Textbook Cases
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NewChap12.docx12 Life Insurance Planning
YOU MUST BE KIDDING, RIGHT?
Michelle and Jason Bailey are in their early 30s and expecting their first child next month. Each earns about $60,000 per year. Currently, they have $50,000 life insurance policies on each of their lives with the other named as the beneficiary. They bought these policies a few years ago to pay for death-related expenses if tragedy struck. With the baby coming, they are thinking about buying $300,000 in life insurance coverage on each of their lives so the proceeds could be used to replace the income lost if one of them died. How much will Michelle and Jason each pay for this additional protection?
A. About $25 per month
B. About $50 per month
C. About $100 per month
D. About $200 per month
The answer is A. Term life insurance for people in their 30s can cost about $1 (or less) per $1000 of coverage per year. Thus, Michelle and Jason could each easily buy this insurance for $300 each or about $25 per month—a small price to pay for the security provided. Always buy inexpensive term life insurance so that you replace the lost income needed by your dependents if you were to pass away!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Understand why you might need life insurance and calculate the appropriate amount of coverage.
Distinguish among types of life insurance.
Explain the major provisions of life insurance policies.
Apply a step-by-step strategy for implementing a life insurance plan.
WHAT DO YOU RECOMMEND?
Stephanie Bridgeman, age 28, and her husband Will, age 30, recently had their first child. Both have small cash-value life insurance policies ($25,000 and $50,000, respectively) that their parents purchased when they were children. Stephanie is a real estate attorney and earns $90,000 per year. She has continued working after having the baby. Stephanie's employer offers a 401(k) plan into which she contributes a maximum of 6 percent of her salary each year matched by her employer one-half of 1 percent for each 1 percent that Stephanie contributes. Her employer does not offer employer-paid life insurance. Will is a high-school teacher and track coach and makes $49,000 per year. His employer pays the full cost of his retirement pension plan. An optional supplemental retirement plan is available into which Will can contribute 5 percent of his salary, but he has not done so as yet. Will has an employer-provided life insurance policy equal to twice his annual salary. Will and Stephanie have no other life insurance.
What do you recommend to Stephanie and Will on the subject of life insurance planning regarding:
1. Their changing need for life insurance now that they have a child?
2. What types of life insurance they should consider and whether they should purchase multiple policies?
3. Coordinating their retirement savings and other investments with their life insurance program?
4. Shopping for life insurance?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to life insurance planning:
1. Calculate your life insurance needs every three years or when major life events occur, such as the birth of a child.
2. Comparison-shop for term life insurance on the Internet to obtain the lowest possible rates.
3. Protect against health-related premium increases by selecting guaranteed renewable term policies and cash-value policies that have a guaranteed insurability option.
4. Employ the principle of “buy term life insurance and invest the rest” by purchasing guaranteed renewable term life insurance.
5. Partially fund your tax-sheltered retirement plan with the money saved by purchasing term rather than cash-value life insurance.
Two financial problems arise because you do not know when you will die. The first problem is the risk of living too long. This raises the possibility that you will outlive your savings during retirement. Life insurance is the wrong way to address the living-too-long problem. For that problem you should invest through tax-sheltered retirement savings plans (discussed in Chapter 17) and over time create a substantial amount of wealth.
The second problem is the risk of dying too soon. This is the possibility that you might die before adequately providing for the financial well-being of loved ones, especially your spouse and children. Life insurance protects your loved ones against the possibility that you may die too soon. As you will see, term life insurance does this best.
life insurance An insurance contract that promises to pay a dollar benefit to a beneficiary upon the death of the insured person.
The need for life insurance is greatest during the child-rearing years because the income of one or more adults is needed to support a child financially. As children get into their teenage years, they need fewer additional years of financial support. Thus the necessity of life insurance on the income earner begins to decline. And eventually, the children leave home for employment, school, or whatever. Over time, the need for life insurance for the family is eliminated because sufficient funds should be available for survivors through savings and investments that will build up over time, primarily through a retirement plan.
12.1 HOW MUCH LIFE INSURANCE DO YOU NEED?
The primary reason for buying life insurance is to allow your family members to continue with their lives free from the financial burdens that your death would bring. Your purchase of life insurance is to benefit your loved ones, not yourself. So if you are young, unmarried, and childless, you need little, if any, any life insurance.
12.1a What Financial Needs Must Be Met upon Your Death?
Financial losses that arise from dying too soon include expenditures for final expenses; the lost income of the deceased; and funds for a readjustment period, debt repayment, and possibly education expenses for a surviving spouse and children.
• Final-Expense Needs Final expenses are one-time expenses occurring just prior to or after a death. The largest of these expenses is for the funeral and burial or cremation of the deceased, which could cost as little as $2000 or as much as $15,000. In addition, there also travel and food for mourners and costs of settling the estate.
final expenses One-time expenses occurring just prior to or after a death.
• income-replacement Needs Once someone else becomes financially dependent on you, your income and employee benefits will be the major financial loss resulting from your premature death.
• readjustment-Period Needs Families often need a period of readjustment after the death of a loved one. This period may last for several months to two or three years and may require the surviving spouse to forgo employment for a time or obtain further education.
• Debt-repayment Needs A family that has bought sufficient life insurance for the replacement of lost income probably will not need to make specific insurance provisions for the repayment of most debts. It is sometimes helpful, however, to buy an additional amount of life insurance to pay off all nonmortgage debt in order to simplify the finances of the survivors.
LEARNING OBJECTIVE 1
Understand why you might need life insurance and calculate the appropriate amount of coverage.
• College-Expense Needs Death of a parent can impede planning for children's college expenses. A suggested amount of additional life insurance would be the current cost of tuition and room and board and expenses for four years at a desired institution.
• Other Special Needs Many families have special needs that must be considered in the life insurance-planning process. For example, a family might have a child with special needs who will require medical or custodial care as an adult. Extremely wealthy families might need extra life insurance to pay federal estate taxes and state inheritance taxes (covered in Chapter 17).
12.1b There Are Three Ways You Can Meet These Financial Needs
There are three ways you can meet your need for protection from losses described earlier: existing assets, government benefits, and life insurance.
1. Existing Assets Can Help Meet the Need The funds held in savings accounts, certificates of deposit, stocks, bonds, and mutual funds often are specifically earmarked for some special goal, such as retirement, travel, or college for children. These could be used by survivors, even though it might be wiser to retain these funds for their originally intended purposes. Retirement accounts, such as 401(k) plans and IRAs (discussed in Chapter 17), will go to the survivor named as the beneficiary on the account. Younger families should not use these funds earlier in life because such action will jeopardize the surviving spouse's retirement.
2. Government Benefits May Help Meet Some of the Needs Widows, widowers, and their dependents may qualify for various government benefits—most notably Social Security survivor's benefits , which are paid to a surviving spouse with minor children or to the children directly if there is no surviving spouse. These benefits generally cease when the youngest child reaches age 18. The level of benefits depends on income earned during the lifetime of the deceased and could be as high as $2500 per month although they average less than $1000.
Social Security survivor's benefits Government program benefits paid to a surviving spouse and children.
3. Life Insurance Can Close Any Remaining Gap in Needs Life insurance is the simplest form of insurance because it protects against only one peril—death. The benefit the policy will pay in cash is known in advance. This payment to the beneficiary (the person named in the policy to receive the funds) will occur within a few days once a death certificate is presented to the insurance company. Some people have existing life insurance that was purchased previously or provided through their employer. These coverages can reduce or eliminate the need for additional life insurance purchases.
beneficiary Person who receives life insurance proceeds, as per the policy.
12.1c What Dollar Amount of Life Insurance Do You Need?
Determining the magnitude of the losses resulting from a premature death can be complicated. Two methods are commonly used: a multiple-of-earnings approach and a needs-based approach. The needs-based approach is more accurate.
The Multiple-of-Earnings Approach Uses Flawed Logic The multiple-of-earnings approach estimates the amount of life insurance needed by multiplying your income by some number, such as 5, 7, or 10. Thus, someone with an annual income of $40,000 would need $200,000 to $400,000 in life insurance. Life insurance agents often suggest this simplistic approach. However, it addresses only one of the factors affecting life insurance needs—income-replacement needs—and does not take into consideration such factors as age, family situation, and other assets that could cover the lost income.
Buying Life Insurance versus Investing
Most college students will live well into their 80s, although about 20 percent will die before retirement. Buy term life insurance to protect against an early death and make investments to prepare for a long life.
Partners Both Need a Life Insurance Plan
Both married and co-habitating couples should coordinate their life insurance planning and they also need individual policies. This is true even if one partner makes the bulk of the family income. When appropriate, the cost of replacing the household labor of a stay-at-home spouse should be included in life insurance planning.
Social Security Survivor Benefits Have a Blackout Period
Once the youngest child reaches age 18, a surviving spouse enters the Social Security blackout period and is ineligible for Social Security survivor benefits. The blackout period ends when the surviving spouse reaches age 60. The surviving spouse may then collect survivor's benefits until age 62, and then may begin collecting Social Security retirement benefits based on his or her own or the deceased spouse's retirement account, whichever provides the higher payment.
