Why People Buy Life Insurance?
People who live in financially developed societies use insurance to help reduce the risk of suffering a financial loss. A common example is the purchase of auto insurance. Auto insurance policies provide liability coverage to protect us from financial loss if we are held liable for an accident as well as collision coverage to pay for repair to a damaged car and medical coverage to reimburse for the treatment of injuries. Life insurance is also a risk management tool, but a unique type. It is unique because its primary purpose is to create a pool of cash that is payable at the death of the insured person.
To meet diverse needs and to enhance the value of life insurance, different types of policies and features have been designed. While some life insurance policies focus exclusively on providing a death benefit, others also build cash value amounts within the policy that the owner of the policy may access to meet emergencies, help purchase a home, or pay for a college education. Finally, to encourage people to buy life insurance, these products have certain income tax benefits. The death benefit paid to the beneficiary is usually income tax free. And any cash value growth inside the policy is not subject to income tax unless it is removed from the life insurance policy.
People use life insurance for many reasons. But, the most important reason, by far, is to protect the family from the financial loss that occurs when a wage earner dies. The death benefit paid to the beneficiaries can be used to replace lost income, ensure that the family can stay in their home, purchase food, clothing and other necessities, pay funeral expenses, as well as create a fund to meet future expenses or education costs.
Personal Uses of Life Insurance
Life insurance death benefits can help in many ways including, but not limited to the following:
Replace the income of a deceased wage earner;
Pay off the mortgage and other debts (including funeral expenses);
Provide funds for the education of the surviving spouse or the children;
Fulfill the obligations of a divorce decree or child support agreement;
Benefit charitable organizations, churches or schools (such as one?s alma mater);
Equalize the inheritance heirs receive.
Business Uses of Life Insurance
Life insurance is a valuable tool in the business setting as well. For example, it is common for businesses ? large and small ? to purchase life insurance on the lives of those key people in the business who are responsible for its success. The business owns the policy and also receives any death benefits paid. If the insured key person dies, then the business can use the cash it receives to help offset the associated business losses such as:
• Make up for any lost profits
• Settle business debt; or
• Use the funds to recruit, hire and train a replacement.
Small, closely held businesses often use life insurance to fund plans that help the business continue if the business owner(s) die, retire or leave the business. These plans are commonly referred to as buy-sell arrangements. These arrangements are contracts between the business and its owners or between the owners themselves. In the contract, the owners promise to sell their share of the business if they die, retire or leave the business and the other owners, or the business, promise to buy it. The party that has promised to buy the business may choose to buy life insurance on the seller. Then, if the seller dies, the death benefit will help the buyer fulfill the terms of the buy-sell contract by providing cash to help purchase the deceased owner’s share.
Other ways the business may use life insurance include:
• Provide extra benefits for key executives of the business as an inducement to staywith the business;
• Paying for group life insurance for all the employees;
• Allowing the employees to purchase personal life insurance through a payrolldeduction program; or
• Including life insurance in the company retirement plan to provide a death benefit to adeceased employee?s family.
Estate Planning Uses of Life Insurance
For affluent people, life insurance assists with transferring wealth to their heirs or to charitable organizations. The most common use is purchasing life insurance within a trust to provide cash to pay the costs associated with settling a large estate. These costs might include the expenses connected with probating the will or estate transfer taxes that may be payable to federal or state governments. In addition, life insurance may be used to:
• Pay off business or personal debts;
• Equalize the estate among heirs;
• Fund estate planning and charitable planning techniques such as charitable remainder trusts, wealth replacement trusts, and grantor retained annuity trusts or unitrusts.
Charitable Giving Uses of Life Insurance
Charitable organizations can benefit from life insurance that insures the lives of their key donors. Typically, the charitable organization is both the policyowner and beneficiary of the policy. The donor makes yearly donations to the charity that are tax-deductible and the charity uses these funds to pay the policy?s premium. At the donor?s death, the charity can use the death benefit funds to help fulfill their obligations.
Living Benefit Uses of Life Insurance ? Accessing Cash Value
While most people are familiar with the importance of the death benefit protection, manyaren’t aware of the living benefits of life insurance. If the policy builds cash value, the policyowner may access these values to meet emergencies or take advantage of opportunities. There are two ways that policy owners can access cash value.
• Policy loans ? all types of cash value life insurance provide the ability to borrow against the cash surrender value in the policy. Loans are typically provided at interest (e.g., 8%) although in some policies the interest charged on the loaned portion may be partially or wholly offset by interest credited to the cash value.Policy loans that are not repaid are deducted from the death benefit at death or from the cash value if the policy is surrendered.
• Withdrawals ? many types of cash value life insurance allow the policyowner to withdraw funds from the policy cash surrender value. Usually there is a fee associated with each withdrawal and there may be limits on the number of withdrawals that may be made in any policy year (e.g., one withdrawal per year).Unlike policy loans that can be repaid, withdrawals permanently remove funds from the policy and as such, are not subject to interest charges like policy loans. Withdrawals may reduce the death benefit.
