Life insurance is one of the most important and expensive purchases you
may ever make. Deciding whether you need it and choosing the right policy
from dozens of options takes time, research, and careful thought.
Consumer awareness of life insurance has changed little over the years.
Life insurance is still more often sold than bought. In other words, while
most people actively seek to buy insurance for their property and health,
they avoid a life insurance purchase until an agent approaches them.
Life insurance is neither mysterious nor difficult to understand. It
works in the following manner.
A person joins a risk-sharing group (an insurance company) by purchasing
a contract (a policy).
Under the policy, the insurance company promises to pay a sum of money
at the time of the policyholder's death to the person or persons selected
by him or her (the beneficiaries).
In the case of an endowment policy, the money is paid to the policyholder
(the insured) if he or she is alive on the future date (the maturity date)
named in the policy.
The insurance company makes this promise in return for the insured's
agreement to pay it a sum of money (the premium) periodically.
The Purpose of Life Insurance
Most people buy life insurance to protect someone who depends on them
from financial losses caused by their death. Life insurance proceeds may
be used to
Pay off a home mortgage or other debts at the time of death.
Provide lump-sum payments through an endowment to children when they
reach a specified age.
The principle of home insurance can be applied to the lives of persons. From records covering many years and including millions of lives, mortality tables have been prepared to show the number of deaths among various age groups during any year.
If your death would cause financial stress for your spouse, children,
parents, or anyone else you want to protect, you should consider purchasing
life insurance. Your stage in the life cycle and the type of household
you live in will influence this decision. Single persons living alone
or with their parents usually have little or no need for life insurance.
Determining Your Life Insurance Objectives
Before you consider types of life insurance policies, you must decide
what you want your life insurance to do for you and your dependents.
First, how much money do you want to leave to your dependents should
you die today? Will you require more or less insurance protection to
meet their needs as time goes on?
Second, when would you like to be able to retire? What amount of income
do you believe you and your spouse would need then?
Third, how much will you be able to pay for your insurance program?
Are the demands on your family budget for other living expenses likely
to be greater or lower as time goes on?
How much life insurance should you carry? This question is important for
every person who owns or intends to buy life insurance. Because of the various
factors involved, the question cannot be answered by mathematics alone.
Nevertheless, an insurance policy puts a price on the life of the insured
person, and therefore methods are needed to estimate what that price should
be.
There are four general methods for determining the amount of insurance
you may need.
The Easy Method Simple as this method is, it is remarkably
useful. It is based on the insurance agent's rule of thumb that a "typical
family" will need approximately 70 percent of your salary for seven
years before they adjust to the financial consequences of your death.
In other words, for a simple estimate of your life insurance needs, just
multiply your current gross income by 7 (7 years) and 0.70 (70 percent).
The DINK (Dual Income, No Kids) Method If you have no dependents
and your spouse earns as much as or more than you do, you have very simple
insurance needs. Basically, all you need to do is ensure that your spouse
will not be unduly burdened by debts should you die.
The "Nonworking" Spouse Method Insurance experts
have estimated that extra costs of up to $10,000 a year may be required
to replace the services of a homemaker in a family with small children.
These extra costs may include the cost of a housekeeper, child care, more
meals out, additional carfare, laundry services, and so on. They do not
include the lost potential earnings of the surviving spouse, who often
must take time away from the job to care for the family.
Stock companies generally sell nonparticipating (or nonpar) policies, while mutual companies specialize in the sale of participating (or par) policies. A participating policy has a somewhat higher premium than a nonparticipating policy, but a part of the premium is refunded to the policyholder annually. This refund is called the policy dividend.
Types of Life Insurance Policies
Both mutual insurance companies and stock insurance companies sell two basic types of life insurance: temporary and permanent insurance.
Temporary insurance can be term, renewable term, convertible term, or decreasing term insurance. Permanent insurance is known by different names, including whole life, straight life, ordinary life, and cash value life insurance.
Term insurance is protection for a specified period of time, usually 1, 5, 10, or 20 years or up to age 70. A term insurance policy pays a benefit only if you die during the period it covers. If you stop paying the premiums, the insurance stops. Term insurance is therefore sometimes called temporary life insurance.
Term insurance is a basic, "no frills" form of life insurance and is the best value for most consumers. The premiums for people in their 20s and 30s are less expensive than those for whole life insurance, discussed in the next section.
The most common type of permanent life insurance is the whole life
policy (also called a straight life policy, a cash-value life policy,
or an ordinary life policy), for which you pay a specified premium each
year for as long as you live. In return, the insurance company promises
to pay a stipulated sum to the beneficiary when you die. The amount of your
premium depends primarily on the age at which you purchase the insurance.
One important feature of the whole life policy is its cash value. Cash
value (or cash surrender value) is an amount that increases over the
years that you receive if you give up the insurance. Hence, cash-value policies
provide a death benefit and a savings account. Insurance salespeople often
emphasize the "forced savings" aspect of cash value insurance.
