Life Insurance

LIFE INSURANCE – WHAT IS IT?
by Bill Baker, J.D.

Life insurance is a contract where a premium is paid to the insurance company by a party having an insurable interest in the life of the insured in return for the insurance company’s promise to pay the beneficiary a defined amount upon the death of the insured.

Specifically, life insurance is an aleatory conditional unilateral contract.

A Life insurance contract is aleatory in that the obligation of the insurance company to pay the beneficiary is conditioned upon the occurrence of an uncertain event; namely the death of the insured. This uncertainty creates an element of chance wherein one party to the contract may receive much more in value than he or she gives under the contract.

Life insurance is conditional in that the insurance company’s obligation to pay a claim is dependent upon the performance of certain acts by the insured (i.e., paying the premium, furnishing proof of death to the insurance company by the beneficiary, etc.).

Life insurance is unilateral in that it contains an enforceable promise of only one party; the insurance company. The owner of the life insurance contract does not make a promise to pay the premiums. However, once the policy is underwritten and issued, if the premiums are paid, the insurance company must accept them and meet its obligations under the contract.

LIFE INSURANCE – TERM LIFE

Term life insurance is a contract that provides life insurance protection for an agreed period of years. Almost all life insurance companies offer choices of term life policies with terms of 1, 5, 10, 15, or 20 years. The face value of the policy is only payable if the insured’s death occurs during the term of the policy.

Term Life Insurance Provisions:

GUARANTEED RENEWABLE – This provision usually provides that up to a certain age, such as 95, a term life policy can never be cancelled as a result of changes in the insured’s health, occupation, etc. This assumes that the premiums are paid in full as they become due.

Guaranteed renewability doesn’t mean the premiums will remain level beyond the initial term specified in the contract. For example, in the case of a $100K ten-year renewable term policy with an annual $150 premium, the premium is guaranteed level for 10 years. However, after the first ten year period the premium will continue to increase with each renewal based upon the insured’s attained age at the time of renewal and the renewal rate then in effect at that time.

CONVERTIBLE – This provision allows for conversion of a term life insurance policy into a permanent (i.e., whole life) policy. An adjustment to the premium charge is made and no evidence of insurability is required.

Annual Renewable Term Insurance

Policy renewal is guaranteed each year, regardless of the insured’s physical condition, until you attain a specified age (depending upon the specific policy and state in which the policy is issued). The cost per $1,000 of this type of term insurance protection automatically increases each year.

Level Term Insurance

The amount of life insurance coverage provided by this type of policy remains level during the policy period. Level term insurance policies are usually issued for 5, 10, 15, or 20 year terms.

The cost per $1,000 of this type of term insurance protection usually remains level. The exceptions to this general rule are hybrid graded premium type level term policies (i.e., a level term policy having a 10 year guarantee period with a 5+5 year stepped rate guarantee providing one set of level guaranteed rates for policy years 1-5 and another set of level rates for policy years 6-10).

Decreasing Term Insurance

The amount of life insurance coverage automatically decreases during the term of the policy until it reaches zero. The premium remains level as the amount of life insurance protection decreases. “Mortgage insurance” (decreasing in conjunction with the amortization of the mort-
gage) is a familiar type of decreasing term insurance.

LIFE INSURANCE – WHOLE LIFE

Whole Life Insurance is a level premium life insurance plan that offers cash value buildup and never has to be renewed or converted.

Whereas with term life insurance nothing is paid to the insured’s beneficiary (or beneficiaries) if the insured dies after the expiration of the policy’s term, whole life insurance pays the death benefit to the beneficiary (or beneficiaries) no matter when the insured dies (assuming that the policy is not surrendered or does not lapse).

In essence, a whole life policy is like having an annual renewable (decreasing) term policy attached to a savings account. The insurance component of the whole life policy becomes less and less as its cash value builds up until the cash value equals or exceeds the death benefit of the policy (see DIAGRAM A below). When cash value equals the amount of the life insurance you are, in effect, 100% self-insured!

As a result of whole life insurance policies building up cash value, there is a leveling of the policy’s premium over the lifetime of the insured. The premiums paid in the early years of a whole life policy are in excess of the amount required to pay the current cost of the insurance protection. The balance (excess) of this money collected is retained by the insurance company as a “reserve” to cover the premium deficiency that results in providing the same level of coverage to the insured during the later years of the policy when the initial “level” premium is no longer large enough to pay the actual cost of the life insurance. To have access to the cash value of your policy you must borrow against the policy and sacrifice part of your insurance coverage or surrender your policy altogether.

An annual mortality charge is paid by the policyowner for the term life insurance component of the policy. In a whole life insurance policy this mortality charge changes each year to reflect, among other factors, the insured’s increased age and the decreasing amount of life insurance protection provided as a result of the increasing cash value & decreasing life insurance component that combine to provide the policy’s death benefit.

There are two principal types of TRADITIONAL WHOLE LIFE POLICIES; ordinary (also known as straight life) life policies and limited-pay life policies.

