Life insurance is a complex amalgamation of legal, tax and economic elements. Basically, it is a unique wealth creation tool that assures the accumulation of a desired amount of liquid capital at death. Depending on the plan of insurance, it may also create more or less capital for lifetime needs.
Through its unique capital creation feature and tax advantages, life insurance can help people solve a host of personal and business problems. However, insurers offer a wide variety of life insurance policies that are suited to a broad host of financial planning problems. Once an advisor identifies a client’s problems, the advisor must match the appropriate life insurance products to the problems. To do so, the planner must first fully understand the legal, tax and economic elements of life insurance and the particular features of each type of policy.
This primer provides an overview of the products available, and is designed to help you gain perspective and balance in your practice.
The advantages offered by life insurance vary with the type of policy and the problem to which the policy is applied. However, all types of life insurance policies provide certain favorable features, which are listed below.
- Life insurance provides a guarantee of large amounts of cash payable immediately at the death of the insured. The amount of the death benefit payable is usually significantly greater than the premiums paid for the policy.
- Life insurance proceeds are not part of the probate estate. The only way life insurance benefits become part of probate is when they are paid to or for the benefit of the estate of the insured. Therefore, the insurance company can pay death proceeds to the beneficiary without the delay caused by administration of the estate.
- There will be no public record of the death benefit amount or to whom it is payable.
- Life insurance policies generally have some protection against creditors of both the policyowner and of the beneficiary. The amount of protection varies from state to state.
- Life insurance cash values provide instant availability to cash through policy loans. The interest rate (or interest-rate formula) for policy loans is known in advance and is usually lower than the rate applicable to loans from other sources.
- The death benefit proceeds from a life insurance policy generally are not subject to federal income taxes.
- The increases in the cash value of a life insurance policy enjoy federal income tax deferral. Interest earned on policy cash values generally is not taxable unless or until the policyowner surrenders the policy for cash.
- Life insurance proceeds often are exempt from state inheritance taxes.
- Despite some highly publicized life insurance company insolvencies, the life insurance industry remains unparalleled in safety among the financial intermediaries such as the savings and loan, banking, and mutual fund industries. It is commonly noted that not a single dollar of death claim has been lost or denied because of a life insurance company insolvency or failure.
- Life insurance is not available to persons in extremely poor health (although almost all individuals in poor health can obtain insurance).
- Life insurance is an extremely complex product that is hard to evaluate and compare. The time required to gather policy information, decipher it, and compare it with other policies discourages purchasers from engaging in comparison shopping.
- The cost of coverage reduces the amount of funds available for current consumption or investment.
1. Annual renewable term life insurance
Characteristics: “Pure” life insurance with no cash value element; initially, the highest death benefit for the lowest premium.
2. Participating ordinary life insurance
Characteristics: Most common and easily understood form of lifetime coverage; known maximum cost and minimum death benefit levels; dividends may reduce premiums, pay-up policy, buy paid-up additions, accum. at interest, be paid in cash.
Market: Anybody who needs lifetime coverage.
Death benefit: Fixed, level.
3. Current assumption whole life insurance
Characteristics: Mixes characteristics of universal life and traditional ordinary life; future premiums, face amount, and/or cash value based on interest, expense, mortality experience.
Market: Upper and middle income prospects.
Characteristics: Whole life contract with assets supporting policy held in separate account; choice of investment assets; death benefits depend on investment results.
Market: Upper and middle income prospects with investment acumen.
5. Adjustable life insurance
Characteristics: May select death benefit and, within limits, choose premiums; face amount and premiums are fixed between adjustment periods; usual features of whole life.
6. Universal life insurance
Characteristics: Flexible premium current-assumption adjustable death benefit policy; policy elements unbundled; two death benefit options.
Market: Middle and upper income looking for ultimate in flexibility.
7. Universal variable life insurance
Characteristics: Combines features of universal and variable life.
Market: Middle and upper income with investment acumen looking for ultimate in flexibility.
Characteristics: Combine tax advantages, investment choice, flexibility and guarantees with various lifetime payout options that cannot be outlived.
Market: Middle and upper income; qualified (IRA) and non-qualified retirement arrangements.