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.
Broadly stated, life insurance is indicated only when there is a NEED.
The following is a checklist of common estate building and estate conservation needs that life insurance can satisfy:
Provide for income needs of surviving dependent family members
Pay federal and state death taxes and other estate settlement costs
Provide for children’s education
Shift wealth from one generation to another in the most cost effective manner possible
Meet “special” financial demands of physically or mentally handicapped or learning-disabled children or parents or other dependents with physical or mental limitations
Benefit a charity
Relieve survivors of financial management burdens by providing an inexhaustible lifetime annuity
Create an “instant estate”
The following is a checklist of business insurance needs that life insurance can satisfy:
Fund a buy-sell agreement
Finance nonqualified deferred compensation arrangements
Finance Death Benefit Only (DBO) plans
Provide a basic level of financial security for families of all employees
Recruit, retain, retire, and reward key employees
The operative word is NEED. Planners should recommend life insurance only if, and to the extent, a need exists. Thus, financial services professionals must first identify the need and then match the type and amount of the product to that need.
Whole life insurance, as the name implies, is a contract designed to provide protection over the insured’s entire lifetime. There are many types of whole life policies, but the oldest and still the most common type of whole life policy is ordinary level premium whole life insurance, or simply ordinary life. This form of insurance is also known as “straight life,” “traditional whole life,” or “continuous premium whole life.” If the term “whole life” is used alone, it is generally accepted that the reference is to ordinary level premium whole life as opposed to any other type of lifelong policy.
1. When should whole life be used as a savings vehicle?
One can view ordinary level premium whole life mathematically (but not legally) as a combination of decreasing term insurance and increasing “savings fund.” Although the level premium payment method permits the policyowner to pay the lowest up-front outlay necessary to acquire lifetime coverage, the premiums are still greater than the mortality costs in the early years. Because premiums remain level while mortality costs increase at later ages, the insurer must set premiums in the early years high enough to pre-fund the excess of mortality costs over premiums in the later years. Consequently, ordinary level premium whole life policies build reserves to pay the future excess mortality costs and to serve as the basis for determining the policyowner’s cash surrender values.
The cash value normally increases each year until it reaches the face value at age one hundred. The cash value grows more slowly in the early years and more swiftly in the later years because the company typically recovers the expenses associated with the sale of the policy over the early years.
See also: The value of cash value life insurance
Policyowners may directly access cash values in ordinary life policies in two ways. First, policies permit policyowners to borrow cash values. As long as the policyowner continues to pay premiums, the policy remains in force, but the death benefit is the face amount reduced by any outstanding policy loans and unpaid interest on the policy loans.
Alternatively, policyowners may terminate or surrender their policies and receive the net cash surrender value shown in the policy as of the date of surrender. The net surrender value is the gross cash value shown in the policy minus any identifiable surrender charges, outstanding policy loans, and unpaid interest on policy loans plus any prepaid premiums, dividends accumulated at interest, cash values attributable to paid-up additions, and any additional terminal dividends. In this case, however, the policyowner must give up the insurance protection.
Because policyowners may access virtually the same amount of cash through policy loans as through surrender of the policy, loans are generally the better alternative if the policyowner expects the need for protection to continue.
In some cases, the policies may permit partial surrenders. Some participating policies permit policyowners to surrender paid-up additions without surrendering the base policy. Although it is not a matter of legal right, in practice some companies also will allow partial surrenders of ordinary life policies. In these cases, the insurer reduces the death benefit and premiums in proportion to the reduction in the cash value.
One additional method to access cash values without giving up coverage entirely may be to exchange a policy for another policy with a lower cash value under the exchange rules of Code section 1035.
2. What is the difference between a participating and a nonparticipating policy?
The premiums, the death benefit, and the minimum cash surrender value schedule are initially fixed in ordinary level premium whole life policies. However, if the policy is a dividend paying, or “participating” (par) policy, the premiums may effectively decrease and the death benefit and the scheduled cash surrender values may increase. Only if the policy is a “guaranteed-cost, nonparticipating” (nonpar) policy that does not pay dividends will each of these features truly remain fixed for the life of the insured.
Because insurance companies must guarantee death benefits and a minimum schedule of cash values in most policies (except variable life policies), they must be conservative when estimating the values of the various premium pricing factors (interest, mortality, expenses, lapse rates, and risk loading factors) used to compute the required premiums under any particular premium payment plan of insurance.
