Term & Universal Life
Chapter 1
Defining Life Insurance
Life insurance is a contract. The contract stipulates that for a financial payment (the premium) a specified party, the insurer, will pay another party, the insured’s beneficiary, a defined amount of money upon the occurrence of death. Having said that, there is much more to life insurance contracts than this simple statement indicates.
Life insurance is intended to protect those that would be financially affected by another’s death. If a husband is the primary wage-earner his wife and children would be financially affected by his death. Why? Because his earnings would stop. That is a fairly simple statement of why people purchase life insurance.
We often hear the statement that life insurance is actually "death insurance," but that is not really true. Life insurance insures one's life, not their death. It would be more accurate to say life insurance insures one's life against death. Even that is over simplified since there are many forms of life insurance and many goals that might be met with purchasing life insurance contracts. Even so, if one only wishes to insure against a premature death life insurance contracts are not difficult to understand and purchase.
Basic Concepts
Life insurance does not necessarily have to be complex but it does require some basic knowledge to be properly purchased and maintained. Simple questions must be answered such as “how much is enough?” and “how long will I need to keep this life insurance coverage?”
While it is not necessary to over-insure most people are more likely to under-insure their life or the life of the major family wage earner. Jack Hungelmann, author of Insurance for Dummies, states anything that would financially affect one’s life should be insured; it is important, he says, to insure any loss that would be more than the individual could afford to lose.[1] Obviously loss of major income is more than most families could afford to lose. Spending premium dollars to protect the life of the wage earner not only makes sense; it would be foolish not to insure such a potential loss.
What motivates an individual, man or woman, to buy life insurance? Agents often say life insurance is bought to bring “peace of mind” but there is really more to it than that. Certainly life insurance policies are bought because the individual does not want to lay awake at night worrying that his or her family would become destitute if he or she died, but life insurance might also be purchased as part of a financial planning strategy. We buy such policies because we love another, and we buy such policies to make sure practical life planning strategies are met.
Anyone who is wealthy enough to be able to continue providing care for those they love following their death without having life insurance probably doesn’t need to consider purchasing it, but few people are in that position. Most of us need each and every paycheck to meet our bills. If that paycheck stops our bills will not be paid.
Even those that do not earn a paycheck may need to purchase life insurance. This is often the case for young mothers who care for small children. In the event of her death, someone must still care for her children and see to their well-being while the wage earner is at work. Would the children’s father be able to handle both the responsibility of going to work each day and the responsibility of caring for small children? It is likely that he would need to hire an individual to provide childcare and perform other household duties.
Although many employers offer life insurance it is seldom adequate. It is important to be aware of any coverage in existence, but it is equally important to purchase additional coverage if:
1. The amount of employer-sponsored life insurance is not adequate, or
2. The worker is likely to change jobs in the next few years.
Most of us have no guarantee that the next employer will offer life insurance benefits. Since costs rise with increasing age it may make sense to purchase adequate life insurance benefits independently of any benefits supplied by an employer.
How Much is Enough?
There are multiple theories when it comes to determining appropriate quantities of life insurance. Perhaps the most often used is the “multiple of income” method. This method is used because it is simple and because it is usually effective in determining an appropriate amount of life insurance. While the quantity needed may vary from family to family, typically multiplying annual income by a quantity of five to eight will supply an amount to aim for.
For example: Ted earns $100,000 per year. Using the multiplication method, he would multiple his yearly $100,000 income by five, six, seven, or eight to determine how much coverage he should buy.
If Ted has other assets in addition to the amount of life insurance he plans to buy he may be able to multiply by five, purchasing $500,000 in life insurance. In theory this will provide his wife and children with at least five years to obtain schooling to acquire a job, or provide income until the remaining parent is able to move up in her job, earning more, which will enable her to meet their financial needs from that point on.
If Ted’s wife and children are young and there are not other financial assets available, Ted may need to multiply his yearly income by as much as eight (or more), purchasing $800,000 in insurance, to meet their coming life needs.
Does Ted wish to do more than merely meet the family’s bills? Does he wish to fund his children’s college education, for example? Is the home new with a very large mortgage? Is the home old and likely to need future remodeling? Had Ted lived, would his income have significantly risen in the next five years? Would the potential increase in income make a financial difference to his family? How much will inflation impact the family? Since many types of coverage, such as term life insurance is cheap (especially at younger ages) it is best to have more life insurance than too little.
It is harder to decide how much insurance a non-working spouse should carry. Obviously the multiple of income method will not work. Few people know how much it would cost to fill the homemaker’s shoes. Will the surviving spouse be willing to do much of what she currently does (laundry, cleaning, and cooking) or will he prefer to hire it done? What are the ages of the children? Will they be in school part of the time or need full-time child care? Will the surviving spouse want to work fewer hours so he or she can be home with the children more? Would working fewer hours be possible if the mortgage is not paid off, for example?
Calculating Expenses
Part of understanding how much life insurance is required relates to current expenses. These debts may also be called immediate expenses. Most professionals recommend use of a worksheet similar to the type an individual fills out when requesting a loan at their local bank. The first part of the worksheet addresses all immediate expenses the family would face upon the death of the major wage earner. This would include federal and state estate taxes if they apply, probate costs, funeral expenses and uninsured medical costs associated with the death of the individual.
Everything that is owned becomes part of the estate. This would include a home, vacation property and other real estate, bank accounts, and any other assets. Property bequeathed to the spouse is not subject to federal estate tax.
Most people do not have to worry about federal estate taxes because the value of their estate is below the minimum taxation level. Federal law also allows the entire estate to be transferred to the spouse tax-free. Some states also allow estates to pass on to the spouse tax-free. As always, it is important that agents know the laws in their domicile state. It is usually best for the family to work with a tax specialist to minimize any possible taxation that would apply.
