In general, life insurance is a type of coverage that pays benefits upon a person's death or disability. In exchange for relatively small premiums paid in the present, the policy holder receives the assurance that a larger amount of money will be available in the future to help his or her beneficiaries pay debts and funeral expenses. Some forms of life insurance can also be used as a tax-deferred investment to provide funds during a person's lifetime for retirement or everyday living expenses.
A small business might provide life insurance to its workers as a tax-deductible employee benefit—like health insurance and retirement programs—in order to compete with larger companies in attracting and retaining qualified employees. In addition, there are a number of specialized life insurance plans that allow small business owners to reduce the impact of estate taxes on their heirs and protect their businesses against the loss of a key employee, partner, or stockholder. Group life insurance is generally inexpensive and is often packaged with health insurance for a small additional fee. Companies that provide life insurance for their employees can deduct the cost of the policies for tax purposes, except when the company itself is named as the beneficiary.
Life insurance is important for individuals as well, particularly those who—like many entrepreneurs—are not covered by a company's group plan. Experts recommend that every adult purchase a minimum amount of life insurance, at least enough to cover their debts and burial expenses so that these costs do not fall upon their family members. The insurance industry uses a standard of five times annual income in estimating how much coverage an individual should purchase. The individual can also use a "backwards" calculation to establish what survivors will need to cope: current debt, two years of income for the spouse to find work, college funds for children, balance on the house, and estimated funeral expenses.
The cost of life insurance policies depends upon the type of policy, the age and gender of the applicant, and the presence or absence of dangerous life-style habits. Insurance company actuaries use these statistics to determine an individual's mortality rate, or estimated number of years that person can be expected to live. Policies for women usually cost less than those for men, because women tend to live longer on average. This means that the insurance company will receive premiums and earn interest on them longer before it has to make a payment. Experts recommend that companies or individuals seeking life insurance coverage choose an insurance agent with a rating of A or better, and compare the costs of various options before settling on a policy.
TYPES OF LIFE INSURANCE POLICIES
Term life insurance is the simplest and least expensive type, as it pays benefits only upon the policy holder's death. With annual renewable term insurance, the policy holder pays a low premium at first, which increases annually as he or she gets older. With level term insurance, the premium amount is set for a certain number of years, then increases at the end of each time period. Experts recommend that people who select term insurance make sure that their policies are convertible, so they can switch to a cash-value plan later if needed. They also should purchase a guaranteed renewable policy, so that their coverage cannot be terminated if they have health problems. Term insurance typically works best for younger people with children and limited funds who are not covered through an employer. This type of policy enables such a person's heirs to cover mortgage and college costs, estate taxes, and funeral expenses upon his or her death.
Whole Life Insurance
With whole life insurance, the policy holder pays a level premium on an annual basis. The policy usually covers until the end of the person's life—age 90 or 100. In most cases, the policy holder is overcharged for the premium, and the extra amount goes into an interest-bearing dividend account known as a cash value account. The individual can use the money in this account to pay future premiums, or can withdraw it or borrow against it to cover living expenses. With a variable whole life policy, the individual controls the investments made with his or her cash value account. Selecting certain types of investments, such as mutual funds, may allow the policy holder to increase the balance in the account significantly. Regardless of the performance of the investments, however, the amount of the insurance benefit can never drop below its original value. When choosing a whole life policy, it is important to analyze the fund's past performance and inquire about commissions and hidden costs. Although whole life insurance can provide added security upon retirement, it should not be considered a replacement for retirement savings. Ordinary investment approaches are meant to provide for the future, life insurance, above all else, is meant to handle the contingency of death.
Universal Life Insurance
Universal life insurance was introduced in the 1980s as a higher-interest alternative to whole life insurance. Universal life premiums are based not only on the cost of the insurance, but also on the interest rate offered on investments. Still, they are usually less expensive than whole life policies. Universal life policies provide individuals with a wider array of investment choices and higher projected interest rates. They are essentially similar to a term policy with a fixed rate of interest guaranteed for a year at a time.
