LIFE INSURANCE BASICS

Many of us buy life insurance because we want to make sure that our loved ones, especially dependents, remain financially secure after we die.  Income replacement is the #1 reason why people buy life insurance.  Non-working caregivers also have an important, and oft overlooked, economic value that should be covered by life insurance.  Life insurance is also purchased by those interested in achieving specific business or estate transfer goals.

There are several choices when it comes to buying life insurance and there are huge pricing differences in the market among different companies offering identical coverage.  Policies are now available from more than 1,500 life insurance companies in the United States.  Most financial planners recommend that each family income provider carry no less than ten times their annual income in life insurance.

Here’s an orderly way to go about shopping for life insurance:  1) assess your life insurance needs, 2) decide on the most appropriate policy type, 3) set high standards for the financial stability ratings of your insurance company and, then 4) shop until you drop to find the best price.

Life insurance is a long-term proposition, which means that you should pay particular attention, at time of purchase and throughout the life of the policy, to the financial stability ratings of your life insurance company.  While the average U. S. adult shops for life insurance once every seven years, it’s not uncommon for people to keep life policies in force for decades.

Assessing your life insurance needs

The first step in life insurance planning is to analyze your life insurance needs or, rather, the economic needs of the dependents left behind:

Because life insurance needs change over time, your life insurance program should be reevaluated periodically.  We recommend a review at least once every five years or whenever you experience a major life event such as change income or assets, marriage, divorce, the birth or adoption of a child, or purchase of a major item such as a house or business.

The reasons you might buy life insurance will vary, depending on your age, financial situation and other factors.  Listed below are some examples:

In theory, you should have a declining need for life insurance as you age because fewer people remain dependent upon you for income support.  Exception to this rule would be for circumstances in which you want to protect a business entity or pay estate taxes for heirs.  If the purpose of buying life insurance is to pay estate taxes, then you’ll only want coverage that is guaranteed for the remainder of your life and that of your spouse as well.

What are my policy choices?

Life insurance policies are divided into two main types:  those that provide only death protection without any side fund buildups or “cash values” (least expensive cost per $1,000 of death coverage purchased) and those which offer or require “cash value” accounts in which a return-on-investment component becomes an often complex and expensive part of the policy (most expensive cost per $1,000 of coverage).

Term Life Insurance

The simplest of all life insurance to understand and the cheapest of all life insurance to buy on a net cost basis is term life insurance.  Term life insurance provides death benefit protection without any savings, investment or “cash value” components for the term of the coverage period.  Term life insurance is available for set periods of time such as 10, 15, 25, 30 years during which the premiums are guaranteed not to increase.  As long as you pay your premium, the company cannot cancel you.  Some new universal life policies perform like term life insurance in that they can be configured at the time of purchase to provide both level death benefits and level premiums that are guaranteed for life as long as you pay the scheduled premium.

Term life insurance has become very popular with consumers in recent years because of the new and longer rate guarantee periods and because premiums for new policyholders have recently dropped to all-time lows.  Term life insurance premiums have recently dropped to all-time lows.  For example, a healthy, non-smoking 40 year-old male can now buy $500,000 worth of 20-year guaranteed term life insurance for just $365 per year.  A $1 million policy goes for only $650 per year, which is far less than twice the cost of the $500,000 policy.

Choosing an initial rate guarantee period is easy.  Simply match the period of time you’ll need coverage to the available rate guarantee period.  For example, if your children are young and you have decades to go on your mortgage, try 30 year term life.  If your children are leaving the nest and your home is paid off or nearly paid off, 10 year term might fit the bill.

Other policy provisions that drive the popularity of guaranteed term life insurance are guaranteed renewal and guaranteed convertibility. 

Term life insurance is widely available on the Internet, from direct-to-consumer life insurance companies and from independent agents and brokers.