In the case of nonparticipating policies, all elements — premiums, death benefits, and the schedule of cash values — are guaranteed and fixed. If a company’s experience is more favorable than assumed with respect to any or all of the pricing factors, the premiums in excess of the amount needed to pay the company’s obligations add to the company’s profit or surplus. However, competitive pressures within the industry as well as from alternative investments have made such entirely guaranteed but nonparticipating policies unattractive in the marketplace. Now most policies issued are participating in one way or another, meaning that they share the benefits of the company’s favorable mortality, investment, expense, or lapse experience with the policyowners.
In what are called traditional participating life insurance products (typically, but not exclusively issued by mutual rather than stock insurance companies), policyowners participate in the favorable experience of the company through dividends. Life insurance dividends are not like stock dividends, which represent a return on investment. Instead, they are more like a return of investment and are generally treated for tax and other purposes as a nontaxable return of prior overpayment of premiums.
Purchasers of participating policies are presented with a schedule of projected dividends when they buy the policy. Basically, the projected dividends generally reflect the company’s best estimate of the values of the various pricing factors as compared with the conservative assumptions built into their premium calculations. But in contrast with quoted premiums, death benefits, and cash value schedules, dividends are not guaranteed. Insurers cannot guarantee dividends because the dividends depend on the insurers’ actual experience relative to their conservative pricing assumptions. The insurers cannot know their performance until the experience actually unfolds.
In relatively recent years, a new type of participating life insurance, generically called current-assumption life insurance, has become popular. In contrast with traditional participating policies, these types of policies do not pay dividends. Rather, if the company’s experience is more favorable than assumed in its premium pricing computations, the favorable experience is reflected directly in the amounts credited to the policy’s cash values. In other words, if the company’s experience is favorable, cash values grow larger and more quickly than shown on the schedule of guaranteed minimum cash values.
Depending on the type of policy, the policyowner may have several options as to how they may use these additional cash value increases. In some cases, policyowners may withdraw the additional cash value without otherwise affecting their death benefits, premium payments, and minimum guaranteed cash values; the insurer may permit policyowners to reduce the level of future premium payments while maintaining the same face amount of coverage; the insurer may allow policyowners to increase the face amount of coverage while maintaining the same premium level; policyowners may keep the face amount and the premium payment level the same but shorten the required premium-payment period; or they may choose some combination or variation of these options.
Purchasers of current-assumption policies are presented with an illustration of projected premiums, cash values, and death benefits that use the company’s current assumptions regarding the various premium pricing factors as well as an illustration showing the minimum guaranteed values based on the current premium and the statutorily mandated conservative pricing assumptions. Similar to projected dividends with traditional participating policies, the projected cash values and any projected death benefit increases above those shown using the required conservative pricing assumptions are not guaranteed. In many cases, even the premiums and the term of the policy are not guaranteed. If the company’s experience turns out less favorably than currently assumed, the policyowner may have to pay premiums for a longer period than anticipated or pay increased premiums in order to maintain the face amount of coverage. Alternatively, the policyowner may have to accept a reduction in the face amount of coverage or a shortened term of coverage.
Variable life policies are the ultimate in participating policies, at least with respect to investment performance. The policyowner bears (almost) all the investment risk and reaps all the investment rewards from the underlying investments; the insurer provides no minimum interest guarantee with respect to cash values. In most cases the policyowner may choose to invest premium dollars among a number of mutual fund type investments. As in other types of policies, the insurer guarantees that mortality charges will not exceed certain maximums and that the death benefit will not fall below a certain minimum, regardless of the investment performance of the underlying assets. However, the insurer makes no assurances regarding cash values. Depending on the type of variable life policy, favorable investment performance may increase the face amount of coverage or the insurer may give policyowners a number of flexible options similar to those described above for certain current-assumption policies.
3. How will dividends be paid on par policies?
Policyowners have considerable flexibility in choosing how to use dividends paid on par policies. Dividends may be paid to the policyowner in cash, though most policyowners find one of the other options more attractive. In addition, dividends may be applied against policy loans and/or interest on policy loans, or in some cases, treated as additional premium payments.