Current Assumption Life Insurance
Current assumption life insurance features a fixed annual premium for the duration of the plan. This type of policy pays a set interest rate on premiums received, less the actual cost of the insurance. They can be useful as a tax-deferred investment vehicle, since they usually pay 2 to 4 percent more than banks. Policy holders may elect to overpay their premiums early in the plan period to accumulate cash value. They can withdraw or borrow from the funds later for any purpose, including retirement income, or can use the cash value to pay the premiums for the remainder of the plan period.
Riders and Options
Most types of life insurance policies give individuals the opportunity to add optional coverage, or riders. One popular option is accelerated benefits (also called living benefits), which pays up to 25 percent of the policy value to the holder prior to his or her death if he or she is struck by a serious illness. Another option, known as a waiver of premium, allows an individual to continue coverage without paying premiums if he or she becomes disabled. Many policies also provide an accidental death and dismemberment option, which pays twice the amount of the policy if the insured dies or loses the use of limbs as a result of an accident.
KEY PERSON PROTECTION
Small businesses tend to depend on a few key people, some of whom are likely to be owners or partners, to keep operations running smoothly. Even though it is unpleasant to think about the possibility of a key employee becoming disabled or dying, it is important to prepare so that the business may survive and the tax implications may be minimized. In the case of a partnership, the business is formally dissolved when one partner dies. In the case of a corporation, the death of a major stockholder can throw the business into disarray. In the absence of a specific agreement, the person's estate or heirs may choose to vote the shares or sell them. This uncertainty could undermine the company's management, impair its credit, cause the flight of customers, and damage employee morale.
Life insurance can help small businesses protect themselves against the loss of a key person by providing a source of income to keep business running in his or her absence. Partnership insurance basically involves each partner acting as beneficiary of a life insurance policy taken on the other partner. In this way, the surviving partner is protected against a financial loss when the business ends. Similarly, corporate plans can ensure the continuity of the business under the same management, and possibly fund a repurchase of stock, if a major stockholder dies. Although life insurance is not tax deductible when the business is named as beneficiary, the business may deduct premium costs if a partner or owner is the beneficiary.
Bougue, Jeff. "Life Insurance Basics." National Fisherman. November 2003.
Fried, Julie. "Details Count When Employers Shift to New Group Life Plans." National Underwriter Life & Health. 28 November 2005.
"In Brief: Variable Life Policy Eyes Small Business." American Banker. 23 February 2006.
Koco, Linda. "Life By the Numbers." National Underwriter Life & Health. 6 March 2006.
Shuntich, Louis S. The Life Insurance Handbook. Marketplace Books, 25 July 2003.
"Tax Planning: The Meaning of Life Insurance." Money Marketing. 30 March 2006.
Zultowski, Walter H. "High-Net-Worth Business Owners Need Retirement Planning Help." National Underwriter Life & Health. 17 October 2005.
Hillstrom, Northern Lights
updated by Magee, ECDI
Sections within this essay:Background
Types of Life Insurance
Individual Life Insurance
Group Life Insurance
Second-To-Die and First-To-Die Insurance
Term Life Insurance
Cash Value Life Insurance
Traditional Whole Life and Universal Life
Variable Life and Variable Universal Life
Denial of Claims
Minors as Beneficiaries
American Council of Life Insurers
National Association of Independent Life Brokerage Agencies (NAILBA)
National Alliance of Life Companies
A life insurance policy is simply a contract between an insurance company and the person who buys the policy, the policyholder. In exchange for payment of a specified sum of money, known as a premium, the life insurance company pays a named beneficiary a certain amount of money if specific events occur while the policy is in force. In life insurance policies the most common event is the death of the person who is insured, in which case the payment is made to the beneficiary, which may be a person, a trust or other legal entity, or the estate of the owner. Some policies also allow the owner to surrender the policy for its cash value or to take advance payments on the insurance in the event of diagnosis of a terminal condition. The sale of life insurance in the United States has historically been a highly competitive commission sales business with a number of products which combine life insurance and investments.