If the estate may face federal and state taxation it might be wise to exclude one’s life insurance proceeds from the estate values. This can be done by giving up several rights: (1) the right to change the beneficiary of the policy, (2) the right to borrow against the policy, or (3) the right to use it as collateral for a loan.
Probate is the legal process by which the state validates the will after the individual dies, pays remaining debts, and guarantees the will is carried out as directed by the testator. If all assets are transferred to the remaining spouse probate can often be delayed, sometimes for years, but going through probate usually makes more sense than delaying it. If special bequests were made probate proceedings will certainly be necessary even if the spouse inherits the bulk of the assets. Probate procedures will involve attorney fees, filing and administrative fees, and fees to the executor. Attorney fees will vary depending upon several factors, including the state of residence. Some states set maximum attorney fees based on the percentage of the estate’s value; others simply require attorney fees to be “reasonable.”
We hear many stories of probate dragging on for years, but most do not. A major reason probate may drag on has to do with one of two things: assets that are difficult to place a value on or heirs fighting over the estate or specific items within the estate. If there are assets that may be difficult to value they should be appraised by a competent and qualified expert when the will is first written. The appraisal should be placed with the will. It is no surprise that the Internal Revenue Service will place the asset’s value high while beneficiaries will place it low. This can lead to delays in settling the estate and it will also increase the cost of probate.
Every individual of legal age should have a will, but if there is not one there are still costs associated with settling the estate. Without a will, the state of residence will distribute assets according to the laws of that state, regardless of what the deceased may actually have desired.
It is difficult to estimate what a funeral will cost but it is probably safe to say it always costs more than the family expects. One can expect to pay around $10,000 as a general figure, especially if a funeral plot has not been previously purchased. In some areas a plot alone can cost $10,000.
If there are medical costs involved, even with health care insurance, there may be unpaid medical bills. While it is not possible to know how much they may be, it is best to have several thousand dollars as an estimate when figuring life insurance amounts. It is always best to have too many dollars on hand than not enough.
Consumer Reports Money Book recommends the following procedure to arrive at a necessary amount of life insurance:
1. Figure the monthly take-home pay (after taxes and other deductions) by multiplying the weekly (if paid weekly) take-home pay by 4.33 – the average number of weeks in a month.
2. Determine how much of the weekly take home pay the family needs to cover expenses, such as utilities, various insurance premiums, car payments, rent or mortgage, and gasoline. A general rule of practice is 75 percent of weekly take home, but some families live so close to the line that 98 percent may be more accurate.
3. Decide whether or not the wage earner wants to fund the entire mortgage. In other words, does the applicant wish to leave enough life insurance to pay off the mortgage entirely? Even if this is the case, the beneficiaries may decide to save the mortgage amount in an interest-bearing fund, continuing to make monthly payments. In this case, the beneficiary often elects to withdraw interest earnings from the funds each month and supplement any shortage with their own earnings. If the applicant wants to provide enough life insurance to pay off the mortgage, list the outstanding amount under repayment of debts on the worksheet.
4. Determine the amount of monthly income the family will have following the major wage earner’s death. This would include the surviving spouse’s take-home pay, Social Security benefits, and survivors’ benefits from a company sponsored pension plan.
5. Figure out the monthly shortfall by subtracting the total in step 4 from the total in step 2.
6. Multiply the monthly shortfall by 12 to arrive at a yearly figure.
7. Determine how many years survivors will need the yearly income that was determined in step 6. If the surviving spouse has never held a job with good earning potential, it may be necessary to also add in the cost of schooling. At some point the surviving spouse should become self-supporting so schooling may be necessary. Retirement funding must also be considered. If the surviving spouse never enters the job market there is not likely to be sufficient income in later life.
8. Multiply the number of years by the amount of annual income that will be necessary to survive comfortably – this represents the amount of insurance that should be purchased. Assume that insurance proceeds would be invested so some income would be generated by the interest earnings. However, it is possible that generated interest would only keep up with inflation. It is always best to supply too many life insurance dollars than not enough.
An Emergency Fund
Every family needs to have an emergency fund. This is true before buying life insurance to protect one’s family and also after death, when insurance has paid out proceeds. If an emergency fund does not currently exist, the life insurance applicant may want to add the amount to his projected insurance needs.
At one time it was thought that three months living expenses were adequate as an emergency fund. Professionals now suggest at least six months and preferably twelve months living expenses should be in an emergency fund. The job market is poor in many areas of the United States. If the current job is lost, an individual may not find a satisfactory job within three months.
Child-Care Expenses
When calculating expenses to replace a homemaker’s duties childcare is typically considered, but agents and applicants may fail to consider the same expense in connection to the major wage earner’s death. If the major wage earner should die, the wife is likely to enter the job market, which means she must pay childcare for young children. If both spouses already work childcare expenses will already be factored into their family expense chart, but if only one spouse is currently working it may need to be added when calculating life insurance needs.
The amount needed for childcare will depend upon the number of children in the household and their ages. Obviously, teenagers will not need a babysitter, but they may have other expenses that younger children will not have, such as braces or athletic activities. Very young children may experience higher childcare rates than school age children or children who are beyond the diaper stage.
Education Fund
College is becoming harder for families with two working parents to manage. A single parent is not likely to be able to manage such high expenses, especially if the child attends a university rather than a junior college. Many parents wish to include the costs of college in their life insurance equations. It is not easy to predict what college will cost ten or fifteen years down the road but we can be sure it will be higher than it is today. Start with today’s costs and then add approximately ten percent for an approximation of costs. It may not be on target but it will likely make any additional college costs manageable.
Debt Repayment
There are always debts. If they are paid, the surviving spouse will be relieved of financial stress. While paying off all debts may not ease the emotions associated with losing a spouse at least the bills will not add additional stress.