Cash Value Life Insurance

If you want more than death benefits from your life insurance policy and want to expand its purpose into that of a long-term savings account (not insured by any federal agency) or stock market investment in addition to its life insurance component, you might consider cash value life insurance such as whole life, universal life or variable life.  But be prepared to pay much higher premiums per $1,000 of coverage precisely because you are now funding a cash value account in addition to paying for expected mortality (death) costs.

In many cash value policies, the annual premium does not increase from year to year but remains level throughout the premium-paying period.  Some universal life policies allow you to adjust your death benefit amounts or to skip premium payments altogether for some periods time.

Because of its complexity and dizzying array of possible outcomes as respects the death benefit and premium payment schedules, regulators insist that cash value insurance be sold using pre-approved illustration formats.  As a forewarning, be aware that the illustrations for cash value insurance can run to 15 or m ore pages.  Cash value life insurance illustrations are divided into two major sections:  the guaranteed section and the projected or “illustrated, non-guaranteed” section. 

Pay particular attention to the guaranteed death benefit and premium payment sections because these columns contain the actual company promises.  If you don’t like what you see there, walk away from signing up.  Another caveat:  think long and hard before you sign on the dotted line because many cash value policies contain harsh penalties for surrendering coverage in the early years.  Most cash value insurance is marketed by agents and brokers in a face-to-face setting where needs and strategies can be discussed.

Whole Life

Ordinary whole life insurance offers what the industry like to call “permanent protection” with a cash value account that grows over time.  This policy form is notable because it provides a level death benefit and level premiums throughout your life and for as long as you continue to pay the premiums.  For example, a healthy 40 year-old female might pay $4,200 per year for a $500,000 whole life policy.  The premium remains level at $4,200 per year for the rest of her life and, in the event of death at any age, the policy will pay $500,000 to her beneficiary.

Whole life also contains a cash value account that builds over time and eventually equals the face amount of the policy.  Cash values generally do not build up to any meaningful sum until the policy has been in force for several years.  So who owns the money in the cash value?  The insurance owns and retains title to the cash value account, but will make this sum available to you in the form of a low interest loan.  But, remember, if you die before you pay back the loan, such loan will be paid back out of the death benefit, before distribution to your beneficiaries.  Example:  Susan has a $500,000 whole life policy in force and, over the years, has borrowed continually from the cash value to where her loan and accrued interest totals $300,000.  When Susan dies dies, her beneficiary will receive only $200,000 because the life insurance company will first pay itself back from the death benefit.

Whole life can be issued as participating or nonparticipating.  Participating whole life policies typically cost more by design and contain the intention of returning some part of the premium to the policyholder each year in what’s called a dividend.  Nonparticipating whole life insurance has no dividend or return of premium features, but generally cost less from the start.

Buyers of whole life insurance like the certainty of having fixed premiums with a known death benefit for life.  They also like watching the cash value account build up, but don’t often realize that, absent of canceling the policy in order to obtain such cash value as a surrender settlement, the cash value account is really a standby line of credit.  A negative with whole life is that it is expensive per $1,000 of death benefit and requires ach buyer to more or less accurately plan for how much life insurance they will want in force at advanced ages, which is often decades into the future.

Universal Life

This kind of policy, while offering greater flexibility than whole or term life  in terms of making changes while the policy in is force, can have many moving parts which should be understood before purchase occurs.  After your initial payment, you have the option of reducing or increasing the amount of your death benefit. If you choose to increase your benefit, you may have to provide medical proof that your health has not deteriorated. Also, after your initial payment, you can pay premiums any time and in any amount, as long as you don’t miss a minimum payment.  In some cases, there are limits to how much extra you can pay in advance premiums.

You will need to manage these policies to maintain sufficient funding, especially because the insurance company can increase charges.

Variable Life

Variable life offers a death benefit and a true investment account feature.  Variable life insurance is designed to shift the uncertainties of investment gains and losses to the policyholder.  That’s because the insurance company invests your premiums.  The insurance company offers you a choice of funds, in which your money will be invested.  The amount of money your beneficiaries will receive and the cash value of your policy depend on how well the insurance company invests your money.  According to the Fundamentals of Insurance for Financial Planning, a variable life insurance policy provides “…no guarantee of either interest rate or minimum cash value.  Theoretically, the cash value can go down to zero, and, if so, the policy will terminate.”