The Needs-Based Approach Is the Best Method The needs-based approach for estimating life insurance needs considers all of the factors that might potentially affect the level of need. The Run the Numbers worksheet below, “The Needs-Based Approach to Life Insurance,” illustrates calculations made via the needs-based approach. You would be wise to calculate your current needs for life insurance and then to revisit those calculations every few years and when changes occur in your employment, family situation or your health status.
needs-based approach A superior method of calculating the amount of insurance needed that considers all of the factors that might potentially affect the level of need.
Calculating Life Insurance Needs for a Couple with Small Children Consider the example of Gene Thomas, a 35-year-old chef from Denver, Colorado, who has a spouse Candice (age 30) and three children (ages 8, 7, and 3 years). Gene earns $56,000 annually and desires to replace his income for 30 years, at which time his spouse would be approaching retirement. The “Example” column of the Run the Numbers worksheet, “The Needs-Based Approach to Life Insurance,” expands on the situation faced by Gene.
1. Final-expense needs. Gene estimates his final expenses for funeral, burial, and other expenses at $12,000.
2. Income-replacement needs. Gene's income of $56,000 is multiplied by 0.75 and the interest factor of 19.6004 (from Appendix A-4). This factor was used because Gene decided that it would be best to replace his lost income for 30 years or until Candice, his wife, reached age 60 and passed through the Social Security blackout period. Gene and Candice are moderate-risk investors and believe that she could earn a 3 percent after-tax, after-inflation rate of return on life insurance proceeds. Income-replacement needs based on these conditions amount to $823,217.
3. Readjustment-period needs. Candice is a reporter for a local newspaper, earning an annual income of $38,000. Allocating $19,000 for readjustment-period needs would allow her to take a six-month leave of absence from her job or meet other readjustment needs.
4. Debt-repayment needs. Gene and Candice owe $10,000 on various credit cards and an auto loan. They also owe about $128,000 on their home mortgage. Candice would like to pay off all debts except the mortgage debt if Gene dies. The mortgage debt would be affordable if Gene's income were adequately replaced.
5. college-expense needs. Gene estimates that it would currently cost $25,000 for each of his sons to attend the local community college. If he dies, $25,000 of the life insurance proceeds could be invested for each child. If invested appropriately, the funds should grow at a rate sufficient to keep up with increasing costs of a college education.
6. Other special needs. Gene and Candice do not have any unusual needs related to life insurance planning, so they entered zero for this factor.
Adequate life insurance can ensure that important goals, such as paying for a child's education, are met should a parent die.
The Needs-Based Approach to Life Insurance
This worksheet provides a mechanism for estimating life insurance needs using the needs-based approach. The amounts needed for final expenses, income replacement, readjustment needs, debt repayment, college expenses, and other special needs are calculated and then reduced by funds available from government benefits and any current insurance or assets that could cover the need. This worksheet is also available on the Garman/Forgue companion website.
7. Subtotal. The Thomases total items 1 through 6 on the worksheet and determine that the family's financial needs arising out of Gene's death would amount to $939,217. Although this sum seems large to them, they have access to two resources that can reduce this figure, as indicated in items 8 and 9.
8. Government benefits. Gene determined from his Social Security Benefits Statement that his family would qualify for monthly Social Security survivor's benefits of $2725, or $32,700 a year.* These benefits would be paid for 15 years, until his youngest son turns 18. The present value of this stream of benefits is $390,369 (from Appendix A-4), assuming a 3 percent return for 15 years.
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9. current insurance and assets. Gene has a $50,000 life insurance policy purchased five years ago. His employer also pays for a group policy with a face amount of $50,000. Gene's major assets include his home and his retirement plan. Because he does not want Candice to have to liquidate these assets if he dies, he includes only the $100,000 insurance coverage in item 9.
10. Life insurance needed. After subtracting worksheet items 8 and 9 from the subtotal, Gene estimates that he needs an additional $448,848 in life insurance. This amount may large, but Gene can meet this need through term life insurance for as little as $30 per month.
Because Candice earns an income that is about two-thirds of Gene's, her life insurance needs may be about one-third percent lower. To determine the specific amount, the couple must complete a worksheet for her as well. Next, the Thomases will need to decide what type of life insurance is best and from whom to buy the additional life insurance needed. These topics are covered later in this chapter.
Calculating Life Insurance Needs for a Young Professional Baomei Zhao of Akron, Ohio, recently graduated with a degree in tourism management and has accepted a position paying $43,000 per year. Baomei is single and lives with her sister. She owes $14,500 on a car loan and $21,800 in education loans. She has about $7000 in the bank. Among her employee benefits is an employer-paid term insurance policy equal to her annual salary.
Baomei has been approached by a life insurance agent who used the multiple-of-earnings approach to suggest that she needs $215,000 in life insurance, or about five times her income. Does she? If you apply the needs-based approach to Baomei's situation, you will see the following:
• Baomei estimates her final expenses at $12,000, which she entered for item 1.
• Items 2, 3, 5, and 6 in the needs-based approach worksheet on page 353 are zero because Baomei has no dependents.
• Baomei would like to see her $14,500 automobile loan and $21,800 education loans repaid in the event of her death. She feels better knowing that her younger sister could inherit her car free and clear. She entered $36,300 for item 4.
• Baomei's survivors will not qualify for any government benefits, so item 8 will also be zero.
• Baomei has other life insurance and certain assets worth a total of $50,000, so she entered that amount for item 9.
Bias toward Avoiding Difficult Subjects
People engaged in life insurance planning have a bias toward certain behaviors that can be harmful, such as a tendency toward avoiding discussing difficult topics. Many people avoid planning for the possibility of death. What to do? Force yourself to do a life insurance needs assessment and purchase the insurance you need.
The resulting calculations show that Baomei needs no additional life insurance ($12,000 + $36,300 − $50,000 = − $1700). The agent also suggested that Baomei buy now while she is young and rates are low. This is not a smart idea because you should never buy life insurance simply to lock in low rates. That would be like buying car insurance before you own a car. Besides, life insurance prices are declining. Unless you have a personal or family-based medical history that might interfere with the purchase of life insurance when needed later, you, like Baomei, should wait until you actually need life insurance before buying a policy.
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CONCEPT CHECK 12.1
1. Distinguish between the dying-too-soon problem and the living-too-long problem and the best ways to address each.
2. List five types of needs that can be addressed through life insurance.
3. Explain why the multiple-of-earnings approach is less accurate than a needs-based approach to life insurance planning.
4. Identify two periods in a typical person's life cycle when the need for life insurance is low and one when it is high.
12.2 THERE ARE ONLY TWO BASIC TYPES OF LIFE INSURANCE
Many people are confused by the wide variety of life insurance plans available. But, in reality, there are only two types of life insurance: term life insurance and cash-value life insurance. Term life insurance is often described as “pure protection” because it pays benefits only if the insured person dies within the time period (term) covered by the policy. The policy must be renewed if coverage is desired for another time period. In this way, it acts much like car or homeowner's insurance.
term life insurance “Pure protection” against early death; pays benefits only if the insured dies within the time period (term) that the policy covers.
All the other life insurance policies are variations of cash-value life insurance . These policies pay benefits at death (like term policies) but also include a savings/ investment element that can provide benefits to the policyholder prior to the death of the insured person. This cash value factor represents the value of the investment aspect of the life insurance policy. Because of the investment aspect of cash-value policies, many people automatically believe cash value life insurance is the better option, but this is false. Cash-value life insurance costs much more than term insurance, and there are much better options for investing than life insurance, as you will learn in upcoming chapters
cash-value life insurance Pays benefits at death and includes a savings/investment element that can provide a level of benefits to the policyholder prior to the death of the insured person.
12.2a Term Life Insurance Is Pure Protection
Term life insurance contracts are most often written for time periods (or terms) of 1, 5, 10, or even 20 years. If the insured survives the specified time period, the beneficiary receives no monetary benefits. Term insurance can be purchased in contracts with face amounts in multiples of $1000, usually with a minimum face amount of $50,000. The face amount is the dollar value of life insurance protection as listed in the policy and used to calculate the premium. Variations on term life insurance include decreasing term insurance, guaranteed renewable term insurance, convertible term insurance, and credit (term) life insurance.
face amount Dollar value of protection as listed in the policy and used to calculate the premium.
LEARNING OBJECTIVE 2
Distinguish among types of life insurance.
The Tax Consequences of Life Insurance
Life insurance proceeds paid to a beneficiary are not subject to income taxes and may be used in any way the beneficiary wishes. If the funds are put in the bank or invested in some way, any interest or dividends earned will be subject to income taxation.
Unless otherwise stipulated by the original contract, to renew the policy you must apply for a new contract and may be required to undergo a medical examination. The premium will increase slightly with each renewal, reflecting your increasing age, of course. For example, a $100,000 five-year renewable term policy for a man age 25 might have an annual premium of $100; at age 35, the policy might cost $135; and at age 45, it might cost $220. Term policies are much less expensive than a new cash-value policy at any given age because they do not include a savings/investment element.
Guaranteed Renewable Term Insurance Proving insurability at renewal of a term policy may be difficult if you develop a serious health problem. To avoid this dilemma, term life insurance policies are usually written as guaranteed renewable term insurance . The guarantee protects you against the possibility of becoming uninsurable due to health status reasons. The number of renewals you can make without proving insurability may be limited to two or three, and a maximum age may be specified for these renewals (usually 65 or 70 years). Unless you are positive that you will not need a renewal, guaranteed renewable term insurance is recommended. The additional cost for this guarantee is negligible but the coverage is critically important.
guaranteed renewable term insurance Protects you against the possibility of becoming uninsurable.