As previously mentioned, the mortgage may be covered by life insurance so there is no house payment for the surviving spouse. Only list the mortgage as an expense on worksheet if the applicant does not plan on paying it off with insurance proceeds. The worksheet is a tool to add up monthly bills, so if the mortgage is paid off it is no longer a monthly bill (although property taxes and insurance will continue to be an ongoing cost).
Credit card debt would be listed on the worksheet as would any expense that is paid monthly. Some people carry credit life insurance for such things as credit card debt but usually a life insurance policy is less expensive. It might be wiser to eliminate the credit life policy and put the debt under the life insurance contract.
Coming to a Conclusion
Add together the total needs as listed on the worksheet. Next address the assets that are available to the surviving spouse. This would include any income from jobs, current cash and savings, real estate equity, IRA and Keogh plans, employer savings plans, pension benefits, current life insurance policies and any asset that would continue to support the surviving spouse and children.
Do not add in assets that would not be cashed in. For example, if the house would not be sold do not add in its equity. Do not forget to include employer-provided life insurance coverage. While these policies are seldom adequate they may be free to the employee and should be considered as an asset.
Social Security Survivors’ Benefits are often a major source of income when the major wage earner dies. These benefits should be listed under the assets column when estimating life insurance needs.
The amount received from Social Security each month will depend on the earnings that were filed with the Social Security Administration through employers. There are several factors involved that will be considered when determining the amount of money received each month, including previous earnings, age at death, ages of the surviving family members, and spouse’s monthly income. A spouse that is under age 60 will receive income from Social Security only if there are small children involved. Payments will stop when the youngest child is 16 but may resume when the surviving spouse becomes 60 years old. If the spouse is disabled benefits may begin at age 50. A disabled child will continue receiving benefits past age 16; they will discontinue when the disability no longer exists.
Social Security benefits are no longer available while the child attends college, although children can receive Social Security benefits to age 18, unless they marry. These benefits are paid regardless of whether or not a parent is also receiving benefits on their behalf. While benefits to children typically cease at age 18, they can continue to age 19 if the child is still in high school. Children who were disabled prior to age 22 will receive Social Security benefits for as long as they remain disabled.
Once total expenses and total assets have been determined, subtract the assets from the expenses to determine the difference. This is the minimum amount of insurance that should be purchased. It is better to have too many insurance dollars than too little. The applicant should not be alarmed if it appears that much more insurance is needed than he or she initially expected. That is why term insurance is often the type chosen since it provides more insurance at lower rates than permanent policies.
Even after a figure is arrived at it is important to be flexible since life changes. Perhaps a child is born, a child is adopted, or a parent becomes disabled and dependent upon their son or daughter. Whatever the change, it is important to consider how it impacts the amount of life insurance purchased.
Insurance Companies Measure Risk
Every applicant represents a risk to the insurance company. Questions are asked on the application to help the insurer judge the risk involved. Sometimes a medical examination is also required. This might be as simple as a nurse coming to the applicant’s home for blood and urine samples or more complex if there is a higher potential risk involved.
Life insurance companies use actuaries to calculate the risk involved with issuing the policy. Mortality tables are used by the actuaries when determining the likelihood of the applicant dying prematurely. Besides the obvious attention to the applicant’s health status, the insurance company also looks at lifestyle with specific questions that might include:
· Does the applicant smoke or chew tobacco products?
· Does the applicant drink alcohol and, if so, how much and how often?
· Does the applicant have a regular exercise routine, such as walking or other type of activity?
· Is the applicant socially active (studies show people who interact regularly with others live longer)?
These are not the only lifestyle questions that may be asked but they demonstrate the types of questions that may be on an application. By looking at the characteristics shared by groups of people actuaries improve the accuracy of their predictions, which affects the benefits the insurance company is likely to pay.
Underwriters tally the information provided, adding points for unfavorable findings and subtracting points for favorable findings. The lower the applicant’s score, the better his or her rating will be. The final point score determines if the premium rate will be standard, substandard, or preferred. Those who pose the least risk will be the individuals who do not smoke or chew, are not overweight, and without a history of heart disease or other serious medical conditions. Not all life insurance companies offer a preferred premium rate for the very healthy individual, so it might be wise to search for a company that does offer lower rates for those who qualify. The vast majority of life insurance policies are issued at standard rates.
It is important to note that one insurer’s standard rate may cost more or less than another’s. Applicants and insurance producers should not assume that all companies charge the same rates.
The applicant has an obligation to tell the truth on their applications for insurance coverage and the writing agent has an obligation to disclose to the insurer all the information he or she received from the applicant. The agent should further disclose any indication that the applicant might not be disclosing their full medical history. For example, the agent sees an oxygen tank in the corner but the applicant does not mention needing oxygen. The agent should ask specifically if the applicant requires oxygen (this is true even if this question is also on the insurance application). In some states agents may not fill out the medical portion of the application on the applicant’s behalf; if this is the case it may be especially important to go over the questions with the applicant prior to the applicant completing the medical portion of the application. If the applicant lies or omits important medical information the insurance company can rescind the policy or deny a claim for the first two years following policy issuance.
What Type of Life Insurance is Appropriate?
There are different types of life insurance available. Many financial planners insist that only term life insurance should be purchased, but it really depends upon the goals of the insured. While term insurance certainly plays an important role in financial planning, especially for young adults who have limited resources, there are situations that call for other types of life insurance.
Once the amount of coverage necessary has been determined, the individual must decide upon the type of coverage they wish to purchase. There are two basic types of life insurance: permanent and term (although each category has subtypes).
Permanent insurance, as the name implies, covers the individual for their entire life; it is intended to be a permanent purchase. Upon death, benefits are paid and the policy ends.