The cash values of a variable life insurance policy fluctuate according
to the yields earned by a separate fund, which can be a stock fund, a money
market fund, or a long-term bond fund. A minimum death benefit is guaranteed,
but the death benefit can rise above that minimum depending on the earnings
of the dollars invested in the separate fund. The premium payments for a
variable life policy are fixed.
Subject to certain minimums, universal life insurance, first introduced
in 1979, is designed to let you pay premiums at any time in virtually any
amount. The amount of insurance can be changed more easily in a universal
life policy than in a traditional policy. The increase in the cash value
of a universal life policy reflects the interest earned on short-term investments.
Since your primary reason for buying a life insurance policy is the insurance
component, the cost of that component should be your main consideration.
Thus, universal life policies, which offer a high rate of return on the
cash value but charge a high price for the insurance element, generally
should be avoided.
In recent decades, group life insurance has become quite popular. A group insurance plan insures a large number of persons under the terms of a single policy without requiring medical examinations. In general, the principles that apply to other forms of insurance also apply to group insurance. Fundamentally, group insurance is term insurance, which was described earlier. Usually the cost of group insurance is split between the employer and the employees so that the cost of insurance per $1,000 is the same for each employee, regardless of age. For older employees, the employer pays a larger portion of the costs of the group policy.
However, group life insurance is not always a good deal. Insurance advisers offer countless stories about employer-sponsored plans, or group plans offered through professional associations, offering coverage that costs 20, 50, or even 100 percent more than policies their clients could buy on the open market.
Endowment life insurance provides coverage from the beginning of the contract to maturity and guarantees payment of a specified sum to the insured, even if he or she is still living at the end of the endowment period. The face value of the policy is paid to beneficiaries upon the death of the insured. The endowment period typically has a duration of 10 to 20 years or the attainment of a specified age.
Credit life insurance is used to repay a personal debt should the borrower die before doing so. It is based on the belief that "no person's debts should live after him or her." It was introduced in the United States in 1917, when installment financing and purchasing became popular.
Credit life insurance policies for auto loans and home mortgages are not the best buy for the protection they offer. Instead, buy less expensive decreasing term insurance, discussed earlier. In fact, some experts claim that credit life insurance policies are the nation's biggest ripoff.
An important provision in every life insurance policy is the right to name your beneficiary. A beneficiary is a person who is designated to receive something, such as life insurance proceeds, from the insured. In your policy, you can name one or more persons as contingent beneficiaries who will receive your policy proceeds if the primary beneficiary dies before you do.
The Grace Period
When you buy a life insurance policy, the insurance company agrees to pay a certain sum of money under specified circumstances and you agree to pay a certain premium regularly. The grace period allows 28 to 31 days to elapse, during which time you may pay the premium without penalty. After that time, the policy lapses if you have not paid the premium.
Policy Reinstatement
A lapsed policy can be put back in force, or reinstated, if it has not been turned in for cash. To reinstate the policy, you must again qualify as an acceptable risk, and you must pay overdue premiums with interest. There is a time limit on reinstatement, usually one or two years.
Nonforfeiture Clause
One important feature of the whole life policy is the nonforfeiture clause. This provision prevents the forfeiture of accrued benefits if you choose to drop the policy. For example, if you decide not to continue paying premiums, you can exercise specified options with your cash value.
Incontestability Clause
The incontestability clause stipulates that after the policy has been in force for a specified period (usually two years), the insurance company cannot dispute its validity during the lifetime of the insured for any reason, including fraud. One reason for this provision is that the beneficiaries, who cannot defend the company's contesting of the claim, should not be forced to suffer because of the acts of the insured.
Suicide Clause
The suicide clause provides that if the insured dies by suicide during the first two years the policy is in force, the death benefit will equal the amount of the premium paid. Generally, after two years, the suicide becomes a risk covered by the policy and the beneficiaries of a suicide receive the same benefit that is payable for death from any other cause.
Automatic Premium Loans
With an automatic premium loan option, if you do not pay the premium within the grace period, the insurance company automatically pays it out of the policy's cash value if that cash value is sufficient in your whole life policy. This prevents you from inadvertently allowing the policy to lapse.
Misstatement of Age Provision
The misstatement of age provision says that if the company finds out that your age was incorrectly stated, it will pay the benefits your premiums would have bought if your age had been correctly stated. The provision sets forth a simple procedure to resolve what could otherwise be a complicated legal matter.]
A loan from the insurance company is available on a whole life policy after the policy has been in force for one, two, or three years, as stated in the policy. This feature, known as the policy loan provision, permits you to borrow any amount up to the cash value of the policy. However, a policy loan reduces the death benefit by the amount of the loan plus interest if the loan is not repaid.
Look for insurance coverage from financially strong companies with professionally qualified representatives. It is not unusual for a relationship with an insurance company to extend over a period of 20, 30, or even 50 years. For that reason alone, you should choose carefully when deciding on an insurance company or an insurance agent. Fortunately, you have a choice of sources.