There are both Universal and Whole Life versions of Variable Life.

In most variable and some universal life insurance policies, if your investments performwell, you'll have a higher cash value and death benefit (some universal and variable universal policies also allow you to add your cash value into your death benefit). If the investments lose money, you'll have a lower cash value and death benefit. Some policies will guarantee a minimum death benefit

You can also take loans against the cash value of your policy, but if you don't pay them back with interest, your beneficiaries will receive a reduced death benefit. You can also surrender your policy for cash or convert it into an annuity, but keep in mind that cashing in a permanent policy after only a couple of years is an expensive way to get insurance protection for a short time.

Because of the high risks involved as respects the investment account options, variable life insurance must be sold with an accompanying prospectus.  The prospectus mandated by the SEC is similar in many respects to the prospectus required for new stock issues.  Look closely at the expense information and investment options insurance companies’ offer for Variable Life policies.  Make sure the expenses are fair and that the investment options are give you an opportunity to invest at your own risk tolerance.

The Life Insurance Buying Process, circa 2006

Not much has changed in the last 30 years as respects life insurance underwriting.  The applications process paper-intensive, can take weeks, and often seems intrusive for people who value their privacy.  A face-to-face paramedical examination is generally required for policies in excess of $100,000, which means, at minimum, the giving of both blood and urine samples to an outside lab technician.  Expect the underwriters to question you in detail regarding your lifestyle, intended foreign travel destinations, your family health history and your personal health history.  Do you intend to scuba dive below 60 feet?  Have you had any siblings contact heart disease or cancer before age 60? Have you ever taken any medicine for anxiety or depression?  These, and more, are the kinds of questions to expect.

Sometimes multiple interviews are required in order to verify and confirm your information.  The paramed examiner typically asks these questions face-to-face and often insurance companies will conduct follow-up telephone interviews so that you can verify or clarify the first set of answers.  Regardless of the type of life insurance you buy, most policies require you to meet certain acceptance guidelines having to do with your lifestyle and health history.  Some life insurers will allow coverage up to $250,000 without a medical exam.

Fraud and misrepresentation are huge, expensive industry problems.  In order to combat these problems and to keep premiums low for all comers, life insurance companies typically require that you give them your social security number as well as grant them permission to use and access outside databases, such as the new prescription drug usage databases and the MIB (Medical Information Bureau).  If you have a health history beyond normal, routine checkups, you can expect them to retrieve all of your medical and doctor records before they will provide you with a firm offer of coverage.

If it sounds tempting to shortcut this process by fudging on an answer or withholding information, don’t do it.  It’s a crime in all 50 states to lie about or conceal information on a life insurance application.  Besides, policies obtain through fraud can be voided at claim time.

All standard life insurance policies generally cover death by any cause at any time in any place, except for death by suicide within the first two policy years (one year in some states). 

In naming a beneficiary, keep in mind that the life insurance company will want to see only the names of those who are actually financially dependent upon you in some way.  An acquaintance, friend or relative, absent of a financial relationship, will not do.  People that you support or owe money to are considered to have a financial interest in you.  You can name a charity if you have a history of giving to that charity.

How do I know if a life insurance policy is right for me?

After reviewing the various life insurance policies available, you might still be unsure about which best meets your needs. The American Council of Life Insurers recommends consulting with an insurance agent.

Carefully study the recommendations and ask for a point-by-point explanation. Make sure you understand the terms. Because your policy is a legal document, it is important that you know what it provides.

If you are considering a term life policy, ask:

If you are considering a cash value policy, ask:

The ACLI points out that cash value insurance can provide protection for your entire life. If you don't plan to keep the policy for many years, consider another type. Cashing in a permanent policy after only a few years can be a costly way to get short-term insurance protection.