Term insurance offers a predetermined “term” of coverage, such as one year, five years, ten years, or more. When the term ends, the coverage ends, although it may often be renewed at higher premium rates. Upon death, the policy also ends with payment of the death benefit.
Permanent insurance is typically used for a financial need that is continuous and often involves a goal beyond just death benefits. Often permanent insurance is used to supplement retirement income, for example. Term insurance is best suited to young adults that have not yet acquired a great deal financially. These consumers may be in the early years of marriage and child rearing, have a new mortgage, and multiple debts associated with establishing themselves in the community. They may be in the early stages of their career as well, when earning ability is relatively low. As time goes by their income will rise and their career will prosper but for now, they must have coverage that is effective but inexpensive.
What Will the Insurance Cost?
There are two parts to life insurance premiums: mortality cost and policy expense cost. The mortality cost is determined by the odds of the insured dying prematurely. Insurers are very good at determining the likelihood of premature death by gender, age, and occupation. Questions on the life insurance application directly relate to how the insurer determines their mortality tables.
Policy expense costs relates to the costs of conducting business, such as staff, underwriting expenses, and agent commissions. Each life insurance policyholder contributes a share to these expenses through the premium costs they pay. Mortality costs increase each year as the insured ages (and risk of dying increases). Policy expenses can, of course, go up too but they tend to remain fairly steady.
Permanent policies that have level premiums average out the cost over the length of the policy. This means that the insured is actually overpaying their premiums in the early years of the policy in order to keep premiums the same in the later years when premiums would normally be higher. The overpayment in the early years is set aside in a reserve the insurer calls cash value. If the policy is canceled the insured receives the premium overpayment (cash value) back. In the first years of the policy there is additional expense of such things as underwriting and agent commissions, so there is not much cash value available.
Term insurance never has a cash value even when the premiums are leveled, with the insured paying higher premiums in the early years to make up for underpayments in the last contract years. Therefore no refund is available if the insured cancels the policy. As a result, many professionals feel that level term premiums are not always a good idea, although if the insured knows he or she plans to hold the policy long-term, they may find better pricing over time in level term policies. If the insured is not sure he or she will hold the contract for an extended period of time, then it gives the potential of overpaying in the first years with no guarantee of return of the extra premium if the policy is discontinued. Term insurance is the least expensive form of life insurance and it may be best to simply pay rising costs each year in an annually renewable policy. Usually income rises with time, so even though the term insurance policy will experience increased premium costs, they will still be relatively inexpensive compared to other forms of cash value life insurance policies.
Term Insurance
Term life insurance does not build cash reserves. Term life insurance may be combined with other products, such as annuities or mutual fund accounts that do have cash reserves, but the actual term insurance contract has no cash reserves.
Under term insurance:
1. The insured must die before the term expires (the period of time during which the policy is effective) in order for the beneficiary to receive insurance benefits.
2. Upon the specified term’s expiration date the insurance ends. A new term may be started, however, depending upon the terms of the policy.
3. The cash outlay (premium) is relatively low, especially at younger ages. Costs do increase with acquired age.
Term life insurance has some variations based on the length of the insurance policy term, renewability options, price guarantees, and conversion options.
Even within the types of insurances, there can be sub-categories. Term insurance has basically four categories although there can be variations of each. The four types are:
1. Annual renewable term insurance, which is renewable each year regardless of the insured's health. The premium will be higher each year due to increased age.
2. Convertible term, which allows the insured to exchange the policy without evidence of insurability. The exchange often means converting to a whole life policy or an endowment type of policy.
3. Decreasing term, which is often called Mortgage Insurance. The death benefit decreases over a specified period of time although the premium usually remains level.
4. Level term insurance generally has both a level death benefit and level premium cost for the entire term of the policy.
Annual renewable term comes up for renewal each year, as the name implies. As the term expires each year, the insured purchases a new annual term policy, with a higher price since the insured is now a year older. As one ages, risk of early death becomes more likely so cost is higher (mortality expenses raise). Annual renewable term is renewed for twelve-month periods (annually).
Generally, annual renewable term is not underwritten each year; the insured merely has to pay another premium to renew the policy for an additional year. At some point, however, it is likely that this no longer becomes possible. Based on the contract language the policy will have a maximum renewal ability specified in the policy. While it may be as little as ten years, it could also be as long as age 100.
Renewability is not the only thing that may be guaranteed. Premium levels may be guaranteed for some specified period of time as well. It would be unlikely that premiums would be guaranteed until age 100, but they may be guaranteed for five or ten years. Changes in health will not affect term policy pricing. In many cases, term life policies have conversion ability, meaning the insured can elect to exchange their term life policy for a permanent life insurance policy. Many policyowners choose to do this when their health deteriorates, although that may not necessarily affect the term policy renewability. Policy conversion will not require underwriting since it is guaranteed in their term life policy. No underwriting means no health questions are asked at the time of conversion.
Some term life insurance policies will have a fixed-rate level term feature. As we know, this means the amount of premium paid stays the same over a specified time period. The price may be locked in for as few as five years or as long as 30 years. Statistically, policyowners keep level term policies longer than annually renewable contracts so it is good for insurance companies to promote fixed-rate level term policies. Underwriting is expensive so it is not surprising that insurers want issued policies to stay on the books. Because insurers know the policies are more likely to stay active, competition often brings about pricing advantages that are not available with annual renewable term contracts.
Level term insurance policies are typically convertible to permanent insurance contracts without evidence of insurability. In other words, the insured will not have to prove their health status at the time of conversion because there will not be any underwriting for the new policy. Some policies may only have conversion privileges for a specified time period, such as ten or twenty years from when the policy is first issued. For example, if the level term policy allows conversion only within the first ten years of the policy, once that time period has passed, the insured would have to successfully complete underwriting requirements in order to convert over to a permanent life insurance policy. Since health conditions are more likely to develop with age, an individual who feels they may want permanent insurance would be wise to convert during the period of time when underwriting is not a concern.
