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.