Beyond these relatively straight-forward options, policyowners may elect to have dividends:
allocated to pay premiums
applied against outstanding policy loans
accumulated at interest
used to purchase paid-up additional amounts of insurance
used to purchase a one-year term insurance
Policyowners may change these options at any time in most policies.
Premium Reduction Option
One of the more frequently used options is to apply dividends against required premium payments. This option is really just an administratively convenient cash option, because, in either case, dividends effectively serve to reduce premiums. In general, the amount of dividends insurers pay on a policy increases over time, ever reducing the policyowner’s net premium outlay (premiums less dividend payments), sometimes to zero or less after the policy has been in force for a long period of time. At this point, the policyowner usually must elect another option for the excess dividend payments.
Under the cash option or the premium reduction option, the policyowner’s net premiums effectively decline over time (because the dividend level generally increases) while the death benefit remains level and the cash surrender schedule remains fixed. Policyowners may also use the “vanishing premium option” described in the “Frequently Asked Questions” section below.
Policy Loan Repayment Option
Similar to the premium reduction option, this option is really just an administrative convenience variation on the cash option. Rather than having the company pay the dividends in cash to the policyowner and then have the policyowner turn around and write a check to the insurance company to pay policy loans or interest on loans, the policyowner may have the dividends applied directly against the policy loans and/or interest on loans.
Accumulate at Interest Option
Policyowners may elect to leave their dividend payments with the insurance company to accumulate in a fund appended to the policy. In other words, the insurance company will provide a savings-type account for dividends. The interest rate payable on the fund is guaranteed to equal or exceed a specified minimum (historically about 4 to 6 percent, but in the past decade of low market interest rates, considerably lower), but most companies have historically credited rates higher than the guaranteed minimum. Policyowners may withdraw cash from the fund at any time. If the insured dies the policy pays the face value. If the policy is surrendered, it pays the net cash surrender value plus the value of the dividend accumulation account.
Paid-up Additions Option
Under this option, the insurer applies each dividend payment to buy as much paid-up single premium whole life insurance as the dividend will allow at the insured’s attained age. Consequently, under this option the premiums payable by the policyowner remain level while the total death benefit and the schedule of total cash values increases over time.
The paid-up additions are available without evidence of insurability. The insurance is purchased at net rates, that is, without any of the commissions and other front-end charges associated with new sales of insurance. Therefore, this is a low cost method of acquiring additional insurance without having to prove insurability.
The paid-up additions usually (but not always) are participating. This means the annual dividends paid on the paid-up additions further escalate overall dividend payments and further supplement the policy’s total death benefit and cash values. Similar to cash values under the base policy, the policyowner may borrow against the cash values of the paid-up additions. As described above, some companies will permit policyowners to surrender paid-up additions for the net surrender values while keeping the underlying policy in force.
One-year Term Insurance Option
Under the general form of this option, the insurer applies each year’s dividend to purchase as much one-year term insurance as the dividend will allow at the insured’s attained age. Similar to the paid-up option, the policyowner acquires the term insurance at net rates and without the need to prove insurability.
Under a second form of this option, the insurer uses the dividend to buy one-year term insurance in an amount up to the cash value of the policy. The policyowner may apply any excess dividends under one of the other options. This form of the option frequently is used with split dollar insurance which is commonly used in key person and other business life insurance applications. (See Chapter 41 for a further discussion of split dollar life insurance arrangements.) With the split dollar arrangement, the premium payer, generally the insured’s company, is entitled to the cash value or an amount equal to the cash value from the death proceeds. The net amount at risk (the difference between the face amount and the cash value) generally is payable to whomever the insured so designates, often the spouse or child of the insured. Under this form of the one-year term option, the insured’s designated beneficiary can receive a death benefit equal to the full face value of the underlying policy.
4. How do policy loans work?
All cash value policies must allow policyowners to borrow cash values from the policy. For many policyowners, the cash values in their life insurance policies represent an important source of emergency funds. The loan provision typically has the following features:
1. In general, policyowners may borrow up to the cash value less interest on the loan as of the subsequent policy anniversary.
2. The interest rate may be fixed or variable, depending on the policy and, sometimes, on the election of the insured.
3. Policyowners generally have no obligation to repay loans and interest on any fixed schedule; they may repay in whole or in part at any time. However, if they terminate their policy or if the insured dies, the cash surrender value or the death benefit is reduced by any outstanding policy loans and unpaid interest. Also, if policy loans equal or exceed the cash value, the policyowner generally must repay the loan in full or in part within thirty-one days of being notified by the company, otherwise the policy will terminate.