Living Benefit Uses of Life Insurance
Death Benefits? During Lifetime
If the insured becomes seriously ill and that illness is anticipated to end in death, most life insurance policies today will pay part of the death benefit amount to the policy owner while the insured is still living. These benefits are known as accelerated death benefits. The amount of the death benefit that will be paid is limited by formula or percentage of the death benefit. To receive this money, the policyowner must provide proof that the insured’s life expectancy will not exceed some period of time. The law permits the anticipated life expectancy to be as long as 2 years, but most insurance carriers limit the period to no more than six months.
The New Business and Underwriting Process
Purchasing life insurance transfers the risk of financial loss that results from the insured?s death from the policyowner to the life insurance company. To be profitable, the insurance company must be able to determine how much it has to charge for a certain life insurance policy to ensure it has sufficient funds to cover the costs of issuing the policy, its ongoing expenses and overhead, as well as pay future claims. The individuals trained to do this type of analysis are known as actuaries. In addition to the ability to price the products correctly, the insurance company must be able to evaluate each person that applies for insurance to determine if it wants to offer insurance coverage to that person. This is done through a process known as underwriting. With the proposed insured?s approval, the company?s underwriters gather and evaluate medical information on the proposed insured, as well as some family medical history and information on hobbies and the proposed insured’s occupation.
Information about the proposed insured?s health and other factors influencing the decision to offer insurance coverage comes from a variety of sources which may include:
• The insurance application and any supplemental forms.
• An exam conducted by a paramedical or a doctor. The size of the policy, as well as the age of the insured, may determine whether an exam is needed and what information will be gathered. Most exams are done by paramedical personnel who gather information about the proposed insured’s medical history, family history, height and weight. They also often collect a blood and urine sample. For higher death benefit amounts or when other circumstances dictate, an exam by a medical doctor as well as additional tests (e.g., stress EKG) may be required.
• An attending physician’s statement (APS) may be requested from the proposed insured?s doctor to get more detailed information about a specific medical condition.
• Inspection reports are often requested to check for any criminal activity or other high-risk behavior.
• Driving records are also checked for high-risk behavior such as an unusually high number of traffic violations or arrests for driving while under the influence of drugs or alcohol.
• Medical Information Board (MIB) information is routinely collected by life insurance companies. The MIB is an association of life insurance companies that provides information to protect companies from attempts to conceal or omit health information that is necessary to make an underwriting decision. As part of the application process, proposed insureds and policyowners are made aware of the information sources companies use. The underwriter uses all this information to evaluate the risk and then approve or decline to issue the policy. For those approved for coverage, the underwriter also determines the rate that needs to be charged to adequately cover the risk. Rates are set on a cost per $1,000 of death benefit. The rates fall into classes such as Custom, Standard, Select, Preferred and Preferred Best. The healthiest individuals would fall into the preferred best categories. These rate classes are also split into nicotine and non-nicotine users. In addition, individuals with more serious health issues may be charged a higher rate per thousand, known as a table rating.
Or, sometimes a flat extra premium is charged. The ratings may last for the life of the policy or may be charged only for a specified period of time.Retention and Reinsurance Insurance companies are in business to manage risk. However, on large life insurance cases, insurance companies typically share the risk with another insurance company known as a reinsurer. Reinsurance companies don?t sell insurance directly. They only underwrite the excess risk of the primary insurance carrier ? the distributors of the product.The amount of insurance that the primary insurance carrier does not reinsure is knownas its retention limit.
For example, life insurance Company A has a retention limit of $1,000,000 for all individual applicants under the age of 70 and life insurance Company B has a retention limit of $5,000,000 for the same group. If both receive applications for $3,000,000 of life insurancecoverage on similar individuals age 50, Company A will retain only $1,000,000 of the risk on their own books and pay a reinsurer to take the other $2,000,000. Company B will retain the entire amount because it is less than its retention limit. The amount that each company retains would be reduced by other insurance they have in force on the proposed insured. On much larger cases, even the reinsurer may choose not to take all of the excess risk. It may, in turn, choose to reinsure some part of its share of the death benefit risk to yet another reinsurance company. The company that takes the excess risk from a reinsurance company is known as the retrocessionaire. Many people with a high net worth may find it advisable to carry large amounts of insurance. However, the reinsurance marketplace limits the total amount of insurance that it will carry on a single individual. This is known as the Jumbo Limit. The Jumbo Limit takes into account all pending applications and in-force life insurance (including amounts being replaced) on the applicant. The Jumbo Limit is currently about $65,000,000.