Level-Premium Term Insurance As you grow older, you can avoid term insurance premium increases in part by buying level-premium (or guaranteed level-premium) term insurance . This is is a term policy with a long time period. Under such a policy, the premiums remain constant throughout the entire life of the policy, perhaps 5, 10, or 20 years. Premiums charged in early years are higher than necessary to balance out the lower-than-necessary premiums in later years covered by the policy. Premiums on policies written for ten or more years usually remain constant for a five-year interval, and then might increase to a new constant rate for another five- or ten-year interval.
level-premium term insurance Term policy with a long term under which premiums remain constant. Also called guaranteed level-premium term insurance.
Decreasing Term Insurance With decreasing term insurance, the face amount of coverage declines annually, while the premiums remain constant. The buyer chooses an initial face amount and a contract period, after which the face amount of the policy gradually declines (usually each year) to some minimum in the last year of the contract. For example, a woman age 35 might buy a 30-year $200,000 decreasing term policy that declines by $5000 each year to a minimum of $50,000.
Convertible Term Insurance Convertible term insurance offers the policyholder the option of exchanging a term policy for a cash-value policy without evidence of insurability. Usually, this conversion is available only during the first five years of the policy. There are two ways to convert a term policy to a cash-value policy. First, you can simply request the conversion and begin paying the higher premiums required for the cash-value policy. Second, you can pay the company the cash value that would have built up had the policy originally been written on a cash-value basis.
convertible term insurance Offers policyholders the option of exchanging a term policy for a cash-value policy without evidence of insurability.
Millions of Families Have No Life Insurance
Surveys show that only 44 percent of families have an individual life insurance policy. Most people think that life insurance is expensive but that is false. On the contrary, term life insurance is very affordable, costing as little as $40 per month for a $500,000 policy and $70 per month for a $1 million policy on a person under age 45.
Group Term Life Insurance Group term life insurance is issued to people as members of a group, typically through an employer, rather than as individuals. Group life insurance premiums are average rates based on the characteristics of the group as a whole and, therefore typically, cost more than individually purchased plans for healthy individuals. If you are insured under a group plan, however, you do not need to prove your insurability. This is a major benefit for people whose health status makes individual life insurance unaffordable or unattainable.
Credit and Mortgage Term Life Insurance Credit term life insurance will pay the remaining balance of a specific loan if the insured dies before repaying the debt. Mortgage life insurance specifically pays off a mortgage debt. In essence, both of these types of term insurance are decreasing term insurance with the creditor named as beneficiary. These products are grossly overpriced, and the only people who should consider their purchase are those who are truly uninsurable because of a serious health condition.
12.2b Cash-Value Life Insurance Has a Savings Element
Cash-value life insurance pays benefits upon the death of the insured and also incorporates a savings/investment element. This cash value belongs to the owner of the policy rather than to the beneficiary. While the insured is alive, the owner may obtain the cash value by borrowing some of it from the insurance company or by surrendering and canceling the policy. Cash-value insurance is referred to as permanent insurance because coverage is maintained for the entire life of the insured as long as premiums are paid. The annual premiums for cash-value policies usually remain constant.
The premiums for newly written cash-value policies are always much higher than those for term policies providing the same amount of coverage. This difference arises because only a portion of the premium is used to provide the death benefit; the remainder is used to keep the premium level and to build the cash value. Figure 12-1 illustrates the premium differences between cash-value and term life insurance policies.
Figure 12-1Comparison of Premium Dollars for Cash-Value and Term Life Insurance Figure 12-2 The Fundamental Nature of Cash-Value Life Insurance The $100,000 death benefit (face value) paid to the beneficiaries comprises a decreasing amount of life insurance and the policyholder's returned built-up cash values.
Cash-value life insurance represents a combination of decreasing term insurance and an investment account that adds up to the face amount of the policy. Figure 12-2 illustrates this concept. Initially, for example, you might have $100,000 of insurance and no savings. About a decade later, you might have built up $2000 in savings within the policy. In the event of your death, your beneficiary would collect $100,000, of which $2000 would be your own money. If you lived long enough, the cash value could equal the $100,000 figure. In effect, your beneficiary would then collect your “savings account” rather than an insurance payment. Discussed below are 5 types of of cash-value life insurance.
Whole Life Insurance Whole, or straight, life insurance is the most popular form of cash-value life insurance, and it provides lifetime life insurance as long as the premiums are paid every year the person is alive. The policy remains in effect and does not need to be renewed.
whole life insurance Form of cash-value life insurance that provides lifetime life insurance protection and expects the insured to pay premiums for life. Also called straight life insurance.
Limited-Pay Whole Life Insurance Limited-pay whole life insurance is whole life insurance that allows premium payments to cease before you reach the age of 100. Two common examples are 20-pay life policies, which allow premium payments to cease after 20 years, and paid-at-65 policies, which require payment of premiums only until the insured turns 65. Although premiums need be paid only for the specified time period in limited-pay policies, the insurance protection lasts for your entire life.
limited-pay whole life insurance Whole life insurance that allows premium payments to cease before the insured reaches the age of 100.
Of course, the annual premiums for limited-pay insurance policies are higher than those for whole life insurance policies because the insurance company has fewer years to collect premiums. Limited-pay policies are said to be paid up when the owner can stop paying premiums. An extreme version of limited-pay life insurance is single-premium life insurance, in which the premium is paid once in the form of a lump sum.
paid up Point at which the owner of a whole life policy can stop paying premiums.
Adjustable Life Insurance Adjustable life insurance allows you to modify any one of the three components of life insurance (premium, the face amount of the policy, and the rate of cash-value accumulation) with corresponding changes occurring in the other two. These changes may be made without providing new proof of insurability.
Modified Life Insurance Modified life insurance is whole life insurance for which the insurance company charges reduced premiums in the early years and higher premiums thereafter. The premiums are lower in early years because some of the protection during the early years is provided by term insurance. Because modified life insurance uses term insurance in the early years, it accumulates cash value extremely slowly.
12.2c Some Cash-Value Life Policies Earn a Variable Return
The rate at which the cash value accumulates in a cash-value policy depends on the rate of return paid by the company. All of the cash-value policies described above earn a guaranteed minimum rate of return, often 2 to 4 percent and are known as fixed-rate policies. Some cash-value policies, however, may instead pay a higher rate depending on the success of the investments made by the insurance company. Table 12-1 illustrates these rates.
A drawback of policies with a variable return is the high expense loadings and fees they carry. A 2 percent annual fee would change a policy with an annual return of 5 percent on its investments to one with a net 3 percent return. Discussed below are 3 types of cash-value life insurance policies.
Universal Life Insurance Universal life insurance provides both the pure protection of term insurance and the cash-value buildup of whole life insurance, along with variability in the face amount, rate of cash-value accumulation, premiums, and rate of return. Initially, the purchaser selects a face amount, and the company quotes an annual premium. The annual premium goes into the cash-value fund, from which the company deducts the cost of providing the insurance protection and charges for company expenses.
universal life insurance Provides the pure protection of term insurance and the cash-value buildup of whole life insurance, along with face amount variability, rate of cash-value accumulation, premiums, and rate of return.
As time goes by, the owner of the policy may choose to pay a smaller are larger premium, with corresponding changes occurring in the insurance protection or amount added to cash value. If premiums drop below the amount necessary to cover the insurance protection and expenses, funds are removed from the cash-value account to cover the shortfall. Essentially, universal life insurance combines annual term insurance with a type of investment program. A popular version of universal life insurance is the indexed universal life insurance policy where the investments portion is invested in an index mutual fund (see Chapter 15).
Table 12-1 Cash-Value Buildup Illustration—Guaranteed Versus Current Rates *
|
Policy Year |
“Guaranteed” Cash-Surrender Value (2.0% rate) |
“Current Rate” Cash-Surrender Value (3.1% rate) |
|
1 |
$ 0 |
$ 0 |
|
2 |
0 |
96 |
|
3 |
289 |
354 |
|
4 |
640 |
730 |
|
5 |
995 |
1,152 |
|
6 |
1,310 |
1,475 |
|
7 |
1,730 |
1,910 |
|
8 |
2,100 |
2,365 |
|
9 |
2,567 |
3,420 |
|
10 |
2,910 |
4,123 |
|
15 |
5,050 |
6,780 |
|
20 |
7,300 |
9,355 |
|
25 |
$10,200 |
$13,630 |
*Figures are illustrative for a $50,000 universal life policy; the annual premium is $684.
Don't Be Fooled by “Return-of-Premium” Riders
A feature of some term life insurance that is sometimes promoted as a great idea is return-of-premium (ROP) rider. Here the salesperson selling the policy promises that it will return all the premiums paid if the insured person maintains the policy and lives past a certain number of years—usually 30. These term policies cost much more in order to provide for the return of premiums. Insurance companies promote these policies as a way to avoid “wasting” your money.
In reality, what they are trying to do is entice you to pay more with the difference becoming analogous to an investment with the profit being the returned premium. of course, most policyholders do not keep their policies for 30 years. And if you die during the policy term you receive nothing on your “investment.” Finally, the extra costs may prevent you from buying enough life insurance. This is definitely not a good idea.