4. If the policyowner does not pay interest when due, the company usually automatically charges an additional loan against the policy equal to the unpaid interest.
5. Policy loans require no approval and are confidential.
6. The amount of loan available generally includes the cash value of any paid-up additions.
5. What is the interest rate on policy loans?
At one time, insurers issued virtually all policies with fixed policy loan rates, often as low as 5 percent or 6 percent. However, when market interest rates were higher than policy loan rates, insurance companies found themselves squeezed by disintermediation — the process whereby policyowners borrow their cash values at low rates and invest outside their policies in higher-yielding market investments. The insurance companies found themselves with an ever-increasing portion of the investment portfolio in low yielding policy loans and their investment performance suffered. As a result, dividends paid on many participating ordinary life policies were not competitive with the interest being credited to current assumption and universal life policies.
The insurance companies took three steps to counter this trend. First, they offered new policies with variable or adjustable loan rates. In these policies, the insurers tied the variable loan rate to an index of corporate bonds and adjusted the rate at least once a year, but, in some cases, as frequently as quarterly. Some insurers still issue policies with fixed rates, but at generally higher rates, ranging from 7 to 10 percent. Many new policies allow policyowners to choose either a fixed or variable loan rate. However, in most cases, insurers offer policyowners potentially higher dividends if they are willing to accept the adjustable loan rate.
Second, insurance companies offered incentives for policyowners of existing policies with low fixed loan rates to either agree to a higher fixed loan rate (usually 8 percent) or to an adjustable loan rate. In return, the company promised to move the policy into a higher dividend rating class. Many companies allow existing policyowners to exchange their existing low loan rate policies for new adjustable loan rate policies with favorable terms or conditions such as enhanced cash value schedules, higher face amounts, a higher dividend classification, and lower than normal upfront exchange fees.
Third, many new policies have “direct recognition” provisions that permit the insurer to adjust dividends within a class of policies based on policy loan activity. Dividends insurers pay on policies with loans outstanding may be lower than those they pay on similar policies without policy loans. This is an important concept because it is essentially an indirect method of increasing the policy loan rate. For example, assume the policy loan rate is fixed at 8 percent. The policyowner would pay $80 interest per year on each $1,000 borrowed from the policy. However, assume that for this class of policies that dividends paid on policies with loans are $10 less for each $1,000 of borrowing than on policies without any loans. The policyowner is actually paying an effective rate of 9 percent on the amount borrowed, not the stated 8 percent policy loan rate. This can have even further implications if, for instance, a policyowner is using dividends to purchase paid-up additions. The additional paid-up face amount and the additional cash value will be less than it otherwise would have been. Also, if the paid-up additions are participating, future dividends will be less than they would otherwise have been as a result of the lower cash values in the paid-up additions, even if the policy loan is later repaid.
6. What is an automatic premium loan?
Most ordinary life policies are issued with an automatic premium loan provision that authorizes the company to automatically pay the premium by borrowing against the cash value if the premium remains unpaid at the end of the thirty-one-day grace period. This provision prevents the policy from lapsing if the policyowner inadvertently misses a premium payment. In most states, the provision is operative unless the policyowner specifically indicates that it should not be operative. In some other states, the provision becomes operative only if the policyowner specifically elects to make it operative.
The automatic premium loan generally is a “no charge” provision that policyowners should look for to avoid unintentional lapses. In most cases, the policy may be reinstated if it inadvertently lapses, but the insured must usually show evidence of insurability.
7. What should I know about premiums?
Life insurance companies are free to set premiums according to their own marketing strategies. Almost all states have statutes prohibiting any form of rebating (sharing the commission with the purchaser) by the agent. The premium includes a “loading” to cover such things as commissions to agents, premium taxes payable to the state government, operating expenses of the insurance company such as rent, mortgage payments and salaries, and other company expenses.
A few companies offer “no-load” or “low-load” life insurance policies. These policies are not really no-load, because certain expenses are unavoidable (e.g., the premium tax), but rather pay either no sales commission or a very low sales commission. Consequently, the cash value buildup tends to be larger in the early years. Although commissions are lower, these companies typically must spend somewhat more money on alternative methods of marketing and may therefore incur generally higher expenses in this area than companies that pay commissions to agents.