Most professionals feel it is vital that the term policy have the option of converting to permanent insurance regardless of current health status. Since term contracts often have a maximum guarantee for renewability there may be a point when the term policy cannot be renewed without evidence of insurability. Having a conversion option offers protection that can prove important if a health situation develops. No one can predict the future; it just makes sense to cover all possibilities.
Reentry renewable level term policies offer the lowest term rates, but there is a reason for that: renewal each policy term is priced based on current health status. In other words, the reentry annually renewable term policy continues to be low priced only if the insured remains healthy. If the insured’s health status declines, his or her renewal rates climb higher and quicker than any other type of term policy upon reentry to a new policy term. Only if the individual can reenter and reapply as very healthy do their rates remain at preferred levels (low). Insurance companies are not required to offer the lowest rates on reentry renewable level term contracts so the insured must continually shop the competition. To emphasize this vital point: rates on reentry renewable level term is very low for the healthy individual but potentially the most expensive in the marketplace if the insured is no longer in good health.
Reentry renewable level term policies should always have a conversion clause so that the insured can change to permanent insurance if his or her health declines. If coverage continues to be necessary, converting to permanent insurance may be the best option when illness occurs under the reentry renewable level term policy.
While it may seem that reentry level term insurance is never a good choice that is not really true. There are reasons that such insurance is a good choice. For example, a young family that needs a large amount of insurance but that has few dollars available would do well to purchase reentry level term insurance, but they should make sure it is renewable for at least five years (longer for some situations). Also be sure that there is the option to convert to a permanent life insurance policy. We cannot say it often enough: no person knows what the future may bring. If health status changes dramatically having a conversion option can mean the difference between leaving beneficiaries sufficiently supported or in poverty upon the death of the insured.
If there is the choice between reentry level turn and traditional non-reentry term insurance select the non-reentry term. It is worth a little more money to keep preferred rates without having to qualify each time policy renewal comes around.
In all cases, agents should stay with financially high-rated companies. If A.M. Best is the standard being used, the companies should have an A rating or better. Represent only guaranteed renewable and convertible term products if possible. Although your clients may not realize it, you are doing them a favor by making sure they can renew their coverage and convert to a permanent contract if their health situation takes a turn for the worse.
Decreasing term insurance is a type that most consumers are familiar with, especially if they have a home mortgage. Under decreasing term insurance the coverage decreases annually but the premium remains level for the duration of the specified period in the contract. There are two types of decreasing term insurance:
1. Level decreasing term, and
2. Mortgage decreasing term.
Level decreasing term insurance reduces coverage a flat amount each year. The amount of decrease is often stated as a percentage per year.
Mortgage decreasing term insurance reduces coverage to correspond to the mortgage payoff amount. In the first few years, the reduction in coverage will be small since most of the mortgage payment goes to interest, not principal. In the later years of the mortgage the decrease will be more dramatic, to match principal payoff. The actual reduction of coverage is tied to the mortgage interest rate and the length of the mortgage, such as twenty or thirty years.
In most cases, the premium doesn’t change during the duration of the insurance term chosen. It is important to realize that near the end of the insured term there is very little insurance actually in place. The amount of coverage has steadily decreased along with the amount of money owed on the insured home. Seldom are these types of policies renewable either. If health conditions have developed, these policies are not designed to protect beneficiaries from an early death; they are merely designed to protect the mortgage. In many cases, the rates for mortgage decreasing term are not competitive when compared to other types of term insurance. It may be better to purchase a different type of term policy, with the intent of using it to pay off any mortgage balance. Only if such insurance is court ordered (as may happen in a divorce) should anyone buy a level decreasing term insurance policy. There are simply better options available.
When a person has a mortgage, the mortgage-holder may offer mortgage level term coverage. The premium rates are seldom good. Most people can do better in the open market unless their health is very poor or they have health factors that would eliminate their eligibility for other life insurance policies. It is important to remember that mortgage companies usually list themselves as the beneficiary of the policy. If the insured dies the policy pays off the house (making the mortgage company the beneficiary); family members will receive nothing in most cases.
Many policies offered through mortgage companies, banks, and other institutions cover only accidental deaths. Since even young people are more likely to die from natural causes, accidental death policies are seldom a good choice. No matter how inexpensive the policy is accidental death plans are not likely to be a wise buy.
Permanent Insurance
Permanent Insurance is coverage designed to last throughout the lifetime of the policyowner. Although permanent insurance, such as universal life policies, are nearly always sold by an insurance agent, there are some types that may be purchased over the internet or through institutions, such as a bank. However, it is likely that an agent still is involved in some way, depending upon state requirements.
The role of the agent should not be taken lightly. Since permanent insurance is complex it is important that the selling agent be well versed in the products. Buying term insurance is relatively easy since there are no cash values and it is pure death protection; it is the least complex type of insurance. Permanent insurance, on the other hand, is complex. Using an agent to purchase any type of insurance, including term insurance, doesn’t cost the consumer any higher premiums, so individuals may as well utilize the expertise of an agent regardless of the type of coverage being purchased. A good agent will help determine the right amount of coverage and make suggestions that the average consumer is unlikely to consider. A professional agent can mean the difference between being vaguely insured and adequately insured. In addition, if the applicant has health issues an agent may be essential in finding a company that will accept the risk. Using an agent doesn’t necessarily mean meeting with an agent face-to-face since many companies utilize agents online or over the telephone with similar results. As long as the agent is able to adequately and professionally complete the transaction with the consumer’s needs and goals in mind, the end result is likely to be satisfactory.
There are many types of agents, from the career agent specializing in life insurance products to the guy who sells one or two policies a year as a sideline. Most professionals feel the full-time professional agent is the best avenue.
