Chapter 3-8 Life Insurance

Most people do not think of life insurance as an investment, but in reality that is exactly what it is.  Similar to an annuity, life insurance is a contract between a policy holder and an insurer in which monthly payments are made in exchange for a future lump sum payout.  Unlike annuities, however, which are purchased to provide contract holders with retirement income, life insurance is primarily purchased to provide policy holders with the peace of mind that their loved ones will be taken care of upon their ultimate demise.  Life insurance policies can be tailored to meet a variety of posthumous financial needs from simply covering death expenses to leaving survivors with a significant inheritance.   There are four important participants involved in the purchase and execution of a life insurance policy.

Consider the following chart that identifies the parties involved:

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In most cases the policy holder, insured, and payer are the same person.  For example, you buy a life insurance on yourself and pay for it.  However, this does not necessarily need to be the case.  A relatively common example of this would be a grandparent paying premiums on a child’s policy owned by the grandchild.  In this case the holder, insured, and payer are all different people.  The beneficiary can be anyone the owner wants it to be, except for the insured for obvious reasons.

There are a number of factors that go into determining the cost of a life insurance policy, primarily age, sex, and tobacco use.  These factors are all used to determine the overall risk that a person might die over the next 5, 10, 15, etc. number of years.  A 60 year old person is more likely to pass away over the next 10 years than a 30 year old person.  Similarly, a 60 year old woman is likely to live more years than a 60 year old man as life expectancy is higher for women than it is for men in the United States.  Finally, tobacco use in both men and women has major negative influences on life insurance policies as it is now common knowledge that tobacco use significantly reduces life expectancy.  Actuaries use statistical information such as mortality tables to determine the expected term of a policyholder and then structure premiums accordingly.

The following chart depicts a life table excerpt from 2006 that shows common ages for purchasing life insurance policies and the resulting life expectancy.  Where do you fall in this category and have you prepared accordingly?

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There are two main categories of life insurance policies- protection policies and investment policies.  Protection policies are designed to pay out a lump sum in the case of a specified event occurring.  This event is almost always the death of the policy holder although sometimes can be the contraction of a terminal or critical illness.  The most common form of protection policy is term life insurance.  Investment policies are designed with the growth of capital through regular or one-time premium payments in mind.  The most common forms of investment policies are whole and universal life insurance policies.

Term life insurance, the main form of protection policy, provides insurance for a specific number of years in exchange for a specific premium.  There are three considerations when purchasing term insurance- face amount, premium, and term.  The face amount is the amount of protection or death benefit that the policy will pay out upon maturity, the premium is the amount to be paid, or the cost to the insured, and the term is the length of coverage as defined in years.  Different insurance companies have different policies on how the three parameters interact so it is important to know exactly what you are signing up for before purchasing a policy.  Many companies offer policies in which the face amount and premiums are variable based on time to maturity.  The term of the policy is generally fixed in all cases.  Terms are commonly 5, 10, 15, 20, 25, 30, 35, and 40 years and often carry the option to restructure along the way or renew upon maturity.  One type of term insurance is the annual renewable policy, a one year policy in which the insurance company guarantees it will issue a new policy of equal or lesser value upon maturity without reevaluating the insurability of the policy holder.

Permanent life insurance, often known as investment life insurance, is life insurance that remains in effect until the policy matures.  The policy cannot be cancelled at any time for any reason unless it has been determined that the policy holder committed fraud during the application process.  The only way for a permanent life insurance policy to default is if the owner fails to make the premium payments.  Permanent life insurance builds cash value over time because premium payments are made all the way up to maturation.  For this reason premiums are lower the younger the policy holder is when he or she begins making them.  A policy with the same face value would be much more expensive for a 50 year old than a 35 year old.

The most common form of permanent life insurance is whole life insurance.  Whole life insurance policies provide for a guaranteed death benefit and cash value in exchange for a constant premium.  The cash value paid in through premiums can be accessed through policy loans at any time and thus allow the policy to act as a “rainy day” savings account.  However, these loans will reduce the death benefit if they are not paid off.

Another form of investment policy is universal life insurance.  Universal life insurance is a relatively new type of policy designed to provide greater flexibility in permanent life insurance.  These policies allow for variable premium payments and the potential to grow greater cash values.  Universal life insurance policies were created to address the common complaints with whole life insurance, namely the fixed nature of the premiums paid and death benefit received.  With universal life policies both of these amounts are flexible based on prevailing interest rates or the performance of the broad financial markets.

There are a number of taxation implications to be considered before purchasing any type of life insurance policy.  The first of these is that unlike some retirement plans, premium payments are made with after tax dollars.  Furthermore, these premium payments are not deductible on either a federal or state level.  The increasing cash value is sheltered from income taxes unless the accumulated premiums are withdrawn prematurely.  Finally, the proceeds paid upon maturity are not taxed as gross or investment income.  However proceeds are subject to federal and state inheritance and estate taxes if they are included in the estate of the policyholder.  The tax implications of life insurance policies can be quite complicated and thus require careful consideration.  Make sure you completely understand all of the taxes associated with any given life insurance policy and how it fits into your investment objectives before you purchase a policy.

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