Hyungsoo Kim
University of Kentucky
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Variable Life Insurance Variable life insurance allows you to choose the investments made with your cash-value accumulations and to share in any gains or losses. The face amount of your policy and the policy's cash value may rise or fall based on changes in the returns earned on the invested funds. The face amount of the policy usually will not drop below the originally agreed-upon amount, however. Instead, the cash value will fluctuate. Variable life insurance policies are complicated and should be read and analyzed very carefully before purchase.
Variable-Universal Life Insurance Variable-universal life insurance is a form of universal life insurance that gives the policyholder some choice in the investments made with the cash value accumulated by the policy. It is sometimes called flexible-premium variable life insurance. It is no longer a popular type of cash-value life insurance even though it appears to embody the philosophy of “buy term and invest the rest.” In fact, it does not do this very well as you will read later in this chapter on page 368. Variable-universal life policies usually provide no minimum guaranteed rate of return.
variable-universal life insurance Form of universal life insurance that gives the policyholder some choice in the investments made with the cash value accumulated by the policy. Also called flexible-premium variable life insurance.
CONCEPT CHECK 12.2
1. Distinguish between term life insurance and cash-value life insurance.
2. Explain why the premiums for term insurance are so much lower than those of cash-value life insurance.
3. Describe the benefit of buying guaranteed renewable term insurance.
4. Explain why the amount of “insurance” declines over time under a cash-value life insurance policy.
5. Distinguish between cash-value life insurance with a fixed return and with a variable
12.3 UNDERSTANDING YOUR LIFE INSURANCE POLICY
A life insurance policy is a contract between an insurance policy holder/owner and an insurance company, where the company promises to pay a designated beneficiary a sum of money (the “benefits”) upon the death of the insured person. It contains all of the information relevant to the agreement. Several parties will be named in the life insurance contract. The owner , or policyholder , retains all rights and privileges granted by the policy, including the right to amend the policy and the right to designate who receives the proceeds. The insured is the person whose life is insured. In addition to the beneficiary, the owner will name a contingent beneficiary who will become the beneficiary if the original beneficiary dies before the insured. The same person may be one or more of these parties.
life insurance policy A contract between an insured (insurance policy holder) and an insurer or assurer, where the insurer promises to pay a designated beneficiary a sum of money (the “benefits”) upon the death of the insured person.
owner/policyholder Retains all rights and privileges granted by the policy, including the right to amend the policy and the right to designate who receives the proceeds.
insured Individual whose life is insured.
12.3a Policy Terms and Provisions Unique to Life Insurance
Life insurance policies define the terminology used in the policy and outline the basic provisions of such insurance. This information serves to clarify the meaning of the policy and the protection afforded the insurer and the policyholder.
The Application The life insurance application is the policyholder's offer to purchase a policy. It provides information and becomes part of the life insurance policy. Any errors or omissions in the application may allow the insurance company to deny a request for payment (usually within the first year) of the death benefit and instead any premiums will be refunded.
Lives Covered Most life insurance policies cover the life of a single person—the insured. First-to-die policies cover more than one person but pay only when the first insured dies. These policies are less costly than separate policies written on each person, but the survivor then has no coverage after the first person dies. An alternative is the survivorship joint life policy, which pays when the last person covered dies.
LEARNING OBJECTIVE 3
Explain the major provisions of life insurance policies.
How Insurance Policies Are Organized
All insurance policies have five basic components including declarations, insuring agreements, exclusions, conditions, and endorsements. In order of their usual location in the policy, these five elements contain information as follows:
1. Declarations provide the basic descriptive information about the insured person or property, the premium to be paid, the time period of the coverage, and the policy limits. Also included may be promises by the insured to take steps to control the losses associated with a specific peril, such as not smoking.
2. Insuring agreements are the broadly defined coverages provided under the policy. The insurer makes these promises in return for the premium paid by the insured. For example, in life insurance, the insurer promises to pay the death benefit amount to the beneficiary upon proof of the insured's death.
3. Exclusions narrow the focus and eliminate specific coverage broadly stated in the insuring agreements. The insurer makes no promise to pay for these exceptions and special circumstances. For example, suicide is commonly excluded during the first two years of a life insurance policy. People who do not understand the exclusions in their policies may believe they are covered for a loss when, in fact, they are not.
4. Conditions impose obligations on both the insured and the insurer by establishing the ground rules of the agreement. For example, they might include procedures for making a claim after a loss, rules for cancellation of the policy by either party, and procedures for changing the terms of the policy.
5. Endorsements (or riders ) are amendments and additions to the basic insurance policy that can both expand and limit coverage or raise the policy limits to accommodate specific needs.
Incontestability Clause Life insurance policies generally include an incontestability clause that places a time limit—usually two years after issuance of the policy—on the right of the insurance company to deny a claim. This clause addresses the problems arising out of erroneous statements that may have been made by the insured on the application.
incontestability clause Places a time limit on the right of the insurance company to deny a claim.
Suicide Clause Life insurance policies always include a suicide clause that allows the life insurance company to deny coverage (although all premiums will be refunded) if the insured commits suicide within the first two years after the policy is issued. If the specified number of years has elapsed, the full death benefit will be paid.
Cash Dividends Insurance dividends are defined by the Internal Revenue Service as a return of a portion of the premium paid for a life insurance policy; they are not considered taxable income. They represent the surplus earnings of the company when the difference between the total premium charged exceeds the cost to the company of providing insurance. Policies that pay dividends are called participating policies , and policies that do not pay dividends are called nonparticipating policies. Both term and cash-value policies may pay dividends.
insurance dividends Surplus earnings of the insurance company when the difference between the total premium charged exceeds the cost to the company of providing insurance.
participating policies Life insurance policies that pay dividends.
Death Benefit The death benefit of a life insurance policy is the amount that will be paid upon the death of the insured person. The amount of the death benefit may be either higher or lower than the face amount. It can be higher due to such items as earned dividends not yet paid or premiums paid in advance. Or it can be lower due to outstanding policy loans or unpaid premiums. Consider a $100,000 participating whole life policy with annual premiums of $1380. If the insured died halfway through the policy year, with an outstanding cash-value loan of $5000 and earned but unpaid dividends of $4000, the death benefit would be $99,690, calculated as follows:
death benefit Amount that will be paid to the beneficiary when the insured dies.
DO IT IN CLASS
Grace Period Prompt payment of the premium is crucial to the continuation of coverage provided by any insurance policy. A lapsed policy is one that has been terminated because of nonpayment of premiums. More than one-half of all whole life policies lapse within ten years of being issued!
Turn Bad Habits into Good Ones
Do You Do This?
Assume that you have life insurance set up by your parents
Put off thinking about life insurance because you are young
Assume a cash-value life insurance policy is the best way to buy life insurance
Rely on a life insurance agent to determine how much and what type of insurance to buy
Do This Instead!
Confirm that you are covered and for how much
Determine the dollar amount of insurance that you need and buy insurance to cover any shortfall
Explore term life insurance as the lowest cost and most appropriate means of protection
Make your own assessments based on your income and family obligations
To help prevent a lapse, state laws generally require that cash-value and multiyear term policies include a grace period , that is, a period of time (usually 30 days following each premium due date) during which an overdue premium may be paid without a lapse of the policy. During the grace period, all provisions of the policy remain intact if payment is made before the grace period ends.
grace period Period of time during which an overdue premium may be paid without a lapse of the policy.
Reinstatement If your life insurance policy lapses, it may be possible to reinstate it. To do so, you typically must prove insurability and pay any missed premiums, plus interest, to be reinstated.
Multiple Indemnity A multiple indemnity clause provides for a doubling or tripling of the face amount if death results from certain accidents. It is most often used to double the face amount if death results from an accident. Such a clause is often included automatically as part of the policy at no extra cost.
12.3b Policy Features Unique to Cash-Value Life Insurance
Cash-value life insurance policies carry special features that all relate to the cash values built up in the policies.
The Policy Illustration Cash-value life insurance policies generally provide a policy illustration that charts the projected growth in the cash value. Table 12-1 (on page 359) provides an example of a policy illustration.
Policy illustrations can be somewhat helpful, but you should only rely on the guaranteed minimum rate of return (the minimum rate that, by contract, the company is legally obligated to pay) and understand that the current rate (the rate of return recently paid by the company to policyholders) is an estimate of future returns and is quickly outdated. For this reason, it is smart to periodically ask your agent for an in-force illustration that shows the cash-value status of the policy and projections for the future given the current rate of return at the time of the illustration (rather than the rate used at the inception of the policy). Reading the middle and right columns in the policy illustration in Table 12-1 reveals that a cash-value policy has very little cash surrender value unless you have held it for ten years or more.
guaranteed minimum rate of return Minimum rate that, by contract, the insurance company is legally obligated to pay.
current rate Rate of return the insurance company has recently paid to policyholders.
Asking a few pertinent questions can help cut through some of the misconceptions:
1. Is the “current rate” illustrated actually the rate paid recently? What was the current rate in each of the past five years?