Unfortunately, insurance agents have been unfairly represented as individuals who take advantage of the average consumer. Most agents realize that their livelihood is based on referrals and therefore they strive to provide good efficient service to their clients. An experienced life insurance salesperson is an advantage for the consumer since the agent will steer them to the right products and help them maneuver through the vast amount of choices available in permanent life insurance options.
Some life insurance may be available through work but the rates are not always a good buy, especially if the worker is young. Group rates are priced on the medium of the group as a whole. If the workplace has a high percentage of older ages the cost may be higher than necessary. Additionally, since younger workers may change jobs it is important to know if the coverage ends when the job ends or if conversion to private insurance is possible.
Perhaps the largest failing of permanent insurance is purchasing less than necessary to keep premium costs down. While some life insurance may be better than none at all, being underinsured is not an advantage for the beneficiaries. If the individual cannot afford sufficient permanent insurance it should be subsidized with term insurance. Permanent insurance is more expensive than term insurance. Some consumers may want permanent insurance for the cash values they acquire but being under-insured is a major financial planning error. While there are valid reasons for buying permanent insurance, it should never be purchased unless sufficient death benefits exist in the policy. The primary reason for buying life insurance is to insure against premature death; if that goal is not met, then the reason for buying it has not been met either.
Surprisingly, many people buy multiple small life insurance policies rather than one with sufficient death benefits. This seldom makes sense from a cost perspective. Buying multiple smaller policies is typically more expensive than purchasing one comprehensive life insurance policy. It probably happens because each small policy does not seem very expensive so consumers impulse-buy rather than actually taking the time to analyze their needs and buy one good contract.
Many small inexpensive policies have a major flaw: they pay only for accidental deaths. Statistically even young adults are much more likely to die from natural causes, not accidents.
Many consumers would say they have not purchased multiple smaller policies when in fact they have. The reason they don’t realize it is simple: they weren’t purchased from agents. Maybe they have a policy through their credit cards, one with their credit union, another from their bank, and yet another from their mortgage company. Some of these may be free, but if they cost a dime, the coverage has been purchased. Many of these will be accidental death plans; definitely a waste of money. Policies that are “free” are nearly always accidental death plans. The money spent on these small policies could be banded together and used to purchase one adequate policy.
All insurance decreases one’s financial risks, even the policies that are never collected on (such as fire insurance on our homes). No one buys insurance because they know for certain that a loss would occur; they buy insurance because there is the possibility of loss. Life insurance is perhaps the one sure thing since all of us will eventually die. For any parent, life insurance should be one of their top priorities. Since no laws require the parent to protect their child in the same way companies and states require drivers to insure their cars or potential liability, life insurance can be overlooked when it is actually extremely important.
Those with sufficient cash flow (to afford the premiums) and who will need coverage for at least fifteen to twenty years will want to consider permanent cash value coverage, such as a universal life insurance policy. As an individual ages term insurance can become very expensive, making permanent life products seem more reasonably priced considering the cash value portion that will eventually be available.
A cash value policy is similar to a term policy with a built-in savings component. Many call this an investment, but the cash values should not be considered an investment since there are so many better ways to invest for the future. The accumulating cash is a savings component rather than an investment. This may seem like a minor distinction but it is important that consumers not consider cash value life insurance policies similar to mutual funds or annuities. Basically, a cash value policy is simply a convenient way to pay for a lifetime of term insurance coverage. In the year it is purchased it will cost much more than term insurance because overpayment is occurring in level priced policies. The early over-payments are used to defray the higher cost of coverage at older ages (later on in the policy) and reduce the amount of coverage needed; if cash values exist less coverage is then needed.
For example, Ted bought $100,000 in benefits in a permanent life insurance contract. Twenty years later there is $50,000 in cash values; if he still needs $100,000 available he can actually insure his life for just $50,000 at this point, relying on the cash values to make up the difference.
Cash values earn interest. The insured can take some or all of the accumulated dollars even if they terminate the insurance policy. Even if the policy is kept active, the insured can take a policy loan against the cash values. A loan will reduce the death benefit so this should not be done without due consideration of the impact a sudden death might have on the family’s financial situation if there is a reduced death benefit.
When a permanent policy is purchased certain levels of death benefits and cash values are guaranteed by the issuing company. The insurer usually projects higher levels of death benefits and cash values, but even if minimum levels are met, there are certain guarantees. While premiums are higher due to the cash values that accrue, if the insured will need the protection for many years, it is generally worth the added cost. Those who want or need coverage for their entire life most certainly would want to purchase cash value products rather than term insurance.
We sometimes hear that it is better to “buy term insurance and invest the difference” in premium, but this is seldom practical, unless it is for a short-term need and even then it is unlikely to happen. Why? Few people actually invest the difference. Over a long period of time, buying term and investing the difference may not even be prudent. If the policy will be held for 20 or 30 years or more, buying cash-value insurance is usually a better deal than term due to the rising cost of insurance as the individual ages. Especially if the policy is allowed to lapse or surrendered, the cash values on a long-held policy will actually return the premiums that have been paid. The insured may end up with more cash upon surrendering a cash-value policy after a couple of decades that he or she would have paid for term insurance. Part of the reason for this is the income-tax advantages held by cash-value life insurance policies. The policy values are not taxed until the policy is surrendered and the cash values taken. They escape income taxation entirely if the policy is held until death.
The largest disadvantage to a cash value policy is the tendency by those who buy them to purchase a too low death benefit. Because the cost is higher than term insurance, people often reduce the amount of protection they purchase to bring the premiums to the level they desire. Maybe they intend to eventually purchase larger death benefits; maybe they just don’t really believe they will die prematurely. Whatever the reason buying too little life insurance is a big financial planning mistake.
