Insurance designed to provide protection against financial hardship for dependents following the death of the insured person; also (especially in the UK) called life assurance. Whole life policies run for the whole of a person's life, accumulating a cash value which is paid when the policy matures (or is surrendered), but which is less than the policy's face value. Endowment policies run for a specified period of time, and pay the full face value when the policy matures. Term policies run for a specified number of years, but when the policy expires there is no cash sum remaining. Premiums may be at regular intervals or made in a lump sum. Policies may be for a fixed money amount or with profits, where the amount payable is related to the profits the life company has been able to make by investing the premium.
As in all insurance, the insured transfers a risk to the insurer. The insured pays a premium and receives a policy in exchange.
How life insurance works
Life insurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a sum of money upon the occurrence of the insured's death. In return, the policyowner (or policy payor) agrees to pay a stipulated amount called a premium at regular intervals.
Parties to contract
There are three parties in a life insurance transaction; the insurer, the insured, and the owner of the policy (policyholder), although the owner and the insured are often the same person. For example, if Qwanda buys a policy on his own life, he is both the owner and the insured. But if Wanda, his wife, buys a policy on Qwanda's life, she is the owner and he is the insured. The owner of the policy is called the grantee (he or she will be the person who will pay for the policy). 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.
Contract terms
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;
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 (typically, 95 years old). The most common reason to buy a life insurance policy is to protect the financial interests of the owner of the policy in the event of the insured's demise.
Costs, insurability, and underwriting
The insurer (the life insurance company) calculates the policy prices with an intent to recover claims to be paid and administrative costs, and to make a profit. The current mortality table being used by life insurance companies in the United States and their regulators was calculated during the 1980s. So in a group of one thousand 25 year old males with a $100,000 policy, a life insurance company would have to, at the minimum, collect $200 a year from each of the thousand people to cover the expected claims.
The insurance company receives the premiums from the policy owner and invests them to create a pool of money from which to pay claims, and finance the insurance company's operations. Contrary to popular belief, the majority of the money that insurance companies make comes directly from premiums paid, as money gained through investment of premiums will never, in even the most ideal market conditions, vest enough money per year to pay out claims. Rates charged for life insurance increase with the insured's age because, statistically, people are more likely to die as they get older.
Since adverse selection can have a negative impact on the financial results of the insurer, the insurer investigates each proposed insured (unless the policy is below a company-established minimum amount) beginning with the application, which becomes part of the policy. Life insurance companies in the United States support The Medical Information Bureau, which is a clearinghouse of medical information on all persons who have ever applied for life insurance.
Life insurance companies are never required by law to underwrite or to provide coverage on anyone.
Many companies use four general health categories for those evaluated for a life insurance policy. Profession, travel, and lifestyle also factor into not only which category the proposed insured falls, but also whether the proposed insured will be denied a policy.
Death proceeds
Upon the death of the insured, the insurer will require acceptable proof of death before paying the claim. If the insured's death was suspicious and the policy amount warrants it, the insurer may investigate the circumstances surrounding the death, before deciding whether there is a legal obligation to pay the claim.
Proceeds from the policy may be paid in a lump sum or as an annuity paid over time in regular recurring payments either for the life of a specified person or for a specified time period.
When a person insures their life they do so knowing that one day they will die. Therefore a policy that covers death is assured to make a payment. even if the policy has a prescribed termination date the policy is still assured to pay on death and therefore is an assurance policy. An accidental death policy is not assured to pay on death as the life insured may not die through an accident, therefore it is an insurance policy.
A policy might also be assured for other reasons.
The test of whether a policy is assurance or insurance is that with an assurance policy the insured event will definitely occur (at some point) whereas with an insurance policy there is a risk the insured event might occur. If the policy has nonforfeiture values (or cash values) then the policy is assured to pay. 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.
Types of life insurance
Life insurance may be divided into two basic classes – temporary and permanent.
Temporary
This type of insurance is characterized by its defined time period that is named when the contract is initially put into force.
Term
Term life insurance (term assurance in British English) provides for life insurance coverage for a specified term of years for a specified premium.
The three key factors to be considered in term insurance are: face amount (protection or death benefit), premium to be paid (cost to the insured), and length of coverage (term).
Various (U.S.) insurance companies sell term insurance with many different combinations of these three parameters. 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 (pays out), unless the owner fails to pay the premium when due (the policy expires). 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 a cash value that reduces the amount at risk to the insurance company and thus the insurance expense over time. This means that a policy with a million dollars face value can be relatively inexpensive to a 70 year old because the actual amount of insurance purchased is much less than one million dollars. The owner can access the money in the cash value by withdrawing money, borrowing the cash value, or surrendering the policy and receiving the surrender value.
The three basic types of permanent insurance are whole life, universal life, and endowment.
Whole life coverage
Whole life insurance provides for 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, and the internal rate of return in the policy may not be competitive with other savings alternatives. The death benefit can also be increased through the use of policy dividends. Premiums are much higher than term insurance in the short-term, but cumulative premiums are roughly eqt if policies are kept in force until average life expectancy. Cash value can be accessed at any time through policy "loans".