Despite their various names, all life insurance policies fall into either individual or group insurance policies. The difference between Individual and Group Life has become less distinct. Many associations sponsor life insurance plans that are called Group Life coverage but which actually require the same underwriting criteria as for Individual Life.
Individual Life insurance generally is underwritten taking into account the actuarial risk of death of the one individual being insured. Life insurance companies' underwriters typically use a combination of factors that statistics indicate equate with the risk of death. These include, but are not limited to applicant's age, applicant's gender (except in states which have uni-sex rate requirements), height and weight, family and applicant health history, marital status, number of children, hazardous occupations, tobacco use, alcohol use, dangerous hobbies, and foreign travel.
Group Life insurance policies cover the lives of multiple persons within a group. Group Life insurance historically was based on the risk characteristics of the group as a whole. The group might consist of employees of a business, members of a professional organization, members of a credit union, or perhaps members of a labor union. There are many other possibilities for these groups. The owner of the master group policy is the group itself, such as the employer, the union, the association, or whatever the group may be.
Most so-called Second-to-Die policies which pay upon the death of the second of two insured people are still regarded as Individual Life insurance. Similarly the so-called First to Die life insurance, where the lives of a small number of people are covered and the life insurance is payable on the first death is also Individual Life insurance. First to Die is often used to cover partners in a business. The proceeds can be used to buy out the share of the partner who dies first.
Either Group or Individual polices can be Term Life Insurance. Term Life Insurance is basic insurance in the event of death. The policy owner pays a premium to the insurance company; it can typically be paid monthly, quarterly, or annually. If the insured dies during the time period that the payments are being made, the insurance company pays the face amount of the life insurance to the beneficiary. As the risk of death increases as people get older, the premium generally also increases. At advanced ages, term insurance costs are extremely expensive.
Cash Value Life Insurance has the same benefits of Term Life Insurance with a savings or investment account. There are several types of Cash Value Life policies.
In Traditional Whole Life and Universal Life Insurance policies, money that does not go to pay insurance costs or the sales representative's commission is invested by the insurance company in fixed dollar type investments. Whole-life policies combine life coverage with an investment fund. Cash value builds tax-free each year, and policyholder can usually borrow against the cash accumulation fund without being taxed. Universal life is a whole-life policy that combines term insurance with a money-market-type investment that pays a market rate of return. To get a higher return, these policies generally do not guarantee a certain rate. However, sales of universal policies tend to be higher than those of plain whole life, due to the higher potential yield.
In Variable Life and Variable Universal Life policies, money that does not go to pay insurance costs or the sales representative's commission is invested by the insurance company in securities mutual fund accounts selected by the owner from among the insurer's available choices. Returns are not guaranteed. Variable products are regulated as securities under the Federal Securities Laws and must be sold with a prospectus.
A basic requirement for all types of insurance is the person who buys a policy must have an insurable interest in the subject of the insurance. With respect to life insurance, an insurable interest means a substantial interest engendered by love and affection in the case of persons related by blood and a lawful and substantial economic interest in the continued life of the insured in other business related cases. Everyone has an insurable interest in their own lives and in the lives of their spouses and dependents. Business partners may have an insurable interest in each other, and a corporation may have an insurable interest in its employees' lives. The insurable interest requirement is designed to prevent people from taking out a life insurance policy on some randomly selected persons and then killing them to get the insurance proceeds. The rule also prevents life insurance from becoming a gambling device and prevents someone from taking out insurance policies simply because people are known smokers or known to drink and drive. However, it is not necessary for the beneficiary to have an insurable interest in the life of the insured.