Permanent insurance has several characteristics:
1. The premium remains level throughout the policy's lifetime.
2. The contract builds up cash reserves in the early years, which allows the company to maintain level premiums even though the insured becomes older which would normally trigger higher premiums. These reserves also bring about a "cash value" that may be borrowed by the policyholder or may be taken as surrender proceeds if the policy is canceled.
3. A whole life contract, by definition, can be kept at the same premium level for the lifetime of the insured.
There are several types of permanent insurance. Whole life is the old standard and is still sold by many agents. It has the highest annual charges but also the strongest guarantees for the buyer. For those who want flexibility, however, it is hard to overlook the universal life insurance policy.
Universal Life Insurance Policies
Many consumers are aware of the term "universal life," but have only a vague idea of what it actually is. A universal life insurance policy is a life insurance policy in which the investment, expense and mortality elements are separately and specifically defined. The policy-owner selects a specified death benefit, which typically remains level. The death benefit may, however, be one that increases over time, coinciding with the increased cash value of the policy (death benefit Option II), or, alternatively, the death benefit can remain level regardless of the underlying value changes (death benefit Option I). A "load" is deducted by the insurance company from the premium amount paid by the policyholder for defined insurer expenses. The premium remaining is then credited towards the contract owner's policy cash values. Mortality charges are next deducted. Interest earned on the remaining cash is credited at whatever percentage current rates happen to be. Since specific policy details do vary from company to company, variations will occur. Increased expenses or "loads" and/or increased mortality rates will also result in lower cash values. Just like annuities, there is usually a minimum contractual guarantee on the interest rate earned; typically around 4 or 4.5 percent. Mortality costs also generally have a guaranteed maximum premium charge for the pure cost of the death benefit. Most insurance companies do not charge that maximum rate, however. Typically, the rate actually charged is lower.
Many consumers assume there is a "standard" universal life insurance policy that is somewhat uniform from company to company. Actually, there is no such thing as a "standard" universal life policy. The level of premium paid, the amount of the death benefit, and the length of time over which premiums are paid are variable. While the first policy year may have a stated minimum premium due, following that first year, the contract owner may usually vary all factors: the premium amount, the payment date, and the frequency of the payments. These features are what make this type of policy favored by consumers. These features are sometimes called "stop-and-go features" or options. The ability to discontinue payments and then resume them at a later date does not require reinstatement of the policy. As long as there are enough cash values within the policy to pay the required expenses and mortality rates, the policy will remain in force. The policy will terminate if the cash values are not adequate, although there is usually a grace period allowed of up to 60 days.
Universal life is similar to whole life in that it allows the insured to build up a cash value within their policy. While whole life does not typically disclose what the insured receives for their money, universal life does allow the insured to see what portion of the premiums went toward covering company expenses and how much was used for the insurance protection, and how much made up the savings component. Initially, universal life was fairly easy to understand, even for nonprofessionals. As time went by, however, many observed that universal life policies became more difficult to understand.
Universal Life Evolution
The product that led to universal life policies was adjustable life insurance. It was considered a major breakthrough in the need for consumer friendly life products. Adjustable life products were designed to accommodate life cycle changes in the insured’s life. The idea was somewhat like variable life insurance in that the policy was sold with the ability to change as the consumer’s needs changed. Instead of having the life insurance amount vary with the prospective increased earnings of an equity-based account, the policyholder made the choices on changing the policy amount, upward or downward. Whole life and term types of life insurance were combined with a wide flexibility as to when and how changes could be made. Consumers, however, probably considered the most important change to be the amount of premiums charged; the premiums could be changed as well as the insured values. This was accomplished by increasing or decreasing the length of the term coverage, or by reducing or lengthening the premium-paying period of the whole life coverage.
Policy amounts could be increased by several methods; two of them traditional in that they were already used in many other life insurance contracts (guaranteed purchase options and dividend options). The new feature was “cost-of-living” increases, by which the insured up to age 55 was permitted to buy additional life insurance every three years without proving insurability (no medical examination was required).
Around 1980, after less than five years of very modest sales in variable and adjustable life insurance products, universal life products made their appearance. Although some mistakenly thought universal life policies were a revolutionary change in life insurance products, they actually adapted traditional life insurance and annuity contracts. Lower costs could result primarily because cash values were credited with current interest rates that were variable, but anticipated to be higher than traditional long-term guaranteed rates. Flexibility was achieved by permitting changes in premium payments and death benefits, rather than being set as fixed amounts. In other words, universal life insurance aims at providing both protection and savings through the combination of yearly renewable term insurance and a flexible-premium annuity.
The actual beginning of the universal life insurance concept began much sooner than the much publicized appearance in 1979 of E.F. Hutton Life Insurance Company’s new universal life insurance product. Twenty years prior, actuaries discussed the general ideas of universal life; G. R. Dinney is credited with actually developing the earliest universal life product proposal in the 1960’s.[2]
Among the new designs was one with a group pension combining term insurance, a cash fund, and a deferred annuity. The most promising new design was a fundamental universal life insurance plan that could adapt individual contracts by applying an adaptation to the savings component. It was universal in the sense that many variations could be developed. James Anderson, in a paper titled “The Universal Life Insurance Policy” that was presented at the 7th Pacific Insurance Conference, popularized a specific universal life product proposal in 1975; by the early 1980s the rush to get such products to the marketplace was on. Several companies presented such products, including Transamerica, Life of Virginia, and Travelers.
How Do Universal Life Policies Compare to Traditional Plans?
The combination of traditional life insurance forms and annuities is not as simple as it might appear. The most important difference is the addition of cash values that build up in the life portion at variable interest rates (based on current interest rates) rather than in predetermined and guaranteed long-term cash values as one would see in whole life insurance contracts. Universal life policies have guaranteed interest rate minimums that were originally near 4% in the 1980s. Excess rates (the amount actually credited) were determined by money market rates or sometimes by external indexes that were usually stated in the contracts. Each year the insured paid a flexible premium, which was sometimes called a “contribution” since the amount was voluntary above certain specified minimums. After deducting expenses and a risk charge for the term insurance protection from the contribution, each month the insurer credited the remainder to the cash value of the contract.
