Planning Your Financial Future, 4eby: Boone, Kurtz & Hearth

Life Insurance

Chapter 11

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Why Purchase Life Insurance?

If you are single with no dependents, you may not need any life insurance

But if you have family members who are financially dependent on you, reasons include: Cash for immediate needs Readjustment funds

Will spouse need time to find work, relocate, etc.? Replacement income Special situations

Help pay off the mortgage, finance child’s college, etc.

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Figure 11.1: Estimating Life Insurance Needs

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How Your Life Insurance Needs Change Over Time

When you’re young, you may have no need for life insurance

As you get married, have children, have a mortgage payment, etc., your need for life insurance increases

As you get older (and have paid down your mortgage and have substantial investments), your life insurance needs may decrease

DEFINITELY review your needs as you experience major life changes

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Types of Life Insurance Policies

Term insurance Only provides death benefit

Whole life insurance Combines a savings feature with death

benefits

Universal life insurance Combines a savings feature with death

benefits

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Term Insurance

Offers protection for a specified term (period of time) and has no value at end of term If policy expires and you don’t die,

insurance company has no further obligation to you

Advantage Inexpensive

Can generally buy five to ten times as much term insurance as other life insurance for same premium

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Term Insurance

Level term vs. decreasing term Level term: fixed premium and a fixed

amount of coverage Commonly issued for one-, five-, and ten-

year terms Decreasing term: policy with a

declining amount of coverage over time (but premiums remain the same) As you pay off mortgage, children leave

home, etc., need less insurance

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Term Insurance

Conversion and renewable features Many term policies offer these features at

additional cost Automatic renewal at term end

Can renew for at least one more term w/o another physical exam

Many companies permit renewal as many times as you’d like up to age 70 or so

Term insurance can be converted to another type of life insurance

Usually limited to coverage equal to or less than current coverage

May require that the conversion occur within a certain time period (well before term expires)

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Term Insurance

Deposit term insurance Pay a deposit (about $10 for every $1,000 of

coverage) on top of regular premium Deposit is placed into high-rate, interest-bearing

account If you maintain insurance coverage for term

period, you’ll get back deposit plus interest If you let policy lapse, you lose deposit plus interest If you die during term, your beneficiary gets deposit plus

interest and face amount of policy Cheapest form of life insurance, if you keep policy One of most expensive if you let policy lapse

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Whole Life Insurance

Purchase for your entire (whole) lifePremiums spent on whole life insurance

are divided between insurance protection and savings Makes whole life more expensive Cost during early years of policy exceeds

actual cost of insurance protection, while cost in later years is less than needed Insurance company invests the excess amount

collected in early years of policy to cover increasing risk in later years of policy

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Whole Life Insurance

Straight life insurance (AKA continuous premium whole life insurance or ordinary whole life insurance) Premiums remain same over life of policy

Premiums determined by your age/health at inception of policy

Most life insurance policies are of this type Within first three years of policy, it begins to

build a cash value (accumulated savings). As time passes, cash value increases You can borrow all or a portion of this cash value at a

relatively low interest rate, which doesn’t have to be paid back (but policy payout upon insured's death is reduced by loan plus interest)

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Whole Life Insurance

Limited-payment whole life insurance Lasts entire life of policyholder, but premiums

are only paid for a limited number of years—10, 20 or 30 years Premiums are higher, but cash value increases

more rapidly Critics argue why pay higher premiums during

years when your need for living income is greater, whereas by the time you pay off your policy (say 30 years from now), your need for life insurance may be less (or zero)

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Universal Life Insurance

Combines term insurance protection with a savings account Part of each year’s premium is used to buy

low-cost term insurance and remainder placed into high-yield investments Policyholders are not taxed on investment

earnings When policyholder dies, beneficiaries

receive policy amount plus accumulated earnings

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Universal Life Insurance

Advantages Policyholder can vary amount contributed to savings portion

once initial premiums are paid Can adjust (up [assuming good health] or down) the amount of

term insurance coverage Can use cash value to pay part of all of annual premiums or to

raise death benefit Can make tax-free withdrawals from investment portion as long

as withdrawal doesn’t exceed total amount already paid in premiums

Disadvantage Much more expensive than term insurance

A 30-year-old spending $200 a year in premiums can buy $250,000 of term insurance, but only $50,000 universal life insurance

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Other Life Insurance Options

Group life insurance Available at rates lower than rates for most

individuals Often available as a perk with your job If you leave your job, coverage ends

May have option of converting group coverage to individual coverage

Variable life insurance Combines a straight life policy with an investment

that could increase the death benefit (but only if the insurance company’s investments perform well) Policy’s cash value can fall from year to year if

investments do poorly

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Other Life Insurance Options

Credit life Guarantees your debt will be paid off if you

die Protects lender and your family

It’s actually decreasing term insurance with the term equal to the length of loan

Very expensive Some critics view as a rip-off May be worth it if you’re in poor health and find it

difficult to obtain life insurance

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Which Type of Life Insurance is Right for You?

Do you need or want Just insurance protection Insurance protection combined with

savings Why not pay lower (in some cases, MUCH

lower) term life insurance rates and put the extra money you’d be saving since you didn’t buy whole life, etc. into investments yourself?