On larger policies, most life insurance companies require the applicant to undergo a physical examination by a medical professional. Samples of the applicant's blood and urine typically are taken by a paramedical person contracted by the insurance carrier to conduct such tests. The insurer will typically also request the applicant's medical records from his or her physicians and have them reviewed by the underwriters. The insure usually will also check the applicant's health history with the Medical Information Bureau (MIB).
MIB is a not-for-profit incorporated association of U. S. and Canadian life insurance companies. It is a provider of information and database management services to the financial services industry. Organized in 1902, MIB now consists of over 600 member insurance companies who agree to share information in the form of medical and avocation codes. There are approximately 230 codes, which MIB uses to signify different medical conditions. Some of the codes indicate risks involving hazardous avocations or adverse driving records. While the MIB does not report actual details about the person's medical condition or problem, the codes alert insurance companies to the fact that there was information obtained and reported by a member insurance company on this particular impairment or avocation risk. Individuals can request their own MIB record and can request that the company correct any errors. There is a small processing fee to obtain a report, which is waived if the request is within 60 days of an adverse underwriting decision. All MIB codes are supposed to be purged seven years from the report date.
Every life insurance policy specifies certain actions that must take place after a loss has occurred. Typically the beneficiary provides the life insurance company with a certified copy of the death certificate. After proof of the death is submitted to the insurance company, the life insurance company should promptly pay the benefits, assuming that the premiums were paid, making the policy in force. Even if premiums on the policy were not currently being paid, the policy may still have been in a paid status, or the company may have failed to send the necessary notices of cancellation, in which case it may be possible to recover on the policy. Usually, once the policy is at least two years old it is beyond the incontestable period and must be paid, except in extraordinary circumstances.
The most common reason life insurance companies use to deny claims is that there was a material misrepresentation in connection with the insurance purchase. The claim regarding material misrepresentation may arise out of the original application for the insurance or from an amendment to the application or in an application for reinstatement. A material misrepresentation sufficient to deny a claim cannot be just any incorrect statement. A material misstatement is almost always one that if it had been disclosed would have meant refusal by the insurer to issue the policy. The most commonly alleged misrepresentations involve an applicant's medical history. Delays in processing claims can sometimes result from legal questions regarding whether the policy was currently in force as of the date of death, or, if the death was a result of foul play, any possibility that the beneficiary may have played a role in the death
An exclusion is a part of an insurance policy which describes a condition or type of loss that is not covered by the policy. In life insurance, a common exclusion is an exception for accidental deaths caused by acts of war or while in active military service. Certain activities may also fall under the exclusion category. Some policies have an exclusion for deaths that occur while the insured was involved in the commission of a felony, or deaths resulting from suicide.
Because insurance companies handle large amounts of money on behalf of individuals and businesses, the level of public interest is sufficient to warrant governmental regulation. Historically, the purpose of insurance regulation has been to maintain the insurers' financial solvency and soundness and to guarantee the fair treatment of current and prospective policyholders and beneficiaries. There is no central Federal regulatory agency to specifically oversee insurance companies, and as a result, insurance companies in the United States are regulated by the individual states. These regulations include rules about matters such as forms, rates, sales agents, and general insurance business practices.
State laws regulating insurance business also include rules about unfair trade practices and unfair claims practices. It is illegal to refuse to sell insurance to someone because of the person's race, color, sex, religion, national origin, or ancestry. In some states the list of prohibited classifications includes marital status, age, occupation, language, sexual orientation, physical or mental impairment, or the geographic location where a person lives. Insurance underwriting decisions generally must be based on reasons that are related in some way to risk. A person has the right to be informed of any reason for refusal to issue an insurance policy.