2. What assumptions have been made regarding company expenses, dividend rates, and policy lapse rates?
3. Does all of my cash value earn a return at the current rate? (If not, the current rate is misleading.)
4. Is the illustration based on the “cash surrender value” or the “cash value”? (The cash surrender value is usually the lower value and reflects what will actually be paid if the policy is cashed in.)
Nonforfeiture Values Nonforfeiture values are important for consumers. These are amounts stipulated in a life insurance policy that protect the cash value, if any has accumulated, in the event that the policyholder chooses at some point to not pay or fails to pay the premiums. The policy owner can receive the accumulated cash-value funds in one of three ways. First, the policy owner may continue the policy with the original face amount but for a time period shorter than the original policy. Second, he or she may simply surrender the policy and receive the cash surrender value , which represents the cash value minus any surrender charges. Third, the policy may be continued on a paid-up basis, with a new and lower face amount being established based on the amount that can be purchased with the accumulated funds.
nonforfeiture values Amounts stipulated in a life insurance policy that protect the cash value, if any, in the event that the policyholder chooses not to pay or fails to pay required premiums.
cash surrender value Represents the cash value of a policy minus any surrender charges.
Policy Loans The owner of a cash-value policy may borrow all or a portion of the accumulated cash value. Interest rates charged for the loan will range from 2 to 8 percent, depending on the terms of the policy. In addition, the interest rate earned on the remaining cash value typically reverts to the guaranteed minimum rate while the loan remains outstanding. As a result, the cash value ultimately accumulated may be significantly reduced. At a minimum, you must pay the interest on the amount borrowed and any amount owed will be subtracted from the face amount of the policy if you die while the debt remains outstanding.
Money Websites for Life Insurance Planning
Informative websites for life insurance planning, including sites that compare policies and prices are:
Accuquote (www.accuquote.com/)
Insweb (www.insweb.com)
Kiplinger's Personal Finance (www.kiplinger.com/fronts/channels/insurance/index.html)
National Association of Insurance Commissioners (www.naic.org/store_home.htm)
New York Times (topics.nytimes.com/your-money/insurance/life-and-disability-insurance/index.html)
CNN Money www.money.cnn.com/magazines/moneymag/money101/lesson20/index.htm
Your State's Department of Insurance (www.naic.org/state_web_map.htm)
Your Worst Financial Blunders in Life Insurance Planning
Based on others' financial woes, you will make mistakes in personal finance when you:
1. Let a life insurance agent tell you how much and what type of life insurance to buy.
2. Buy cash-value life insurance rather than term policies.
3. Ignore your changing need for life insurance as your get older.
An automatic premium loan provision allows any premium not paid by the end of the grace period to be paid automatically with a policy loan if sufficient cash value or dividends have accumulated. In the first few years of a policy, this provision may not offer much benefit because cash value and dividends accumulate slowly. Eventually these funds may grow enough to pay premiums for a considerable length of time, thereby effectively preventing the lapse of the policy.
automatic premium loan Provision that allows any premium not paid by the end of the grace period to be paid automatically with a policy loan if sufficient cash value or dividends have accumulated.
Some life insurance policies have a living benefit clause (or accelerated death benefits rider) that allows the payment of a portion of the death benefit prior to death if the insured contracts a terminal illness or requires long-term medical care such as in a nursing home. These early payments are not cash-value loans but do reduce the death benefit ultimately paid. Viatical companies specialize in buying life insurance policies from terminally ill insureds for a percentage of the death benefit in return for being named owner and beneficiary on the policy. The viatical company continues to pay the premiums on the policy.
Waiver of Premium A waiver of premium is a clause in an insurance policy that waives the policyholder's obligation to pay any further premiums should he or she become seriously ill or disabled. It usually applies when a policyholder becomes totally and permanently disabled, but it may also apply under other conditions, depending on the policy provisions. In effect, the waiver-of-premium option (for an extra cost) protects against the risk of becoming disabled and being unable to pay premiums.
waiver of premium A clause in an insurance policy that waives the policyholder's obligation to pay any further premiums should he or she become seriously ill or disabled.
Guaranteed Insurability The guaranteed insurability (or guaranteed purchase ) option permits the cash-value policyholder to buy additional stated amounts of cash-value life insurance at stated times in the future without taking a health exam. This option differs from the guaranteed renewability option for term insurance in that it enables the owner to increase the face amount of the policy or to buy an additional policy. The policy might allow the exercise of these options when the insured turns age 30, 35, or 40, or when he or she marries or has children. The added cost of this option is nominal and worthwhile.
guaranteed insurability (guaranteed purchase option) Permits the cash-value policyholder to buy additional stated amounts of cash-value life insurance at stated times in the future without evidence of insurability.
12.3c Settlement Options Specify How the Death Benefit Will Be Paid
Settlement options are the choices that the life insurance policyholder has in determining how the death benefit will be paid. The owner may choose the option before death, or the beneficiary may select the option after the insured's death. The five settlement options are as follows:
settlement options Choices from which the policyholder can choose in how the death benefit payment will be structured.
1. Lump sum. The death benefit may be received as a lump-sum cash settlement immediately after death. This is often the best approach to take because the beneficiary can invest the proceeds and earn a return higher than the insurance company would pay.
2. Interest income. The beneficiary can receive the annual interest earned from the death benefit. For example, the beneficiary would receive $4000 each year from a $100,000 death benefit earning 4 percent interest. The $100,000 principal would remain intact and would continue to earn interest until the death of the beneficiary, when it becomes part of his or her estate.
3. Income of a specific amount. The beneficiary may receive a specific amount of income per year from the death benefit. Under this option, payments cease when the death benefit and interest are exhausted. For example, a $100,000 death benefit earning 4 percent interest would provide a $15,000 annual income for approximately eight years.*
4. Income for a specific period. The beneficiary may receive an income from the death benefit for a specific number of years. For example, a widow with small children may choose to receive an income for 18 years. The insurance company would calculate a level of income that would allow for equal proceeds each year, with all funds, including interest, being exhausted at the end of the 18th year.
5. Income for life. The beneficiary may elect to receive an income for life. In such a case, the insurance company would use the life expectancy of the beneficiary to calculate the level of income that would allow for equal annual payments so that funds would be exhausted by the expected date of the beneficiary's death. If the beneficiary lives longer than expected, the income payments would continue.
CONCEPT CHECK 12.3
1. Distinguish among the owner, the insured, the beneficiary, and the contingent beneficiary of a life insurance policy.
2. Briefly describe each of the five components of all insurance policies.
3. Identify the five settlement options for the payment of the proceeds of a life insurance policy to its beneficiary.
4. Besides taking the cash value as a lump sum, what are some additional ways a cash-value policyholder may take the proceeds of the policy at cancellation?
5. Distinguish between an automatic premium loan and a waiver-of-premium option in a life insurance policy.
6. Explain how guaranteed renewability for term life insurance and guaranteed insurability for cash-value insurance protect insured people who develop serious health conditions.
About Life Insurance after Divorce
If you receive income from a former spouse either through alimony or child support, life insurance on that person is strongly advised. If a policy that was purchased while a couple was married remains in effect, it is smart to keep it. To be certain that the correct beneficiary is named, have that requirement stated in a court order and/or made part of the divorce decree. The custodial parent should be named as owner of the policy, thereby preventing the noncustodial parent from making any changes in the policy. Also require written confirmation from the insurance company each year that the premium has been paid and the policy is in force. Noncustodial parents will also need life insurance on their former spouses because they will probably receive custody of the children if the former spouse dies and he or she may need additional income to support the larger household.
12.4 HOW TO BUY LIFE INSURANCE
Your life insurance needs vary over your life cycle and so should your insurance plan.
12.4a Integrate Your Life Insurance into Your Overall Financial Planning
Figure 12-3 depicts a life insurance and investment plan recommended over an individual's life cycle. This plan is built on two foundations: (1) the purchase of term insurance for all or major portion needs because term insurance is more flexible than cash-value insurance and provides more protection for each premium dollar and (2) a systematic, regular investment program.
LEARNING OBJECTIVE 4
Apply a step-by-step strategy for implementing a life insurance plan.
As a family ages, life insurance needs typically decrease. Figure 12-3 Wisely Using Life Insurance and Investments over the Life Cycle
†Layered term insurance policies.
‡ Includes vested employer-sponsored retirement (e.g., 401[k]) plans. (See Chapter 17.)
A base of insurance can provide for funeral, burial, and other final expenses. A $20,000 to $50,000 guaranteed-renewable term or guaranteed-insurable, cash-value policy is sufficient. The remainder of your life insurance should consist of multiple term insurance policies that you start buying when you begin to have dependents. These should be five-or ten-year, level-premium, guaranteed renewable policies in increments of $100,000 or more. The policies should be layered so that you can drop policies as your need declines. By the time you reach retirement, you can drop all your policies as your retirement investment plan can provide for your survivor's needs.
12.4b Get a Great Price Buying Life Insurance Online
Smart personal financial managers take a do-it-yourself approach to life insurance. They regularly calculate their needs and decide what types of insurance to buy and cancel in what increments. This allows them to use a premium quote service that offers computer-generated comparisons from among 20 to 80 different companies. Premium quote services can be found at www.insure.com, www.quotescout.com, and www.accuquote.com. These websites also offer online life insurance needs calculators and a wealth of information on life insurance from an unbiased perspective. In addition, all the major life insurance companies have an online purchase system. Term insurance is easiest to buy this way, but even cash-value insurance can be purchased online.
premium quote service Offers computer-generated comparisons from among 20 to 80 different companies.
