By Michael S. Jackson, CPA
Life insurance is usually not a particularly popular subject to discuss. Images of pushy salesmen waving the policy that “you absolutely must have” instantly come into your mind. However, if purchased wisely, life insurance can be used to meet many different needs of the policy holders.
Life insurance is unique. No investment or asset can provide the purchaser with such extraordinary leverage and the ability to create liquidity when, in many cases, it is most needed. A young professional looking to create an estate in order to replace future income lost to the family in the event of a premature death cannot make a better purchase. But not everyone falls into this category.
Obviously, most people purchase life insurance solely for the ultimate payout upon the death of the insured in order to provide for their dependents. However, life insurance can also be used to pay death taxes and estate settlement costs, to shift wealth from one generation to another or to benefit selected charities. Certain types of life insurance also have an investment feature in which funds accumulate while the policy is in place and may be used to pay future premiums. In a business context, life insurance can be used to fund all or a portion of a buy-sell agreement between partners or co-shareholders.
Life insurance policies are typically divided into two major types: term insurance and permanent insurance. From these two basic policies, the insurance industry has developed a number of products using the same essential principals.
Term Life Insurance
Term insurance is a policy which will pay a death benefit only if the insured dies during the term of the policy. Simply stated, term insurance is “pure insurance.” No benefits are paid if the insured lives beyond the term of the policy and there is no investment or cash value feature inherent in this type of policy. For this reason, term insurance policies will carry the lowest premiums in the earlier years of the policy. However, as an individual gets older, term insurance gets more expensive.
One of the biggest problems with term insurance is that once the policy expires, the individual will usually need to replace the insurance at a higher cost. For some individuals, insurability becomes an issue once a policy terminates if they are no longer in good health. As a result, insurance companies may offer “renewable” term policies. For a small additional premium, the insured is entitled to keep the policy in force at the end of the original term. Despite the fact that the insured is making a unilateral decision to extend the policy, evidence of good health is not required.
Some term insurance policies feature a convertibility option. At the request of the insured, the policy is changed from a straight term policy into a permanent whole life insurance policy. This feature will come at the cost of higher premiums than regular term life insurance and often expires after a certain number of years or once the insured reaches a predetermined age.
Permanent Life Insurance
The alternative to term life is a permanent life insurance policy. A permanent life insurance policy, often referred to as whole life insurance, is intended to provide protection throughout the life of the insured. In an effort to keep the premiums level while the policy is in place, the cost of a whole life policy is somewhat more expensive than for a term policy in the earlier years because, as the insured gets older, their mortality rate (risk of dying in the next year) increases.
One feature inherent in every whole life policy is a cash surrender value. In the earlier years of a whole life policy, a portion of the premium will exceed the real cost of the insurance. This excess is applied to a separately maintained account for the insured which will earn money just as any other investment. Without this cash surrender value, the insurance company would be unable to cover an insured for their entire life using a level premium since the cost to insure an individual naturally increase every year. The cash surrender value can then be used in the later years of the insured to maintain the policy at what is actually a lower cost than what they would otherwise pay with a term policy at that time. If the whole life insurance policy is cancelled for some reason, the cash value of the insurance policy is then paid to the insured.
As an offshoot of regular permanent life insurance policies, there is universal life insurance. A universal life insurance policy provides flexibility for the insured by allowing the individual to select the premium they would like to pay. The death benefit is then adjusted to match the premium payments based on current interest rates and mortality charges.
Another type of permanent life insurance is variable life insurance. This type of policy has grown in popularity due to the rapid rise in the stock market since the 1980s. Essentially, variable life insurance is a policy in which the insured has the ability to direct the investments of the cash surrender value to achieve potentially higher returns than could otherwise be realized. If the investments perform well, the death benefit will increase. On the other hand, poor returns on investments may decrease the death benefit, but not below a guaranteed minimum as stated in the policy.
Determining Your Need
There are a number of factors to consider when evaluating life insurance products. The most important of these factors is to determine the amount of insurance needed. The insurance need is usually the greatest when there are young children in the family, only one breadwinner, or there is not enough saved to support the survivors for any length of time. For example, a family with only one spouse working and two small children may face several obstacles if that spouse should die, e.g., funding education for the children and providing for the surviving spouse at a lifestyle to which they have grown accustomed.
The type and amount of insurance which is being considered must also be predicated on the affordability of the premiums. A policy which is too expensive to carry may result in an early termination. The insured would then need to reapply, usually at higher costs, and potentially subject him or herself to a physical examination to determine overall health.
At the same time, the duration of the need must be determined. If an individual knows that the need will exist for only the next 10 years or so, a different insurance policy is likely to be selected than if the need is expected to exist for “life”.
Evaluating the Policies
Term policies from different companies can usually be compared relatively easily. You are paying a certain amount for a defined death benefit for a specified number of years. As long as the features which are included in the policies are identical, a true premium comparison will provide you with the most cost efficient life insurance policy.
On the other hand, whole life policies which are exactly identical in premium, stated death benefits and other options could be substantially different in many other ways. Insurance companies must use certain assumptions, guarantees and projections in valuing their policies. These variables could greatly affect the cost and level of coverage for the policy and include:
• Surrender charges. The amount the company will charge if the policy is terminated.
• Cash value projections. Shows whether the cash value will be sufficient to keep the policy in force in later years. These projections are based upon a guaranteed rate of return and a projected (higher) rate of return. It is essential that these rates be reasonable.
• Policy loans. Do the illustrations use policy loans to fund premiums in some years?
• Dividends. Ensure that the dividends which the company is projecting are in line with what the company has typically paid in the past.
• Mortality assumptions. Each insurance company uses its own statistical analyses to determine the risk of an individual dying at a point in time while the policy is in place. For this reason, some insurance companies are willing to price their product differently than others by assuming a more aggressive mortality factor.
The insurance company and their stability should be considered in evaluating any policy. A life insurance company whose financial stability is in question may need to price policies below that of their competitors. Several independent companies provide life insurance company ratings. The most well known rating companies are A.M. Best Company, Moody’s Investors Service and Standard and Poor’s Corporation.
Above all else, ask questions. Many of the answers will not be spelled out for the insured and others may be subject to interpretation. Life insurance is a very complex product and, yet, is essential for many individuals in order to protect their loved ones or meet the other needs for which it is being purchased.
Michael S. Jackson, CPA, a principal with the Philadelphia based firm, Martin J. Satinsky & Associates, P.C., is a certified public accountant with special expertise in personal financial planning.