Understanding Life Insurance Policies

Do life insurance policy terms confuse you to the point of indecision? What do those commonly thrown industry acronyms mean and how does if affect you? The following information is a general discussion of life insurance concepts.

To qualify for life insurance, you will have to provide evidence of “insurability”, or prove to the insurance company they are healthy. Most people neglect the fact when you’re buying a life insurance policy, what you’re buying is risk and betting on the fact you’re initial monthly investment will generate a large profit to your loved ones. The process known as “Underwriting” determines the risk to an insurance company, thereby setting your policy premium, and can either be quite extensive or fairly simple.

Fully underwritten policies may require blood tests, urine samples, and MIB (Medical Information Bureau) reports determining your current and past health conditions. If you have had a history of health conditions, usually in the past 5-10 years, these conditions could eliminate your “insurability” giving the insurance company grounds to decline a policy. Generally, if diagnosed with cancer, HIV, heart disease, stroke, depression, Type II diabetes, Crohn’s disease, and other death-causing ailments in the past 10 years, you are what insurance companies call, “un-insurable.”

A growing popularity of Simplified policies, commonly referred to “instant issues” are sold at your local Bank, Credit Union, or telemarketed. These are policies that only require you answer yes or no questions to common health problems. Also, risk-based activities, IE do you fly a plane, skydive, race cars or on active duty with the military, can immediately result in a turn-down if you answer “yes” and engage in any of these practices. Generally, policies that do not require full-underwriting, will cost more than a fully underwritten policy as the insurance company is taking your word for common health questions without scientific proof of your good health.

If you choose to lie and the insurance company fails to discover your deception, a period of contestability exists where your insurance company will investigate the cause of death. In Colorado, the clause for contestability is 2 years, which means once a policy has been in force, or you’ve paid into it for 2 years, the insurance company must pay out the claim regardless of the cause for death. Ask your agent for your state specific law as they are required to pass an insurance exam before obtaining license to sell life insurance.

If the insurance company concludes you lied on your application, your “beneficiaries” or the people you list to receive the insurance benefit, will receive the premiums paid if your claim is denied. Suicide is only covered if you commit after the policy is in force for one year, but again, check with your local state agent for the state specific law. Questions of mental health are often asked during the application process to eliminate this risk to the insurance company.

Your age, smoking habits, and overall health will determine the amount of your “premium”, or price. Obesity suggests ill-health and will cause an increased premium amount.

If you are young and healthy, generally your premium will be cheap. As you grow older and less healthy, your premium will become more expensive as insurance companies use what is known as the actuarial process to determine the cost of insuring you. Actuary tables identify the “risk” associated, or the statistical data to provide the insurance company the likelihood you’ll die. These tables factor life expectancies as well as additional statistical data when processing the final premium quote.

Congratulations, you’re healthy, and qualify for life insurance, now the question of what type of insurance to buy arises. There are lots of different bells and whistles insurance policies can carry but the common types of insurance you’ll encounter are TERM, Permanent Insurance (Whole Life), and Annuities, all priced accordingly. Variations of Whole Life include Universal Life and Variable Universal Life. Variations of Annuities include Fixed and Variable. Much of how each type of insurance works is implied in the name. All insurance policies allow payment of premium either monthly, quarterly, or annually, some providing discounts for annual payments. Also, all insurance products are tax-deferred in earnings and growth and in some cases tax-free. The policy’s stated face value is always tax free to your beneficiaries upon an untimely death.

The most common type of insurance offered and purchased is TERM insurance, and as the name implies, the insurance is offered for a specific term, provided you make your premium payments on time. When you purchase term insurance, you generally need to prove eligibility for coverage, or provide information to ensure you are healthy. Typically, people will buy term to cover a specific liability or debt for a specific period of time, and often, you’ll see TERM insurance called Mortgage Protection Insurance.

Just remember, the term, TERM can apply to any life insurance with these basic characteristics, specific period of time for coverage, usually a fixed face value, and hold a guarantee your premiums will not increase for the term you purchased, even if you develop health conditions during the policy period. *(Be cautious of decreasing term, popularized in conjunction to mortgages, and just as the name states, your benefit amount decreases although your premiums may stay the same price)

Term insurance is pure insurance, much like auto insurance where premiums are priced at the “cost of insurance.”

WHOLE LIFE insurance refers to insurance that covers you for your entire life, or in some cases age 95-100. Your premium is divided into two areas, the cost of insuring you and a separate cash value account. Generally, the cash value account has stated interest rate, with a minimum guarantee as determined by your insurance company, which grows and can increase the face value or policy benefit over time. The greater the guaranteed rate minimum, the better, as you’ll only benefit from earning higher interest rates.

Whole life premiums are determined by assessing the average cost of insurance over a policy-holder’s life. Usually, you pay into a whole life policy for your whole life unless the policy has been structured to pay itself through the separate cash value account after the interest has compounded, increasing your policy value.

