LIFE INSURANCE

Fundamentally, life insurance is about providing a death benefit that is funded through an insurance policy. Life insurance has many use cases and tax advantages. However, it is important to remember life insurance is about the death benefit first, and then possibly as a savings vehicle.

As a society, the life insurance industry serves an important role in protecting the lifestyles – current and future – of millions of Americans. The cost is lowest when people are young, but even at mid-life and later, life insurance is affordable relative to the benefits. Although the concept of life insurance is straightforward, what most people don’t realize is that there are a variety of policy riders that allow insureds to tailor the coverage to provide for other needs like long-term care.

Income Replacement

The cost of rent or mortgage payments, utilities, food, car payments and gas, childcare, and college tuition strain the budgets of most households. Now imagine what the impact from the premature death of one of the income providers or household caretakers would be on the ability of a household to maintain its standard of living.

Life insurance provides an affordable way to maintain that standard of living and alleviate the financial stress and difficult choices that a premature death brings. The first question most potential insureds ask: How much life insurance do I need? Before answering it, people should review their monthly budget, targeting current expenses and future financial objectives. They also need to consider the impact of inflation on their future goals, so they have enough insurance to meet them. Other considerations include whether there is a special needs child (or adult) that may be financially dependent for a longer period time.

While there are many “rules of thumb” regarding how much is needed, a common range is 10 - 15 times annual income depending on the number of people in the household, their ages and other sources of income. A common mistake is not including the replacement cost of childcare and the other family duties performed by someone who is not working outside the home. An insurance agent can help you create a family needs analysis that considers a variety of factors.

The Business Need

Life insurance also serves a critical need for the business community: providing life insurance on the company’s key employees. Whether a large or small business, the premature death of the owner or CEO can have a devastating impact on the continuity of the business. Lenders usually require that key employees have life insurance to help ensure that the business can continue and that the loans can be repaid in the event of their death.

Of special concern is the death of one of the business owners or partners. In that case, the business loses the key contributions of an owner, such as sales and management of operations, and then also may have to buy out the value of the owner’s interests to pay the heirs. This concern is addressed by having a buy-sell agreement, with life insurance serving as the critical funding ingredient. The owners buy life insurance on each other to buy out the deceased owner’s interest using a predetermined valuation method.

Paying for Taxes

Structured properly, the death benefit is free of income taxes to the beneficiary.

For people with sizeable estates – or illiquid assets like a farm, real estate or a closely held business – life insurance can pay for estate taxes. While the federal estate tax is usually the primary concern, several states also have estate taxes that start at a much lower threshold than federal estate taxes. Without life insurance, these assets might have to be sold, disrupting family legacies and putting employees out of work if the business is consolidated.

This type of need involves permanent insurance and usually the use of trusts such as an irrevocable life insurance trust (ILIT), which has certain tax advantages when properly structured. The estate planning team should include the attorney, accountant and life insurance agent to coordinate the policy structure.

Death-related Costs and Other Goals

Final expense costs, which include funeral and burial costs, are expensive. Also, there can be final medical costs to be paid that are not covered by insurance. A permanent life insurance policy can guarantee the funds will be there. Life insurance policies can be paid in a matter of days and provide liquidity when money is needed immediately.

Legacy Goals

As people contemplate what has been important to them during their lifetime, leaving a legacy upon their death is a meaningful way to serve the needs of family members, friends, charities or universities, and to aid special remembrances. A life insurance policy can accommodate these beneficiaries, providing support even after the policy owner’s passing.

Types of Life Insurance Policies

How do you determine what kind of life insurance policy meets your needs? Broadly, the answer can be divided into two basic categories: temporary or permanent. Temporary should not be confused with short term. It can refer to as long a period as 20 to 30 years. But it does mean the insured understands that the life insurance policy will eventually end if the insured does not die before that term expires. A temporary need usually involves providing immediate income to dependents until they are no longer financially dependent. As the dependents become adults, the need may lessen, although other objectives like paying off a mortgage may remain.

The other category is permanent. This means that the insured’s objectives require having the life insurance policy be in force whenever the insured passes on. Permanent needs can include business perpetuation, estate taxes, burial costs, and legacy objectives.

Term Life Insurance

Term life insurance is basically what the word “term” implies: It is available for a selected period. Basically, the policy provides a set face value, such as $500,000, for the term selected — 10, 20, or 30 years — with the death benefit payable to the beneficiaries. Longer term insurance policies generally have a level premium for the length of the term. There are no policy cash values so you cannot borrow from the policy.