DO IT IN CLASS
Buy Term Insurance and Invest the Rest
Americans tend to buy the wrong type of life insurance—cash-value—when term insurance policies cost about 80 percent less. They incorrectly think of life insurance as an investment and not as an expense. And the life insurance industry likes it that way. Be smart and spend as little money as possible to buy the coverage you need. One way to do this is to use the strategy to “buy term and invest the rest.” If you invest the money difference between the cost of premiums for a term life insurance policy and the cost of premiums for a more expensive cash-value policy, you will always come out ahead financially. To see why, consider the buildup of protection for Seth Cameron, a 30-year-old art gallery administrator from New York City who is considering life insurance policies. Seth could pay an $870 annual premium to buy a $100,000 whole life policy. Alternatively, he could spend $130 for the first-year premium of a $100,000 five-year renewable term policy and invest the $740 difference ($870-$130) in through a tax-sheltered retirement account (assuming a 5 percent after-tax rate of return).
If Seth were to die tomorrow, the policy's beneficiary would receive both the $100,000 in insurance proceeds and the $740 in savings. After five years (age 35), Seth's annual $740 in savings would have grown to $4293; if he were to die at that time, the total death benefit would be $104,293. If Seth dies years into the future, the estate is even further ahead because of the growing principal in the account. By age 60, Seth's mutual fund investment would have grown to $58,052. If the account earned higher than 5 percent annually, the amount would be much greater. By the time Seth reached age 60, the term insurance premiums would exceed the premiums for the cash-value policy. However, his need for life insurance would presumably be eliminated or greatly reduced at that point. If Seth's children were self-supporting by then, he could probably drop the term insurance policy altogether. Nevertheless, his mutual fund account would remain to provide a financial nest egg of $58,052 or more to his heirs.
With the “buy term and invest the rest” strategy, Seth would have been insured more than 30 years at total premium cost of just $7350. By contrast, the cash-value policy would have required total premiums of $26,100 ($870 × 30), and the policy's cash value at year 30 would be about $44,000.
For “buy term and invest the rest” to work, however, the difference between the term and cash-value policy premiums must, in fact, be invested on a regular basis. Many people say that they will invest this money but then fail to follow through on that promise. You can, like Seth, succeed with a little discipline. The easiest way to ensure that your money is actually invested is to set up an automatic investment program (AIP) in which a mutual fund is authorized to withdraw money from your checking account, perhaps monthly, to buy mutual fund shares. When you agree to invest the “difference” automatically, the strategy will work well for you.
Buy Life Insurance from a Financially Strong Company
The most important feature of any life insurance company is its ability to pay its obligations. The company you choose must have the stability and financial strength to survive for the many years your policy will remain in force. Ratings of the financial strengths of insurance companies are available from A.M. Best Company (www.ambest.com), Standard & Poor's (www.standardandpoors.com). Weiss Ratings (www.weissratings.com/), Moody's Investor Services (www.moodys.com/), Duff and Phelps (www.duffandphelps.com/)
12.4c Or Contact a Local Insurance Agent
An insurance agent is a representative of an insurance company authorized to sell, modify, service, and terminate insurance contracts. In the United States, life insurance is typically sold through exclusive agents who represent only one company.
insurance agent Representative of an insurance company who is authorized to sell, modify, service, and terminate insurance contracts.
The life insurance agent must be qualified to design a program tailored to your specific needs and should understand all life insurance needs. The agent should have earned the professional designations chartered life underwriter (CLU) and either the certified financial planner (CFP) or chartered financial consultant (ChFC) designation. In addition, you should check your agent's reputation with your state's insurance and securities investment regulatory agencies. See www.naic.org/state_web_map.htm.
Layer Your Term Insurance Policies and Never Pay More than $60 per Month
You can meet your life insurance needs by layering term insurance policies so that coverage grows and then can be decreased as your needs change.An example is provided in the following chart. It assumes that the person is age 25 when a first child is born and age 30 when a last child is born. In this example, the parents buy several level-premium term policies near the birth of the first child, with the policies having differing time periods. They buy another policy when their last child is born and another as the first child gets close to college age. As the children go out on their own, some of the earliest policies expire, thereby reducing the overall amount of insurance as the parents' needs decline.
layering term insurance policies Purchasing level-premium term policies so that coverage grows when you need it most and then can be decreased as your needs change.
One benefit of layering is affordability. Based on premium rates for healthy nonsmokers, the cost for the plan illustrated here would never be more than $60 per month.
12.4d Sales Commissions Can Amount to 90 Percent of the Annual Premium
Part of the premium you pay for life insurance each year goes toward the sales commissions that are paid to the selling insurance agent. Ssales commissions on term insurance policies are very low—often no more than 10 percent of the premium if the policy is purchased directly rather than through an agent.
Cash value policies are different, and that is a major reason why agents try to sell them instead of term policies: They make more money. Sales commissions are as much as 90 to 100 percent of the first-year premium paid for a cash-value life insurance policy. Over the following years, commissions decline annually to 50, 40, 30, 20, and eventually 10 percent. Then more of the premium each year builds cash value.
You can buy life insurance policies with low sales commissions. Such low-load life insurance can be bought on the Internet at such sites such as www.llis.com. You can also do so through fee-only financial planners and fee-for-service insurance agents who charge a set fee rather than a percentage commission.
12.4e Fair Prices for Term Life Insurance
The price people pay for life insurance depends on their age, health, occupation, and lifestyle. Life insurance companies offer their lowest prices to “preferred” applicants whose health status and lifestyle (for example, nonsmokers) suggest longevity. “Standard” and “impaired” applicants would pay more. Because companies differ in how they assign these labels to applicants, you should comparison-shop for the best treatment. For example, some companies allow an occasional (monthly) cigar smoker to qualify for non-smoker rates.
Term life insurance premiums are usually quoted in dollars per $1000 of coverage. Generally, the higher the face amount of the policy, the lower the rate per $1000. For example, a company might sell term life insurance for $1 per $1000 per year when purchased in face amounts of $100,000 or more and for $1.25 per $1000 per year for policies of less than $100,000. Policies with face amounts of $1 million can cost less than $0.50 per $1000 per year for people younger than age 35.
It is easy to pay too much for term life insurance, especially if you do not comparison-shop. Table 12-2 on page 371 shows fair prices for term life insurance based on price per $1000 of coverage. Note that smokers pay much higher premiums than nonsmokers because, as a group, smokers die ten years earlier than nonsmokers. Men pay more than women because they typically die three years earlier.
DO IT IN CLASS
Sean's Success Story
Sean has always felt that life insurance planning is an important part of his overall financial well-being. When he graduated from college, his first job provided him with a term-life insurance policy equal to his annual salary. He calculated his need for life insurance and found that this amount was more than adequate. He has been in a steady relationship for almost two years and has begun to think about how his life insurance needs might change should he get married. Last week, he met with a life insurance agent who suggested that Sean buy a $50,000 whole life policy with annual premium of $587. He shopped around on his own and realized he could buy as much as $1 million of term insurance for the same money. After more research, he plans to buy multiple guaranteed-renewable, level-premium term policies that he can add and discard in a layering process. The money he saves by purchasing term insurance will be invested in a Roth IRA retirement account that he can use to pay for his children's college or his own retirement when the time comes.
Signs of an Unethical Life Insurance Agent
In an effort to earn maximum commissions and fee revenues, some agents act unethically, and may do any of the following:
1. Seven times your salary should do the trick. To assess your insurance needs the agent uses the multiple earnings approach rather than the needs approach.
2. Cash-value is a great investment. The agent discourages you from buying a term policy and instead pressures you to buy a cash-value policy.
3. I have a better policy for you. The agent encourages you to replace an existing cash-value policy with another (this is illegal in some states).
4. The policy pays for itself. The agent focuses strongly on the net cost of the policy rather than how the policy genuinely meets the needs of your family.
5. Look at how much you will make. The agent suggests that the high current rate of return is all but guaranteed and unlikely to go down.
6. I can make you even more money. The agent says it is a good idea to borrow from a policy to make some other investment such as an annuity.
7. Hurry, act now. The agent pressures you to sign and pay for a policy without giving you ample time to read it and compare the policy to others.
8. I will keep your situation to myself. The agent tells you to misstate your health status or age in order to lower your premium a bit.
9. You get a rebate. It is illegal for the insurance agent to give you a rebate of premium out of his commission as an inducement for you to buy a policy.
10. Talk, talk, talk. The agent does all the talking and uses lots of insurance jargon rather than addresses your issues in understandable language.
12.4f Two Methods May Be Used to Compare Similar Life Insurance Policies
It is much more difficult when comparing different types of cash-value policies. The cost of insurance measured in dollars per $1000 is not an appropriate way to compare term with cash-value insurance or when examining different types of cash-value insurance. Also inappropriate is the net cost of a life insurance policy which equals the total of all premiums to be paid minus any accumulated cash value and accrued dividends. The net cost is often a negative figure, giving a false impression that the policy will pay for itself. You should ignore net cost calculations provided by a life insurance agent.
Table 12-2 Fair Prices for Term Life Insurance* Table 12-3 Premiums for a $100,000 Life Insurance Policy (Typical annual premiums for various types of policies)
DO IT NOW!