Insurance companies have a range of payment or premium levels which can be charged for insurance. These are based on such factors as the applicant's age and health condition. Rating factors must be reasonably related to the risk being insured. The rates and rating factors for insurance must be filed with the insurance regulatory agency for each state where the insurance is to be sold. While a policyholder may elect to cancel an insurance policy at any time by giving notice to the insurance company, once a policy is issued, the insurance company cannot simply revoke it at will. The insurance company can only cancel the policy for reasons specifically outlined in the policy. State laws typically put limits on what an insurance company can include in the cancellation section of its policies. Generally, policies will be subject to cancellation only for some type of serious misrepresentation by the policyholder or for failure to pay the required premium on time. State law often requires insurers to allow a grace period of as much as 30 days after a payment is late before any insurance coverage can be terminated. Once the grace period expires, however, reinstatement is the sole option of the insurance company.
While children can lawfully be named as beneficiaries on a life insurance policy, the insurance company will not be permitted to pay benefits to a minor. The funds would likely be dispersed to the legal guardian of the minor child. Many divorced parents are shocked to discover that naming their minor children as beneficiaries makes their ex-spouse the direct recipient of any insurance proceeds. This situation can be avoided by creating a trust which can hold the funds until the children are of legal age.
Insurance: From Underwriting to Derivatives: Asset Liability Management in Insurance Companies Briys, Eric, Wiley, John & Sons, Incorporated, 2001.
True Odds: How Risks Affects Your Life Walsh, James, Merritt Company, 1995.
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What It Means
A life insurance policy is a legal agreement between an insurance agency and the policyholder, according to which the insurance agency agrees to pay a predetermined amount of money to a person or to a group of people, such as the insured’s family, upon the death of the policyholder. Those who receive this money are called the beneficiaries of the life insurance policy. Most policies also state that the insured person, rather than the beneficiaries, becomes eligible to receive these funds if he or she lives to be a certain age, often 90, 95, or 100. In return for these benefits, the policyholder pays a fee called an insurance premium. Most policyholders pay this fee annually. Many people receive life insurance as part of the benefit package (the terms of employment contract including insurance coverage and other benefits) associated with their jobs.
For example, a life insurance policy identifies the policyholder’s wife as the beneficiary scheduled to receive $200,000 in the event of the policyholder’s death. The policyholder is required to pay a $90 premium annually. If the policyholder dies three years after buying the policy (having paid only $270), the insurance company will pay his wife $200,000. Assuming this is one of the most basic types of policies, the insurance company would be required to pay the same fee of $200,000 if the policyholder died 20 years after buying the policy, having paid a total of $18,000 in premiums to the insurance company. The policy also states that if the policyholder lives to be 95 years old, he will collect the $200,000. Over the life of the policy, the policyholder is free to change beneficiaries or to add beneficiaries to the policy. If the policyholder’s wife were to die before he did, he would be able to name one of his children as the new beneficiary. If the policyholder wishes to add a child to the policy, he is required to stipulate how the $200,000 should be divided among the beneficiaries.
When Did It Begin?
Life insurance dates back to ancient Rome, when groups of men formed burial clubs. Members pooled their money together, establishing a common fund. When one of the members died, the living members used the funds to pay the deceased’s funeral expenses and to provide financial support for the surviving members of his family. Life insurance more closely resembling the policies available today first appeared in sixteenth-century London. This life insurance was originally available only to merchants and shipowners who met with policy sellers at a place called Lloyd’s Coffee House to draft the terms of the policies. Out of these meetings grew Lloyd’s of London, one of the world’s best-known insurance firms.
In the United States life insurance was initially sold to plantation owners in the South who bought the policies for their slaves. According to some records, an insurance company called Nautilus sold more than 450 policies to slaveholders during a two-year period in the 1840s. Life insurance first appeared in the northern United States in the early 1760s, when Presbyterian churches in New York City and Philadelphia established the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers. Churches of other Protestant denominations followed suit later in the decade, and shortly thereafter many more life insurance companies appeared. From 1787 to 1837 nearly 30 new life insurance companies opened, but only a small fraction survived.