Universal life coverage
Universal life insurance (UL) 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. Interest is paid within the policy (credited) on the account at a rate specified by the company. The surrender value of the policy is the amount remaining in the cash account less applicable surrender charges, if any.
With all life insurance, there are basically two functions that make it work. The cash function inherent in all life insurance says that if a person is to reach age 95 to 100 (the age varies depending on state and company), then the policy matures and endows the face value of the policy. So in order to cover the cash function, a minimum rate of investment return on the premiums will be required in the event that a policy matures.
Universal life policies guarantees, to some extent, the death proceeds, but not the cash function - thus the flexible premiums and interest returns. If interest rates are low, then the customer would have to pay additional premiums in order to keep the policy in force. When interest rates are above the minimum required, then the customer has the flexibility to pay less as investment returns cover the remainder to keep the policy in force.
The universal life policy addresses the perceived disadvantages of whole life.
Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at age 95. This caveat is that in order for the policy to keep its tax favored life insurance status, it must stay within a corridor specified by state and federal laws that prevent abuses such as attaching a million dollars in cash value to a two dollar insurance policy. If this corridor is ever violated, then the universal life policy will be treated as, and in effect turn into, a Modified Endowment Contract (or more commonly referred to as a MEC). 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.
Universal life policies are sometimes erroneously referred to as self-sustaining policies. In the 1980s, when interest rates were high, the cash value accumulated at a more accelerated rate, and universal life coverage was often sold by agents as a policy that could be self-paying.
Variable universal life Insurance (VUL) is not the same as universal life, even though they both have cash values attached to them.
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.
Endowments
Endowments are policies which the cash value build up inside the policy, equals the death benefit (face amount) at a certain age. 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 endowment date is earlier.
Endowment Insurance is paid out whether the insured lives or dies, after a specific period (e.g.
Accidental death
Accidental death is a limited life insurance that is designed to cover the insured when they pass away due to an accident.
It is also very commonly offered as "accidental death and dismemberment insurance", also known as an AD&D policy. To be aware of what coverage they have, an insured should always review their policy for what it covers and what it excludes.
Accidental death benefits can also be added to a standard life insurance policy as a rider. If this rider is purchased, the policy will generally pay double the face amount if the insured dies due to an accident.
Related life insurance products
Riders are modifications to the insurance policy added at the same time the policy is issued. These riders change the basic policy to provide some feature desired by the policy owner. A common rider is accidental death, which used to be commonly referred to as "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.
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. Group life insurance often has a provision that a member exiting the group has the right to buy individual insurance coverage.
Senior and preneed products
Insurance companies have in recent years developed products to offer to niche markets, most notably targeting the senior market to address needs of an aging population. These are often low to moderate face value whole life insurance policies, to allow a senior citizen purchasing insurance at an older issue age an opportunity to buy affordable insurance.
Preneed (or prepaid) insurance policies are whole life policies that, although available at any age, are usually offered to older applicants as well. Since a whole life policy has a cash value component, and a loan provision, it may be considered an asset;
Tax and life insurance
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;
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.
Tax deferred benefit from a life insurance policy may be offset by its low return or high cost in some cases. This depends upon the insuring company, type of policy and other variables (mortality, market return, etc.).
The tax ramifications of life insurance are complex.
Taxation of life assurance in the United Kingdom
Premiums are not usually allowable against income tax or corporation tax, however qualifying policies issued prior to 14th March 1984 do still attract LAPR (Life Assurance Premium Relief) at 15% (with the net premium being collected from the policyholder).
Non-investment life policies do not normally attract either income tax or capital gains tax on claim. If the policy has as investment element such as an endowment policy, whole of life policy or an investment bond then the tax treatment is determined by the qualifying status of the policy.
Qualifying status is determined at the outset of the policy if the contract meets certain criteria.
Although this may seem complicated the taxation of life assurance based investment contracts is broadly deemed beneficial compared to alternative equity based collective investment schemes (unit trusts, investment trusts and OEICs). One feature which especially favours investment bonds is the ability to draw 5% of the original investment amount each policy year without being subject to any taxation on the amount withdrawn.
The proceeds of a life policy will be included in the estate for inheritance tax (IHT) purposes.
History of insurance
Insurance began as a way of reducing the risk of traders, as early as 5000 BC in China and 4500 BC in Babylon. Modern life insurance started in late 17th century England, originally as insurance for traders: merchants, ship owners and underwriters met to discuss deals at Lloyd's Coffee House, predecessor to the famous Lloyd's of London.
The first insurance company in the United States was formed in Charleston, South Carolina in 1732, but it provided only fire insurance.
Prior to the American Civil War, many insurance companies in the United States insured the lives of slaves for their owners. New York Life for example reported that Nautilus sold 485 slaveholder life insurance policies during a two-year period in the 1840s;
Criticism
Although aspects of the application process (such as underwriting and insurable interest provisions) make it difficult, life insurance policies have been used in cases of exploitation and fraud. In the case of life insurance, there is a motivation to purchase a life insurance policy, particularly if the face value is substantial, and then kill the insured.
User Comments Add a comment…