ORDINARY WHOLE LIFE POLICIES [see above DIAGRAM A] operate on the theory that the policy premiums will be paid until the insured reaches age 100 at which time the cash value of the policy will equal the death benefit. In the vast majority of cases premiums are not paid until age 100 because: (1) most people die before reaching age 100, (2) policyowners may pay up the policy in a shorter period, (3) surrender the policy and receive the cash value, (4) convert the policy to a smaller paid-up policy, (5) let the policy lapse, etc.

With LIMITED PAY WHOLE LIFE POLICIES the premium paying period is compressed. Therefore you pay larger premiums for the same amount of whole life insurance for a shorter time. The compressed premium payment period is usually expressed in terms of the number of years the premium is to be paid (i.e., Life-Paid-Up in 10, 15, or 20 years; Ten-Pay Life, etc.) or the age at which premium payments cease (i.e., Life-Paid-Up at 65).

DIVIDENDS. Policies eligible for dividends are call “participating” policies. Without getting too complicated and launching into an explanation of the technicalities involved in determining a mutual life insurance company’s surplus distribution, we can say that dividends are paid annually as the result of the insured’s participation in the profit and loss elements of the policy class that he or she belongs.

The size of the dividend is based upon mortality factors, interest, and the loading factor (an assessment of expenses). Items calculated into the loading factor include, but are not limited to: commissions, rent, salaries, supplies, advertising, etc.

DIVIDEND OPTIONS. The insured or owner of the “participating” whole life policy may elect to use the dividend he or she receives in a number of ways. Among the dividend options available (either individually or in combination) to the policyowner are:

1). receiving the dividends in cash,

2). leaving the dividends with the company to earn interest,

3). reducing the policy premiums,

4). buying additional paid-up insurance,

5). using the dividends to “pay-up” the original policy,

6). purchasing a one-year term policy.

INTEREST SENSITIVE WHOLE LIFE POLICIES are level premium whole life policies that don’t pay dividends. Instead, the cash value grows in an accumulation account from premium payments paid in and interest credited (the interest is paid on the reserve cash value in your policy’s accumulation account). A life insurance charge is also deducted from this accumulation account to pay for mortality costs and the insurance company’s other expenses.

The mortality charge is the cost per thousand dollars of life insurance you have. For cash value policies, like interest sensitive whole life insurance, this cost per thousand is applied against a figure that is the result of deducting the policy’s death benefit from its reserve cash value in the accumulation account. For instance, if you have an interest sensitive whole life policy with a $100,000 death benefit and a $25,000 cash value, your mortality cost would be based upon the $75,000 for which the insurance company is “at risk” if you die.

The interest rate is usually declared by the insurance company each year and reflects the current interest rate trends. These policies usually offer a guaranteed base interest rate meaning that no matter how low interest rates are you will never be paid less than the guaranteed interest rate on the reserve cash value in your policy’s accumulation account.

UNIVERSAL WHOLE LIFE INSURANCE is an adjustable premium whole life policy. This type of life insurance policy offers flexible premiums with an adjustable death benefit coupled with an “unbundling” (specific definition) of the policy’s mortality charges, investment component, and administrative charges.

With universal life the policy may be tailored so that the death benefit remains level or increases over time. The charge for providing this death benefit is referred to as the mortality charge. When your premium is paid to the insurance company for a universal life policy the following charges and distributions are made: (1) mortality charge (this amount increases each year because, according to the actuarial tables your chance of dying increases each year); (2) “load” (fees) for administrative and “other” expenses defined in the policy; and (3) the remaining premium is credited to the policy’s cash value.

Universal life policies also contain “stop and go” provisions that allow you to discontinue and resume premium payments at any time (assuming that you have enough cash value in the policy to pay the recurring “load” (administrative and other fees) and mortality charges. If your policy should not have the cash in it to pay these charges it will terminate, subject to a grace period that allows for reinstatement.

VARIABLE LIFE INSURANCE is a variant of other whole life insurance policies. By choosing a variable life insurance policy in lieu of a more traditional one the policyowner may be able to realize a net investment return in excess of other more traditional whole life products. On the other hand, the policyowner gives up the guarantee of cash values and other elements of fixed benefit whole life insurance policies such as non-forfeiture benefits and traditional policy loan provisions.

The premium the policyowner pays minus mortality, administrative, sales, and an assortment of other charges is invested in a “separate investment account” where a reserve (cash value) accumulates. Unlike other types of whole life policies there is no guaranteed interest rate applied to the “separate investment account” and the policy death benefit increases or decreases based upon the performance of this account. The “separate investment account” can be invested in stocks, money market instruments, bonds, foreign securities, etc. The policyowner decides where (from among the investments presented by the company) to invest the “net” premium.

Variable life insurance is defined as a security. The advertisement and sale of variable life insurance policies is regulated by the U.S. Securities and Exchange Commission. People who sell variable life insurance policies must have a life insurance license and hold a Series 6 or 7 securities license which requires additional testing and registration with the Securities and Exchange Commission.