Universal life policies are also different from traditional insurance in how the potential use of cash values is allowed. Traditional life insurance only permits full cash-value withdrawal when the policy is surrendered or allows loans up to the cash-value amount. The universal life insurance policy adds the option of partial withdrawals, sometimes with extra fees charged. These withdrawals are not considered loans, but they do reduce the policy’s face and cash values just as traditional policies do. The general purpose of the cash value buildup is not intended for sporadic emergency withdrawals at younger ages however, since these values are needed for paying the increasing cost of the term protection in the policy (term life costs more as the insured ages). Universal life does expect to see some withdrawals as the insured ages since one-time expenses might happen for various reasons, such as a child going to college or to fund a nursing home confinement for an elderly parent.
Another difference from traditional life products is the universal life insurance policy’s adjustable death benefits. Initially, policyholders will select one of two basic forms: the fixed face value or a face value that pays the face value purchased plus the accumulated cash values.
At any time following the initial selection the policyholder may decrease the face value to specified minimum amounts or he can increase it with evidence of insurability without rewriting the contract. It is important to note that insurability must be proven in order to increase the death benefit.
How do these differences apply to the general policyholder? They may make universal life insurance products advantageous, depending upon the insured’s personal situation, which always must be taken into account. As always, one of the most important considerations is adequate levels of life insurance. If the individual cannot afford the universal life policy’s premiums, he or she may need to remain with term insurance protection until universal life products become affordable. If the universal life product is affordable at sufficient insurance levels, the advantages include:
1. Flexibility in premiums, benefits, and withdrawals, and
2. Cash-value increases that reflect current interest earnings and mortality rates.
As with all insurance, there may also be disadvantages to purchasing universal life insurance products. Flexibility, while usually a good element, may also have a pitfall. Not all policyholders will use common sense when considering withdrawal of cash values. Those who understand how the policy best performs will only make changes when they are necessary by real needs or economic adversity. Universal life allows the insured to make even bad changes to their policies, so agents are likely to see some changes that appear foolish (and indeed are foolish). Too much flexibility is often a disadvantage since consumers do not exercise careful thought to the changes they have the ability to initiate. Part of preventing foolish choices is providing proper information and education regarding the universal life product they have purchased. Once provided, however, it is still the insured’s right to make any changes the contract allows.
Another possible disadvantage is a false sense of what the universal life product will produce in cash values. While there is a guaranteed rate specified in the policy, usually the amount actually credited is higher. In severe economic downturns the minimum guaranteed rate is a safety net; unlike stocks this product will not lose value. In most cases, the insurance policy will credit higher values than the guaranteed rate. However, no policyholder should believe that their policy will always pay rates high enough to be a substantial financial investment – it is life insurance, not an investment.
The insurance industry did actually experience agents selling universal life products with projected interest rates far higher than would actually be paid. Since the software supplied by insurance companies allowed the selling agent to enter any interest rate they wanted, some agents entered unrealistic figures selling products on the basis of unrealistic projections for future earnings. Most states took steps against those agents and hopefully this problem has primarily been solved. Interest rates, even properly projected rates, do not apply to the entire premium paid; they are calculated only on what is left after expenses and term insurance coverage is subtracted. As the insured ages, the amount it takes to buy the term coverage increases so the amount of remaining premium earning interest is reduced. The policy may refer to “gross rates of return” and “net rates of return” to reflect this important point.
When universal life contracts first appeared in the marketplace in the 1980s, interest rates were very high, encouraging this type of product development. Agents could present very favorable outlooks using universal life products that combined the advantages of cash-value life insurance with higher yields possible through the “invest-the-difference” philosophy. As interest rates came down it became more difficult to do that with most types of cash value life insurance products. Increased yields on money market funds, corporate and government bonds, and other types of investments during high interest periods hurt any type of cash value life product, encouraging a return to purchase of term policies. Products like universal life were the insurance industry’s answer to this problem.
Universal life is a trade name, not a specific policy type. Insurers may use various names for policies that meet the universal life definition. If the policy has similar characteristics it may be a universal life insurance policy, even though it has a different name. Universal life plans divide death protection and cash-value accumulations into separate components. This division distinguishes them from the traditional cash-value policy that is an indivisible contract with unified death protection and cash value accumulations. Universal life is able to guarantee more competitive rates of return from year to year than can traditional cash-value products. Flexibility is achieved by adjusting the amounts of savings and protection to meet the needs of the individual policyowner.
Flexibility can be very important to a policyowner. As we go through life there are times when we have more cash than other times. When children are young there may be emergencies that take all available cash, temporarily leaving no dollars for insurance premiums. Times of unemployment may also require premium payments to be skipped until the insured is able to return to work. Cash values will keep the policy active even though the insured cannot pay premiums during difficult financial times. As children grow, becoming financially independent, more premium dollars are probably available. As the cash-value fund grows in the policy it will eventually help supply retirement income.
All types of life events can affect a person’s ability to continue paying their premiums. Such things as divorce, deaths in the family, births, remarriages, and responsibilities relating to disabled children or parents, or any number of other events can affect the insureds ability to pay premiums on a regular basis. A universal life policy is able to keep the policy in force during difficult times by dipping into cash reserves to pay premiums that are due.
When universal life policies first emerged, there was some question as to whether or not they would receive the same tax-sheltered status traditional cash-value policies enjoyed. The Internal Revenue Service said yes, universal life did qualify for the same tax-sheltered status.
End of Chapter 1