EF Hutton during the late 70’s devised UNIVERSAL life adding a tweak to whole life insurance, designing policies that allow cash values to grow faster. UL’s charge the actual cost of insurance, rather than the average cost of insurance. The current age of the insured determines the yearly cost for insurance, then places the additional premium into a separate cash value account. With whole life, the insurance company assesses the average cost of insurance at the time of policy purchase, averaging this cost over life expectancy. With UL’s the cost is re-evaluated every year the policy holder keeps the policy in force.

This forward thinking version of Whole Life, invented in the 17th century, with some ties to French Tontines in the 16th century, combines the best features of term insurance and whole life, by utilizing the policy holders dollars in the most cost-effective manner. UL’s offer the same guarantees around rate as a whole life policy and covers the insured for their entire life versus a 10, 20, or 30 year period.

Variable Universal Life actually invests the cash value portion into “investment markets” or mutual funds; a pooling of investor’s dollars with a common objective. The risk associated with VUL’s, is that if the market has negative returns, a policy holder may have to invest more dollars to support the cost of insurance, or the policy may collapse, because premiums earmarked to pay the cost of insurance must now feed the negative returns in your separate cash value account. VUL’s are usually offered as “single premium”, or a large, one-time investment, but can be sold as a policy with a recurring premium paid monthly, quarterly or annually.

With permanent insurance, generally the insurance company will have provisions where you can borrow against the policy’s cash value. These distributions are considered tax-free and in some cases can assist with retirement income pre 59 1/2. Ask your agent about the policy net loan rate and stay away from insurance companies that charge a net rate greater than zero. You shouldn’t have to pay to borrow your own tax-protected money. If you do borrow against your policy, the insurance company will subtract the amount borrowed, from the face value paid to beneficiaries, upon your untimely death.

Fixed Annuities are an insurance product usually requiring an initial lump-sum investment and offer a stated guaranteed rate with a minimum guaranteed rate your annuity will accrue in spite of market conditions.

Variable annuities will take your initial lump-sum investment and offer “sub-accounts” for your assets. These sub-accounts are usually mutual funds and can provide higher rates of return over longer periods of time versus a fixed annuity. Risk is again at the hands of the investor as sub-account performance is never guaranteed. Many VA’s will offer a fixed rate sub-account, an account with a guaranteed rate and some will offer Dollar Cost Averaging, which means the issuing company will take a portion of your lump sum, place the majority in the guaranteed account, then every month from 6 months-2 years, take 1/6 or 1/24 of the initial amount and invest in your chosen sub-accounts. A VA works much like a 401 (k) or retirement plan offered through your employer.

All annuities grow tax-deferred and follow the rules of 59 1/2. Once you start taking distributions, all gains will be taxed at ordinary income or whatever tax bracket you’re in versus long-term capital gains (20%). There are provisions to withdraw funds from an annuity early and avoid the 10% penalty, called 72(Q) but consult your investment advisor for additional details.

DO NOT annuitize, unless you are looking for a guaranteed stream of income to supplement your SSI benefit or other retirement income. Once you annuitize, the money is the insurance company’s and you bear the risk of dying early, leaving your initial investment to the insurance company rather than your beneficiaries.

Annuities do not require evidence of insurability and for people in the later years of life, annuities offer additional guarantees to act in the place of life insurance. Annuities offer what is know as “M&E expense” or Mortality and risk Expense, guaranteed options to increase the initial investments where beneficiaries will receive the initial amount plus whatever stated guarantees are offered by the issuing company.

Life Insurance plays an integral role in your personal financial plan. Often, we as individuals forget the two guarantees of life: death and taxes, and Life Insurance offers a solution to both issues.

The majority of Americans own Health Insurance, Home Insurance, and Auto Insurance, with laws enacted over time to enforce individuals to own or carry these types of policies. Let me offer you a few statistics-1 out of 14,400 homes will catch on fire, addressing the need for Home Insurance, 1 out of 47 individuals were involved in a Car Accident last year, 82% of the population owns some type of health insurance coverage. However, statistics show only about 25% of the population owns life insurance with the majority under-insured. Most insurance professionals suggest owning at least 5 times the salary of the primary bread-winner. If you do not make a salary but another is dependent upon your survival to defray intangible expense, IE childcare, pet-care, it is still wise to purchase a policy with enough death benefit to cover the work you provide daily.

Remember, life insurance is the most selfless financial commitment you can buy, as it’s main purpose is to benefit the people who survive you. Even if you are single, young, and have little debt, the average funeral costs between 5,000-25,000. Imagine if your parents, friends or family had to fork up funds to cover this expense.

As many industry professionals state, life insurance is really “Death Insurance” a financial tool to supply tax-free income for those that survive your passing, and many Americans forget, it’s not a matter of IF you’ll die, but when.