life, both the premiums and death benefit are flexible. With the exception of guaranteed-death-benefit universal life policies, universal life policies trade their greater flexibility off for fewer guarantees.
"Flexible death benefit" means the policy owner can choose to decrease the death benefit. The death benefit can also be increased by the policy owner, usually requiring new underwriting. Another feature of flexible death benefit is the ability to choose option A or option B death benefits and to change those options over the course of the life of the insured. Option A is often referred to as a "level death benefit"; death benefits remain level for the life of the insured, and premiums are lower than policies with Option B death benefits, which pay the policy's cash value—i.e., a face amount plus earnings/interest. If the cash value grows over time, the death benefits do too. If the cash value declines, the death benefit also declines. Option B policies normally feature higher premiums than option A policies.