Life insurance is meant to protect those who would suffer financially if the insured individual died. This is known as having an insurable interest. Just as one person cannot purchase insurance on someone else?s car, someone with no financial stake in the insured’s continued life cannot buy life insurance on that person. State law determines whether an insurable interest exists. Insureds who own their own policy, can name any beneficiary. Insurable interest issues arise when the owner and insured are not the same. In the absence of a blood relationship, all states require that the policyowner have a greater interest in the insured?s continued life than in the insured?s death at the time the policy is issued. Some states require that both the owner and the beneficiary hold an insurable interest. This usually means that both would suffer a financial loss if the insured died. Even if a financial loss is not apparent, certain family members are assumed to have an insurable interest in the insured based on love and affection. These include the insured?s:
ParentsThe following may also have an insurable interest (documentation supporting insurable interest may be required):
Brothers and sisters of insured
Financé of the insured
Domestic partner of the insured
Business owned by insured
Business partner or co-shareholder
Trust established by the insured, or a trust in which the insured is a beneficiary (provided the grantor and the trust beneficiaries have an insurable interest in the insured at the time the policy is issued)
Employer, but only if the insured is a key employee, officer or owner of the company
Creditors of the insured
A charitable organization to which the insured makes donations
Assuming the applicant for insurance has an insurable interest in the insured, it is also necessary to determine if the amount of insurance being applied for, plus the sum of all life insurance currently in force on the insured, is reasonable. This is because no one should be insured for more than the amount of financial loss that would occur if the insured died.
Financial underwriting isn?t an exact science. Rather, it is an evaluation based on many factors such as the individual?s future earnings capacity or net worth. Sometimes the amount of coverage is tied to a contractual agreement such as a buy-sell arrangement. In that situation, the value of the share of the business owned by the insured helps to determine the amount of life insurance that may be purchased. Other times, the amount might be tied to anticipated estate tax liability that will be due when the individual dies. Company published guidelines will provide information on acceptable limits. If the total amount of insurance in force plus the amount being applied for exceeds these limits, it is important to provide additional information for the underwriter. A cover letter is a good place to explain the reason for the coverage amount. Additional documentation such as financial statements, estate tax analyses, businesses? financial statements or balance sheets, or any other pertinent information helps the underwriter reach an informed decision.
Parties to the Application
There are generally four parties to a life insurance policy: the insured individual, the insurance carrier, the policyowner, and the beneficiary. Many times the policyowner is also the insured. The insured is the person whose death will trigger the payment of the death benefit.Some policies will cover more than one insured under the same policy. The policyowner is the person or entity that will own the life insurance policy and who will have all the rights under the policy. These rights include the right to name and change the beneficiary (unless named irrevocably), the right to access any policy cash value, and the right to surrender the policy for cash. If the policyowner is not the insured, then the policyowner must have an insurable interest in the insured?s life (see the sections on Financial Underwriting and Insurable Interest above). There may be both a primary policy owner and a contingent policyowner. If a contingent owner has been named, ownership of the policy will pass to the contingent owner if the primary owner dies.
The beneficiary is the person or legal entity who is entitled to receive the death benefits paid under a life insurance policy. A beneficiary can be a primary beneficiary or a contingent beneficiary. There may be more than one beneficiary to a life insurance policy. The primary beneficiary receives the death benefit if he or she is alive at the time of the insured?s death. The contingent beneficiary doesn?t receive any death benefit unless the primary beneficiary is deceased (or if a legal entity, no longer exists).
Drafting Beneficiary Designations
A well-drafted beneficiary designation for a life insurance policy provides a descriptionthat both:
Clearly identifies the beneficiaries; and
Fulfills the policyowner?s intent with respect to how the death benefit is to be paid.Below are general guidelines for drafting beneficiary designations.
Include both the name of the beneficiary and identifying information about the beneficiary such as the beneficiary?s relationship to the insured, date of birth or Social Security number.
If a trust is the beneficiary, the names of the trust and trustee, and the trust’s date,are required.
If a business is the beneficiary, you are not required to provide the name of the officers of the corporation or partners of the partnership. These individuals can change over time.
When there are two or more beneficiaries, define how the benefit should be split. If unequal shares are requested, use only percentages to establish portions.
Avoid situations where the insured, the policyowner and the beneficiary are all different. This can result in adverse gift or income tax consequences.
If appropriate, use beneficiary wording that can accommodate future changes to the policy owner’s situation (such as the expectation that the insured will have more children).Use class designations if there are multiple beneficiaries when the designation is made, butmembership in the class is not yet known.
Overview of Types of Life Insurance
Life insurance generally falls into one of two broad categories ? term life insurance or cash value life insurance. Cash value life insurance polices can be further divided into two general types ? whole life insurance and universal life insurance.
Term Life Insurance
Term insurance is a death benefit in exchange for a premium payment. It does not build
cash value although some policies sold today now offer return of premium benefits or
cash value riders.