You know more about personal finance after reading this chapter, so get started right now by:
1. Finding out if you currently have life insurance and, if so, what type you have.
2. Using the needs approach (a calculator can be found on this book's website) to determine your present need for life insurance.
3. Discussing the results of the above with your closest family members.
There are two methods suitable for comparisons. Table 12-3 shows illustrative premiums for various types of life insurance policies. These range from annual renewable term to a paid-at-age-65 policy.
1. Interest-adjusted cost index method. A cost index is a numerical method used to compare the costs of similar plans of life insurance. The interest-adjusted cost index (IACI) measures the cost of life insurance, taking into account the interest that would have been earned had the premiums been invested rather than used to buy insurance. The lower the IACI, the lower the cost of the policy. Ask for 5-, 10-, 20-, and 30-year IACI values as well because companies have been known to manipulate their dividend and cash-value accumulations to look especially good at the 20-year point. You should insist on being told the index before you agree to buy a policy, and you should shop elsewhere if the agent refuses, resists, or implies that the index has little value.
2. Interest-adjusted net payment index method. The IACI assumes that the policy will be cashed in and surrendered at the end of a certain period (usually 20 years) rather than remaining in force until the death of the insured. If the policy will remain in force until death, you can use the interest-adjusted net payment index (IANPI) to effectively measure the cost of cash-value insurance. The lower the IANPI, the lower the cost of the policy.
interest-adjusted net payment index (IANPI) If a policy will remain in force until death, this method allows you to effectively measure the cost of cash-value insurance. The lower the IANPI, the lower the cost of the policy.
CONCEPT CHECK 12.4
1. List the benefits of buying term and investing the rest.
2. Explain how the pattern of one's life insurance program should vary from young adulthood through retirement years.
3. Explain how you can benefit by layering your term insurance policies.
WHAT DO YOU RECOMMEND NOW?
Now that you have read the chapter on protecting loved ones through life insurance, what would you recommend to Stephanie and Will Bridgeman in the case at the beginning of the chapter regarding:
1. Their changing need for life insurance now that they have a child?
2. What types of life insurance they should consider and whether they should purchase multiple policies?
3. Coordinating their retirement savings and other investments with their life insurance program?
4. Shopping for life insurance?
BIG PICTURE SUMMARY OF LEARNING OBJECTIVES
LO1 Understand why you might need life insurance and calculate the appropriate amount of coverage.
Life insurance is designed to provide protection from the financial losses that result from death. The reasons to purchase life insurance change over the life cycle. The need for this type of protection is nonexistent or very small for children and single adults. Factors affecting life insurance needs include the need to replace income, final-expense needs, readjustment-period needs, debt-repayment needs, college-expense needs, availability of government programs, and ownership of other life insurance and assets. Two methods to calculate life insurance needs are the multiple-of-earnings approach and the needs-based approach. The needs-based approach is the more accurate of the two and should be conducted every three years or whenever your family situation changes.
LO2 Distinguish among types of life insurance.
Two basic types of life insurance exist: term life insurance and cash-value life insurance. Variations on term life insurance include decreasing term insurance, guaranteed renewable term insurance, convertible term insurance, and credit life insurance. Variations on cash-value insurance include whole life insurance, limited-pay life insurance, and universal and variable life insurance.
LO3 Explain the major provisions of life insurance policies.
A life insurance policy is a contract between an insurance policy holder/owner and an insurance company, where the company promises to pay a designated beneficiary a sum of money (the “benefits”) upon the death of the insured person when buying life insurance, you should pay attention to the policy's general terms and conditions, the special features of cash-value life insurance, and settlement options.
LO4 Apply a step-by-step strategy for implementing a life insurance plan.
Life insurance should be purchased to address the dying-too-soon problem. Your investments should manage the living-too-long problem. Addressing these two problems appropriately requires high amounts of term insurance while you are raising children, and a sound investment program to prepare for your retirement years. You should not purchase life insurance until you have determined the actual dollar amount and type of policy you need and compared premiums using various life insurance cost indices.
LET's TALK ABOUT IT
1. Thinking About Life Insurance. What were your feelings about the need for life insurance before you read this chapter? What are they now?
2. Are You Insured? Are you covered by life insurance? If so, how much? Do you feel that you are over- or under-insured?
3. Term Versus Cash-Value Insurance. Why do you think people persist in buying cash-value life insurance when, in most cases, they would be better off buying term insurance and investing the money saved into a retirement account.
4. Life Insurance for Unmarried Couples. Many people today choose to cohabitate rather than marry (at least for some time period). How might this affect their thinking about life insurance?
DO THE MATH
1. Life Insurance Needs for a Young Single. Matthew Paul of Sisseton, South Dakota, is single and has been working as an admissions counselor at a university for five years. Matthew owns a home valued at $156,000 on which he owes $135,000. He has a two-year-old vehicle valued at $12,500 on which he owes $8000. He has about $13,800 remaining on his student loans. His retirement account has grown to $7800, and he owns some stock valued at $4400. Matthew has no life insurance and is considering buying some. How much should he buy?
DO IT IN CLASS PAGES 353 AND 355
2. Life Insurance Needs for a Young Married Couple. Amy and Mack Holly from Macomb, Illinois, have been married for three years. They recently bought a home costing $212,000 using a $190,000 mortgage. They have no other debts. Mack earns $42,000 per year, and Amy earns $41,000. Each has a retirement plan valued at approximately $10,000. They recently received an offer in the mail from their mortgage lender for a mortgage life insurance policy of $190,000. Their only life insurance currently is a $20,000 cash-value survivorship joint life policy. They each would like to provide the other with support for five years if one of them should die.
(a) Assuming $10,000 in final expenses and $20,000 allocated to help make mortgage payments, calculate the amount of life insurance they need using the needs-based approach.
(b) How would their needs change if Amy became pregnant?
3. Calculating a Death Benefit. Alexandra Cunningham of College Park, Maryland, has a $100,000 participating cash-value policy written on her life. The policy has accumulated $4700 in cash value; Alexandra has borrowed $3000 of this value. The policy also has accumulated unpaid dividends of $1666. Yesterday Alexandra paid her premium of $1200 for the coming year. What is the current death benefit from this policy?
DO IT IN CLASS PAGE 362
FINANCIAL PLANNING CASES
CASE 1
The Johnsons Change Their Life Insurance Coverage
Harry and Belinda Johnson spend $15 per month on life insurance in the form of a premium on a $10,000, paid-at-65 cash-value policy on Harry. Belinda has a group term insurance policy from her employer with a face amount of $85,500. By choosing a group life insurance plan from his menu of employee benefits, Harry now has $39,000 of group term life insurance. Harry and Belinda have decided that, because they have no children, they could reduce their life insurance needs by protecting one another's income for only four years, assuming the survivor would be able to fend for himself or herself after that time. They also realize that their savings fund is so low that it would have no bearing on their life insurance needs. Harry and Belinda are basing their calculations on a projected 4 percent rate of return after taxes and inflation. They also estimate the following expenses: $10,000 for final expenses, $6000 for readjustment expenses, and $5000 for repayment of short-term debts.
(a) Should the $3000 interest earnings from Harry's trust fund be included in his annual income for the purposes of calculating the likely dollar loss if he were to die? (See the discussions about the Johnsons in Chapter 3 beginning on page 86.) Explain your response.
(b) Based on your response to the previous question, how much more life insurance does Harry need? Use the Run the Numbers worksheet on page 353 to arrive at your answer.
(c) Repeat the calculations to arrive at the additional life insurance needed on Belinda's life.
(d) How might the Johnsons most economically meet any additional life insurance needs you have determined they may have?
(e) In addition to their life insurance planning, how might the Johnsons begin to prepare for their retirement years?
CASE 2
Victor and Maria Hernandez Contemplate Switching Life Insurance Policies
Victor and Maria Hernandez have a total of $200,000 in life insurance. Victor has a $50,000 cash-value policy purchased more than 20 years ago when the couple was first married and a $100,000 group term policy through his employer. Maria has a $50,000 group term insurance policy through her employer. The couple has been approached by a life insurance agent who thinks that they need to change their policy mix because, he says, they are inadequately insured. Specifically, the agent has suggested that Victor cash in his cash-value policy and buy a new variable-universal life insurance policy.
(a) If Victor cashes in his policy, what options would he have when receiving the cash value?
(b) Determine what the $16,000 in cash value in Victor's life insurance policy would be worth in 20 years if that sum were invested somewhere else and earned an 8 percent annual return. (Hint: Use the Garman/Forgue companion website.)
(c) Would cashing in the policy be a wise decision? Why or why not?
(d) As the Hernandezes' children are now grown and out on their own, and both Victor and Maria are employed full time, give general reasons why Victor may need more or less insurance.
(e) Explain why it would be a bad idea for Victor to buy a variable-universal life insurance policy.