You’ll probably earn more money in the long run

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Table 11.1: Comparing the Cost of Term to Whole Life Insurance

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Term vs. Whole Life

Most insurance companies argue that term life policyholders will outlive their terms and to obtain a new policy will be very expensive

Experts argue that term insurance is still a good buy for people in their 50s May not need much insurance at this

stage anyway Goal could be to be self-insured by age 60

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The Life Insurance Contract

Beneficiary clause Names the person(s) or organization to receive

policy proceeds Proceeds aren’t subject to income taxes but may have

to pay estate taxes Names secondary beneficiaries Can be changed—unless you name an

irrevocable beneficiarySettlement options

Lump sum vs. periodic payments (life income, fixed income, interest only with principal in lump sum at later date)

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The Life Insurance Contract

Premium payment clause Premium amount, how often (quarterly,

monthly, annually)

Dividend clause Only with mutual life insurance companies Specifies how dividends are paid

Reducing future premiums May offer various options

Cash, premium reduction, purchase additional life insurance

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The Life Insurance Contract

Accidental-death clause If policyholder dies by accident, get extra benefit

AKA as double- (or triple-) indemnity clause Restrictions

Suicide Riot/insurrection Airplane disaster During commission of a felony

Suicide clause Limits company’s liability within first two years of

policy to amount already paid in premiums

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The Life Insurance Contract

Waiver-of-premium clause If you become disabled (or lose your job), the

insurance company may waive the premium for some time period so that you don’t lose coverage (and company doesn’t lose client)

Guaranteed insurability clause Policyholder has right to purchase additional

insurance without physical Usually obtainable through age 40 Good idea for younger policyholders who can’t

afford premiums for additional insurance right now

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The Life Insurance Contract

Nonforfeiture option Protects you if policy lapses and your policy has cash value

May surrender policy for portion of cash accumulated by your premium payments

May use cash value as a single premium and buy a reduced amount of paid-up life insurance

May use cash value to buy term insurance for as long as the single premium will provide

Policy reinstatement Allows policyholders to put a lapsed policy back into effect

if policyholder Offers proof of continued insurability Pays accumulated premiums plus interest May have to meet specified time frame

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Buying Life Insurance

Shop around Impossible to compare value of term

insurance to cash-value policiesMake sure you compare similar policies

(amount, term, renewability options, etc.)Rates are usually quoted per $1,000 of

coverage But, rates on larger policies don’t increase in

a linear fashion

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Net Cost Method

With policies having cash valueValue of premiums paid less accumulated

cash value Can even show a negative net cost

(suggesting policy ‘pays for itself’) Ignores interest you could have earned if

you had invested premiumsCompany could assume an abnormally

high investment return on cash value

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Interest-Adjusted Cost Index Method

Considers total premiums paid, accumulated cash value, value of accrued dividends, and what interest buyer could have earned had premiums been invested

You’d like to see this value for different points in time 5-, 10-, 20-years

You should request to see this methodThe lower the index, the cheaper the policy

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Choosing the Right Company and Agent

Check out their financial rating Standard & Poor’s or A.M. Best Only buy from firm with high rating

Remember, most agents receive a commission Higher the more insurance you buy Higher with cash value policies

Analyze your needs, read up on the policies, and buy straight from insurance company—bypass the agent

Use an online quotation service Such as http://www.insurance.com/

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Web Links

Information about ratings is available at:

http://www.ambest.com/ http://info.insure.com/ratings

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Common Sales Pitches

You wouldn’t be able to afford term life insurance when you’re old May not need life insurance then

A cash value policy is a form of forced savings True, but you’ll probably earn more reinvestment

return if you invest the money yourself

Cash value policies offer tax-deferred savings So does a 401(k) and other retirement plans and will

probably earn higher returns!

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Common Sales Pitches

You may not need insurance now but if you buy it now it will cost less and guarantee future insurability Odds of developing a health problem that

will cause future uninsurability are smallAfter X number of years, you’ll no

longer have to pay a premium Often based on assumption that

insurance company will earn very high interest rates

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Long-Term Care Insurance

About 40% of all people who recently turned 65 will need long-term care Odds are higher for women

Long-term care is very expensive Average cost of nursing home is $125 per day

Rising at a rate greater than inflation

Medicare doesn’t pay for extended long-term care

Medicaid does pay, but only after you’ve used up your assets

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Should People Purchase Long-Term Care Insurance?

It is expensiveTypical nursing home stay is fairly short

Highly unlikely a long-term care policy will ever pay for itself Unless you stay in a nursing home for a lengthy time

period and few people do

Medicare will pay the bulk of nursing home bills if certain conditions are met

Medicaid will pay if a person depletes his assets Some nursing homes won’t take Medicaid patients

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Buying the Right Long-Term Care Policy

Relatively new type of insurance Policies and premiums differ widely

Shop around and do your homeworkThe younger you are when you buy the

policy, the cheaper the policy Typical policy doesn’t increase the benefits paid

in tandem with the expected increase in costs Thus the gap between costs and benefits paid will be

greater than younger you are when you buy your policy

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Figure 11.6: The Impact of Inflation on a Long-Term Care Insurance Policy