Since the policy will eventually lapse, one tactic is to save the difference for lower cost premiums versus permanent insurance for retirement income needs. People who purchase term insurance generally want to obtain the maximum coverage for the lowest cost.

Whole Life Insurance

Whole life insurance provides the guarantee of a permanent policy that remains in force as long as premiums are paid. In addition to the death benefit, it builds cash value over time at a guaranteed rate scheduled in the policy, which can be borrowed against according to the policy’s terms.

Whole life policies provided by mutual insurance companies usually provide the opportunity to participate in the overall performance of the insurance company, which is owned by the policyholders. Policyholders “participate” by receiving dividends that increase the cash value or increase the face value of the policy. If the policy is no longer needed, it can be surrendered, and the policyholder will receive the policy’s accumulated cash value.

Because of the cash values, whole life insurance premiums are significantly higher than term life insurance premiums. Buyers of whole life like the guaranteed cash values and know they can plan on receiving the death benefit if premiums are paid. Cash values grow tax deferred and are not taxable when withdrawn until the cash value exceeds the total premiums paid. Frequent uses of whole life insurance are for funding estate planning and taxes, as well as funding a buy-sell agreement.

A variation of a whole life insurance policy is a “second to die” policy, which is based on two lives and pays the death benefit after the death of both insureds.

Universal Life Insurance

As inflation increased and interest rates soared in the 1970s, owners of whole life insurance found that the purchasing power of the death benefit was being diminished. In response, the life insurance industry created universal life insurance. Universal life insurance provides permanent coverage and some flexibility to let the policyholder adjust the premium payments, the death benefit, or both.

Universal life premiums are tied to current interest rates, so it gained great popularity during the 1980s when interest rates were high. During the 1990s and beyond, policyholders became frustrated that the policy illustrations that were used when it was sold — which were not guaranteed and based on interest rates at the time — no longer matched what they had to pay. Guaranteed policy projections were provided, but most buyers looked at the lower premiums of the illustrated policy proposals when interest rates were higher for their budget.

As a result, universal life is not as popular as it was in the 1980s. Like whole life, it accumulates cash value based on current interest rates that can lead to a higher chance of the policy lapsing if higher premiums are not paid when interest rates decline. It is a way to purchase life insurance in between the cost of term insurance and whole life insurance, if the buyer understands the trade-offs. Generally, people that purchase universal life want a permanent policy but with some flexibility.

Variable Life Insurance

When interest rates declined in the 1980s and the stock market took off, again some whole insurance policyholders felt that they missed an opportunity to participate. The industry responded with variable life as a way to combine a death benefit with investment subaccounts.

As long the stock market produces sizable returns (equal to or exceeding the policy illustrations) both the cash value and death benefit increase. But if the investment returns underperform, the policyholder may have to put more money in the contract to maintain the policy.

There is even a variation—variable universal life—which combines aspects of both policies.

People purchasing the newer generation of insurance policies should always compare the guaranteed policy illustration along with projected illustrations and pay particular attention to the assumptions used. Variable life insurance and variable universal life require the life insurance agent to be licensed to sell securities in addition to their life insurance license.

Consider the Insurance Company’s Rating

Unlike a bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to certain limits, the insurance companies’ own assets are the financial safeguard behind the policies. Accordingly, they must have sound mortality, expense, investment and other assumptions, in addition to having adequate capital to satisfy a promise to pay that could be 50 years or longer into the future.

The insurance company’s ratings should be a primary consideration in the life insurance transaction. How can a consumer find out how an insurance company is rated? And should they rely on a single rating service? Compare the ratings from at least two independent rating agencies for more perspective. The four major independent rating services are: A.M. Best, Moody’s, Standard & Poor’s, and Fitch Ratings. A.M. Best is perhaps the best known of the group and uses a scale of A++, A+, A, A-, B++, B+, B, and so on. For life insurance, a rating of “A” or better is desirable.

There are state assurance guarantee funds (or associations) to help shore up the insurance companies that write insurance in their state. But the amounts that are backed vary by state. Insurance agents should not discuss state assurance guarantee funds in the context of being a backstop. When they do step in, they sometimes must modify the terms of the policy to satisfy financial needs of a large group of policyholders.