CASE 3
Julia Starts Thinking About Life Insurance
Julia Price is now in her late 30s and has always wanted children. She has arranged to adopt two siblings from overseas, ages 2 and 4. Julia is happy that she earns enough money to support the children adequately, but the agency sponsoring the adoption also requires that adoptive parents purchase sufficient life insurance. Julia currently has a $20,000 paid-up cash-value life insurance policy purchased by her parents when she was a child. In addition, Julia's employer provides term insurance that matches her salary as an employee benefit. She talked with the agency, and they suggested that she buy a whole life insurance policy in the amount of $450,000 based on her current salary of $150,000. Julia isn't sure this is the way to go. For one thing, the policy would cost about $5000 per year. Further, she realizes that the amount the agency requires would not maintain the children's lifestyle for long and not be sufficient to help pay for their college educations. Julia is thinking that guaranteed renewable term insurance would be a better way to go. Offer your opinion about her thinking.
DO IT IN CLASS PAGE 367
CASE 4
Life Insurance for a Newly Married Couple
Just-married couples sometimes over-indulge in the type and amount of life insurance that they buy. Jason and Nicole Greenwood of Walnut, California, took a different approach. Both were working and had a small amount of life insurance provided through their respective employee benefit programs: Jason, $40,000, and Nicole, $50,000. During their discussion of life insurance needs and related costs, they decided that if Nicole completed her master's degree in industrial psychology, she would have better employment opportunities. Consequently, they decided to use money they had available for additional life insurance to pay for Nicole's education. They both feel, however, that they do not want to have inadequate life insurance.
DO IT IN CLASS PAGE 367
(a) In what way does Nicole's return to school alter the Greenwoods' life insurance needs?
(b) Would you agree that the amount of life insurance provided by the Greenwoods' respective employers is adequate while Nicole is in school? Explain your response.
(c) Summarize how the Greenwoods' life insurance needs might change over their life cycle.
CASE 5
Fraternity Members Contemplate Permanent Life Insurance
Zachary Chen is a college student from Waterville, Maine. Soon to graduate, Zachary was approached recently by a life insurance agent, who set up a group meeting for several members of his fraternity. During the meeting, the agent presented six life insurance plans and was very persuasive about the benefits of a universal life insurance plan that his company calls Affordable Life II. Under the plan, the prospective graduate can buy $100,000 of permanent life insurance for a very low premium during the first five years and then pay a higher premium later when income presumably will have increased. Zachary was confused after the meeting, as were his friends. Armed with your knowledge from this personal finance book, you have been asked to respond to some of their questions.
DO IT IN CLASS PAGES 360 AND 370
(a) Do you think universal life insurance is a good deal for these people? Why or why not?
(b) How can the individual fraternity members decide how much life insurance they need?
(c) Life insurance cannot be as confusing as the agent made it seem. What clearer explanation would you give to the fraternity members?
(d) What type of life insurance, if any, would you advise for the fraternity brothers?
(e) How would they know if a life insurance policy is offered at a fair price?
CASE 6
A Married Couple with Children Address Their Life Insurance Needs
Joseph and Marcia Michael of Troy, New York, are a married couple in their mid-30s. They have two children, ages 5 and 3, and Marcia is pregnant with their third child. Marcia is a part-time book indexer who earned $15,000 after taxes last year. Because she performs much of her work at home, it is unlikely that she will need to curtail her work after the baby is born. Joseph is a family therapist; he earned $68,000 last year after taxes. Because both are self-employed, Marcia and Joseph do not have access to group life insurance. They are each covered by $50,000 universal life policies they purchased three years ago. In addition, Joseph is covered by a $50,000, five-year guaranteed renewable term policy, which will expire next year. The Michaels are currently reassessing their life insurance program. As a preliminary step in their analysis, they have determined that Marcia's account with Social Security would yield the family about $1094 per month, or an annual benefit of $13,128, if she were to die. For Joseph, the figure would be $2072 per month, or an annual benefit of $24,864. Both agree that they would like to support each of their children to age 22, but to date, they have been unable to start a college savings fund. The couple estimates that it would cost $40,000 to put each child through a regional university in their state as measured in today's dollars. They expect that burial expenses for each spouse would total about $12,000, and they would like to have a lump sum of $50,000 to help the surviving spouse make payments on their home mortgage. They also feel that each spouse would want to take a three-month leave from work if the other were to die.
(a) Calculate the amount of life insurance that Marcia needs based on the information given. Use the Run the Numbers worksheet on page 353 or the Garman/Forgue companion website. Assume a 3 percent rate of return after taxes and inflation and an income need for 22 years because the unborn child will need financial support for that many years.
(b) Calculate the amount of life insurance that Joseph needs based on the information given. Use the Run the Numbers worksheet on page 353 or the Garman/Forgue companion website. Assume a 3 percent rate of return after taxes and inflation and an income need for 22 years because the unborn child will need financial support for that many years.
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. Calculating Life Insurance Need. Review the material in “How Much Life Insurance Do You Need?” on pages 351–354. Then using dollar amounts that fit your personal situation, complete Worksheet 48: Determining My Life Insurance Needs from “My Personal Financial Planner.” If you are currently single and childless, for the purposes of this activity, assume that you are 30 years old, have two children under age 5, are married, and earn $60,000 per year and redo the estimate of need. How would having a family change your need for life insurance?
2. Review Your Life Insurance Program. Review the material in “There Are Only Two Basic Types of Life Insurance” and “Understanding Your Life Insurance Policy” on pages 355–356 and 361–365. Then examine any life insurance policies on your life. Given what you learn from those policies and your own need for life insurance as determined in item 1 above, decide on the amount and type(s) of additional life insurance you probably need and any appropriate policy features, such as who should own the policy(s) and be named as beneficiaries.
3. Name Your Beneficiary. Review the information in “Understanding Your Life Insurance Policy” on pages 361–365. Then revisit the naming of the beneficiary on any policies currently in force on your life and make any changes desired. If you are not currently covered by an insurance policy, assume that you have taken a job after graduation and your employer offers free life insurance as an employee benefit. Who would you name as your beneficiary?
4. Life Insurance Settlement Options. Review the material in “Settlement Options Specify How the Death Benefit Will Be Paid” on page 365. If you were the beneficiary on another person's life insurance policy in the amount of $100,000, how would you choose to receive the benefits if you were to receive the proceeds of the policy?
5. Life-Cycle Life Insurance Planning. Review the information in “Integrate Your Life Insurance into Your Overall Financial Planning,” including Figure 12-3 on pages 367–368. Then map out a plan for yourself that integrates life insurance and investments. The plan should protect you from both the dying-too-soon and living-too-long risks outlined on page 350. Make appropriate assumptions for your plans regarding marriage and having children and project your plan out to age 65.
6. Set Up a Layered Term Insurance Program. Review the material in the Did You Know? box titled “Layer Your Term Insurance Policies and Never Pay More than $60 per Month” on page 369, and then complete Worksheet 49: Layering Term Insurance Policies from “My Personal Financial Planner,” which allows you to set up a term insurance program until age 60. Use your current personal situation if you currently have dependents, or assume that you will earn an annual salary of $45,000 at age 25 and plan to have at least two children.
ON THE NET
Go to the Web pages indicated to complete these exercises.
1. Obtain a Quote on Your Life Insurance. Visit the website for AccuQuote at www.accuquote.com to obtain a quote for the annual premium on a $200,000 guaranteed renewable, ten-year term policy for you. Then call a life insurance agent in your community to obtain a quote on the same term insurance coverage. How do the term rates quoted by your local agent compare with the rates found over the Internet? Also, ask for the quote on a $100,000 universal life policy with guaranteed insurability and waiver-of-premium options. Ask the agent to explain why the quotes for the two types of policies differ. Analyze his or her response based on what you learned in this chapter.
2. Check an Insurance Company's Financial Strength. Visit the websites for A.M. Best Company at www.ambest.com/ratings/guide.asp and Moody's Investor Services (www.moodys.com/) to check the ratings for the insurance company recommended by the agent in Exercise 1 as well as the company with the lowest cost for term insurance that you found on the Web. What do the ratings tell you about the relative strengths of those companies?
3. Determine Your Need for More Life Insurance. Visit the Life and Health Insurance Foundation for Education website at www.lifehappens.org/life-insurance-needs-calculator. Calculate your current need for life insurance. Then recalculate your need for five years from now given your estimates of your income and family situation.
ACTION INVOLVEMENT PROJECTS
1. Review Life Insurance Company Websites. Visit the websites of two large life insurance companies. Focus on how their approaches to educating the public about life insurance are similar to or different from the information provided in this chapter. Write a summary of your findings.
2. Talk to a Life Insurance Agent. Visit a life insurance agent and ask for an assessment of your life insurance needs given your current situation. Compare the information you receive with what you have learned in this chapter and write a summary of your findings.
3. How Others Approach the Need for Life Insurance. Talk to three friends and/or relatives below age 30 who are married. Ask about their approach to life insurance and how they have gone about setting up a life insurance program. Write a summary of your findings and compare what they have done to what you would do if you were in a similar situation.
4. Term Versus Cash-Value Life Insurance. Talk to three of your friends or acquaintances who have never purchased life insurance. Explain to them the differences between term and cash-value life insurance. Then inquire about which type they would prefer to buy. Write a summary of your findings and compare their views with yours.
Visit the Garman/Forgue companion website at www.cengagebrain.com .
*Your personal Social Security benefits can be estimated by requesting a Social Security Statement from the Social Security Administration (www.ssa.gov) or see Appendix B.
* This option and options 4 and 5 are variations of an annuity and are covered further in Chapter 17.