Protection is available from a wide range of private and public sources, including insurance companies and their representatives; private groups such as employers, labor unions, and professional or fraternal organizations; government programs such as Medicare and Social Security; and financial institutions and manufacturers offering credit insurance.
Some of the strongest, most reputable insurance companies in the nation provide excellent insurance coverage at reasonable costs. In fact, the financial strength of an insurance company may be a major factor in holding down premium costs for consumers.
Locate an insurance company by checking the reputations of local agencies. Ask members of your family, friends, or colleagues about the insurers they prefer.
For a more official review, consult Best's Agents Guide or Best's Insurance
Reports at your public library. For the latest
ratings, visit www.standardandpoor.com
An insurance agent handles the technical side of insurance. However, that's only the beginning. The really important part of the agent's job is to apply his or her knowledge of insurance to help you select the proper kind of protection within your financial boundaries.
Choosing a good agent is among the most important steps in building your insurance program. How do you find an agent? One of the best ways to begin is by asking your parents, friends, neighbors, and others for their recommendations. However, note that you will seldom have the same agent all your life.
You may also want to investigate an agent's membership in professional groups. Agents who belong to a local Life Underwriters Association are often among the more experienced agents in their communities.
Each life insurance company designs the policies it sells to make
them attractive and useful to many policyholders. One policy may
have features another policy doesn't; one company may be more selective
than another company; one company may get a better return on its
investments than another company. These and other factors affect
the prices of life insurance policies.
Five factors affect the price a company charges for a life insurance
policy:
the company's cost of doing business
the return on its investments
the mortality rate it expects among its policyholders
the features the policy contains
competition among companies with comparable policies.
Ask your agent to give you interest-adjusted indexes. An interest-adjusted
index is a method of evaluating the cost of life insurance by
taking into account the time value of money. Highly complex mathematical
calculations and formulas combine premium payments, dividends, cash-value
buildup, and present value analysis into an index number that makes
possible a fairly accurate cost comparison among insurance companies.
The lower the index number, the lower the cost of the policy.
The web addresses and telephone numbers of some price quote services:
These services are not always unbiased, since most sell life insurance
themselves; they may recommend more coverage than you need. Ask
them to quote you the rate each insurer charges most of its policyholders,
not the best rate, for which few persons qualify. Compare quotes
from several sources.
A life insurance policy is issued after you submit an application for insurance and the insurance company accepts the application.
The application usually has two parts. In the first part, you state your name, age, and sex, what type of policy you desire, how much insurance you want, your occupation, and so forth.
In the second part, you give your medical history. While a medical examination is frequently required for ordinary policies, usually no examination is required for group insurance.
The company determines your insurability by means of the information in your application, the results of the medical examination, and the inspection report. Of all applicants, 98 percent are found to be insurable, though some may have to pay higher premiums because of an existing medical condition.
A well-planned life insurance program should cover the immediate expenses resulting from the death of the insured. However, that is only one of its purposes. In most instances, the primary purpose of life insurance is to protect dependents against a loss of income resulting from the premature death of the primary wage earner. Thus, selecting the appropriate settlement option is an important part of designing a life insurance program. The most common settlement options are lump-sum payment, limited installment payment, life income option, and proceeds left with the company.
Lump-Sum Payment. The insurance company pays the face amount of the policy in one installment to the beneficiary or to the estate of the insured. This form of settlement is the most widely used option.
Limited Installment Payment. This option provides for payment of the life insurance proceeds in equal periodic installments for a specified number of years after your death.
Life Income Option. Under the life income option, payments are made to the beneficiary for as long as she or he lives. The amount of each payment is based primarily on the sex and attained age of the beneficiary at the time of the insured's death.
The payments may begin at once (immediate annuity) or at some future date (deferred annuity).
Because the annual payouts per premium amount are determined by average mortality experience, annuity contracts are more attractive for people whose present health, living habits, and family mortality experience suggest that they are likely to live longer than average. As a general rule, annuities are not advisable for people in poor health, although exceptions to this rule exist.
Why Buy Annuities?
A primary reason for buying an annuity is to give you retirement income for the rest of your life. You should fully fund your IRAs, Keoghs, and 401(K)s before considering annuities.
Although people have been buying annuities for many years, the appeal of variable annuities has increased recently due to a rising stock market.
A fixed annuity states that the annuitant (the person who is to receive the annuity) will receive a fixed amount of income over a certain period or for life. With a variable annuity, the monthly payments vary because they are based on the income received from stocks or other investments.
Tax Considerations
When you buy an annuity, the interest on the principal, as
well as the interest compounded on that interest, builds up
free of current income tax. The Tax Reform Act of 1986 preserves
the tax advantages of annuities (and insurance) but curtails
deductions for IRAs. With an annuity, there is no maximum annual
contribution. Also, if you die during the accumulation period,
your beneficiary is guaranteed no less than the amount invested.