The bulk of an insurance company’s expenses for a policy are incurred when the policy is issued. It may take the company five years or longer to recover all its front-end costs. The state premium tax is an ongoing expense that averages about 2 percent of each premium payment. With most cash value policies the aggregate commission paid to the selling agent is approximately equal to the first year premium on the policy. About half (often 55 percent) is payable in the year of sale and the other half is paid on a renewal basis over a period of three to nine years.
Most ordinary level premium life insurance policies have no explicit surrender charges. However, most participating policies will pay a terminal dividend. The terminal dividend is typically higher the longer the policy has remained in force. In essence, this is a form of surrender charge because the company is essentially holding back dividends it could otherwise pay currently and rewarding those policyholders who maintain their policy longer with a greater terminal dividend.
8. What is the ideal frequency of premium payment?
Insurance companies usually quote insurance premiums on an annual basis, but the insurer can convert the annual payment to monthly or quarterly payments, if the policyowner desires. When insurers convert annual premiums to monthly or quarterly payments, they typically charge an implicit interest rate on the payments that are deferred until later in the year. In other words, the insurance company essentially is loaning the policyowner a portion of the annual premium that the policyowner then repays over the term of the year with a “borrowing” rate equal to the implicit rate. If the implicit rate is greater than the policyowner’s after-tax opportunity cost of funds (the policyowner’s potential after-tax investment rate), he or she should pay the premium annually, if possible. Conversely, if the implicit rate is less than the policyowner’s potential after-tax investment rate, the policyowner will be better off deferring payments by electing to pay monthly or quarterly.
If, for cash flow reasons, the policyowner cannot pay the premiums annually, the issue is whether the insurance company’s implicit rate is greater than or less than the after tax-rate at which the policyowner could otherwise borrow money to pay the annual premium. If the implicit rate is higher than the policyowner’s after-tax borrowing rate, he or she should borrow the money elsewhere and pay the premium annually. Conversely, if the implicit rate is lower than the after-tax borrowing rate, the policyowner should elect to pay premiums quarterly or monthly.
The decision as to which payment plan to elect depends on the insurance company’s implicit rate. One may determine the implicit rate in the following manner. The ratio of the monthly (or quarterly) premium to the annual premium is called the monthly (or quarterly) conversion factor. Once one knows (or computes) the conversion factor, one can determine the interest rate that the insurance company is implicitly charging for the monthly or quarterly payment plan. For example, if the monthly payment is equal to 1/12 (.083333) of the annual premium, the insurance company is charging 0 percent interest on the premium payment plan.
In virtually all cases, however, the monthly payment is greater than 1/12 (.083333) of the annual premium because of an implicit interest charge. Figure 14.1 shows the interest rate the insurance company is implicitly charging for various monthly and quarterly conversion factors. For example, assume the premium for a policy is $1,000 if paid annually or $88.75 if paid monthly. The monthly conversion factor is the ratio of the monthly premium to the annual premium, $88.75/$1,000, or 0.08875. According to the table, the implicit interest rate for this monthly conversion factor is about 14 percent.
9. What is meant by the “vanishing premium” option?
This option is similar to the premium reduction option except that the dividends are applied as additional premiums while the policyowner continues to pay the full annual premium. Under this option, the policyowner is essentially converting what is an ordinary level premium whole life policy into a form of increasing premium limited pay policy. After a number of years, the policy will be entirely paid-up and the policyowner will require no further premiums to keep the full face amount in force for the remainder of the insured’s life. In other words, if the assumptions are met the premium “vanishes”. (Of course, if the level of dividends projected is not met, it will take longer than anticipated for this to occur.) Once the policy reaches paid-up status, policyowners typically use additional dividends to buy paid-up additions, but they generally may apply the additional dividends under any of the other dividend options.
Although it would be unusual, if a policyowner applies dividends as additional premiums, it is theoretically possible for dividend payments to reach a sufficiently high level soon enough to violate the modified endowment contract (MEC) rules. Because having the policy classified as a MEC would have adverse tax consequences, policyowners and their advisers should take some care when this dividend option is selected to assure that premiums do not exceed the MEC levels.