More Detailed Information
At first glance, it might seem insurance companies take an unwise financial risk when selling an insurance policy. There is a chance that any given client could die shortly after purchasing the policy, in which case the insurance company has to make a large payout to a beneficiary without having received much money from the policyholder. To minimize this risk and to maximize the probability that they will profit from the sale of the policy, insurance companies use a complex statistical system to establish premiums for each of their clients. The professionals who analyze mortality (death) rate statistics to determine the cost of a policy are called actuaries, whose practice is called actuarial science.
When establishing premiums actuaries consider a number of important variables, such as the age and gender of the client, the type of policy being purchased, and the number of dangerous lifestyle obligations, habits, or hobbies that the client maintains. Holding a life-threatening job, such as firefighting, or having a dangerous habit, such as smoking tobacco, or having a risky hobby, such as skydiving, increases the likelihood of an early death. Therefore clients who participate in such endeavors are required to pay higher premiums for their life insurance policies. Insurance companies also review the health history of a client’s family to determine the cost of the policy. If, for example, there is a history of cancer in his family, the client will be required to pay a higher premium. Evaluating risk and determining price through these exhaustive background checks, which include questioning both the client and his or her physician, is called “underwriting.” An insurance company pools the premiums it receives from individual clients and makes investments to cover losses incurred when a client dies.
Different types of life insurance are available; the most common are term insurance, whole life insurance, and universal life insurance. Term life insurance is the most basic and least expensive type of policy. It offers a predetermined payoff only in the event of the policyholder’s death. According to most term life insurance policies, the client begins by paying a small annual premium and gradually pays a higher rate as he or she gets older. Experts recommend term life insurance for young people in their early to mid-20s who do not receive some form of life insurance from their employers. Experts also recommend that these people obtain what is called a “guaranteed renewable policy,” since many life insurance companies retain the right to terminate the agreement if the condition of a policyholder’s life changes.
As with term life insurance, whole life insurance policies usually pay beneficiaries at the end of the insured’s life. However, with these policies the insured usually pays the same high premium throughout the policy. According to these policies, a specified portion of every premium is invested on the insured’s behalf in an interest-bearing account. The interest earned on the funds in this account increases the value of the payoff to the beneficiary upon the death of the client. There are many different types of whole life policies, each of which offer clients various options. According to some policies, clients can control the amount they invest and how the money is invested over the course of the policy. Clients can often borrow money against whole life policies. Despite these options, it has been shown that whole life insurance policies tend on average to yield relatively small returns. Universal life insurance policies were established in the 1980s to offer potentially higher returns than whole life policies. Such policies offer a wider range of investment choices and often guarantee fixed interest rates on investments for a year at a time.
Reports from the first years of the twenty-first century indicated that more people worldwide purchase life insurance than any other form of insurance. In 2005 a total of $1.45 trillion was paid in life insurance premiums across the globe, while the combined premiums paid for all other types of insurance that year totaled $1.97 trillion. The ratio of life insurance premiums to all other nonlife premiums was nearly the same in the United States, where $517 billion in life premiums and $626 in nonlife premiums were collected in 2005. These figures made the United States the largest life insurance market in the world. Japan was the second largest market with $376 billion in life insurance premiums collected, and the United Kingdom was third with $101 billion.
Other data from 2005 indicate that excluding Japan, the rest of Asia was the largest growing life insurance market. The total in premiums collected in this geographic region increased 10.5 percent from the previous year. The growth, especially in China and India, has been attributed to three closely related factors. First, improvements in technology, namely the development of the Internet and data-management technologies, have allowed the world’s leading insurance firms to perform more sophisticated actuarial studies in emerging markets in the developing world. In other words, insurers now have the capacity to analyze a much broader customer base in more parts of the world. Second, rapidly developing economies in these areas have created a larger base of people able to afford life insurance policies. Third, governments in these markets have passed laws allowing major international firms to open branch offices there in order to compete with local insurance underwriters.
life in·sur·ance • n. insurance that pays out a sum of money either on the death of the insured person or after a set period.