Fundamentals of Life Insurance

Table of Contents

1. The What and Why of Life Insurance

A. Definition

B. Purposes for Buying Life Insurance

1) Providing protection for beneficiaries 2) Life insurance as an investment 3) Life insurance as a tax shelter 4) Life insurance as part of estate planning

C. Advantages of Purchasing Life Insurance

D. Types of Life Insurance

2. Term Life Insurance

A. The What and Why of Term Life Insurance

B. Types of Term Life Insurance

1) Level term insurance 2) Decreasing term insurance 3) Increasing term insurance

C. Other Options on Term Insurance

1) The option to renew 2) The option to convert 3) The option to re-enter

D. Pros and Cons of Term Life Insurance

1) Advantages

2) Disadvantages

3. Whole Life Insurance

A. The What and Why of Whole Life Insurance

B. Some Important Concepts1) Cash value

1) Definitions 2) Premiums 3) Death benefit 4) Dividends 5) Loans against the policy 6) Termination

C. Types of Whole Life Insurance

1) Standard whole life 2) Single-premium life 3) Modified Life 4) Graded premium life 5) Interest-sensitive product

D. Pros and Cons of Whole Life Insurance

1) Advantages 2) Disadvantages

4. Universal Life

A. The What and Why of Universal Life

1) Definition 2) How it works

B. Death Benefit Options

1) Fixed death benefit 2) Increased death benefit 3) Decreased death benefits

4) Pre-funded death benefit

C. Premium Options

1) Determine the premium 2) Increase premiums 3) Decrease premiums 4) Discontinue premiums 5) Pre-pay premiums

D. Cash Options

1) Borrow cash 2) Withdraw cash 3) Surrender policy

E. Pros and Cons of Universal Life Insurance

1) Advantages 2) Disadvantages

5.Variable Life

A. The What and Why of Variable Life Insurance

1) Definition 2) How it works 3) Who needs it

B. Variable Life Investments

C. Variable Life Insurance Death Benefits

D. Straight vs Universal Variable Life

E. Other Options of Variable Life

F. Pros and Cons of Variable Life

1) Advantages 2) Disadvantages

6. Special Interest Policies

A. Group Life

B. Endowment Policies

C. Industrial Life

D. Mortgage Insurance

7. The Insurance Contract

A. Key Terms and Concepts

B. Characteristics of Insurance Contracts

C. Parties Involved in a Life Insurance Contract

D. Provisions and Options

1) Ownership options

2) Death benefit payment options

a) Lump-sum payment b) Installment payments c) Maintaining the principle (interest-only payments) d) Payments for life

3) Provisions

a) Incontestability clause b) Age and sex c) Entire contract clauses d) Insuring clause e) Premium and grace period provisions f) Reinstatement clause g) Assignment clause h) Termination

4) Exclusions

a) Suicide b) War c) Dangerous activities d) Non-commercial aviation e) Filing a Claim

The What and Why of Life Insurance

A. Definition

The dictionary defines life insurance as protection against the death of an individual in the form of payment to a beneficiary and--usually a family member, business, or institution. In exchange for a series of premium payments or single premium payment, upon the death of an insured, the face value (and any additional coverage attached to a policy), minus outstanding policy loans and interest, is paid to the beneficiary.

The number-one reason to have life insurance is, obviously, to protect a person's beneficiaries if s/he dies prematurely. But there are several other good reasons for purchasing life insurance.

B. Purposes for Buying Life Insurance

1) Protection for beneficiaries

Protecting survivors means replacing the income an individual brings in if s/he dies prematurely. If the insured has children, a good portion of his wages probably goes to the cost of bringing them up. If he dies, the life-insurance death benefit replaces those earnings so that the family won't have to suffer financially. The cash death benefit can be invested for the survivors to provide a continuing stream of income.

The death benefit of a life insurance policy can also handle the following expenses:

� Burial expenses. � Federal and state estate taxes. � A mortgage on the family house, to enable the family to stay in its home after the death of the main wage-

earner. � Other debts, such as credit card balances, bank notes, margin loans, or family loans. � A child's education. � A charitable contribution--for example, to an alma mater or church. � Lastly, if the insured is a part-owner of a business, the business may purchase the life-insurance policy on

him so that if he dies, the partner can use that death benefit to buy out his share of the business from the deceased's heirs.

2) Life insurance as an investment

A second purpose of having life insurance is to use it as part of an investment portfolio. Most financial advisers encourage investors to balance their investments so that if one kind of investment goes down (the stock market, for example), another one will likely go up (bonds or real estate, perhaps). By balancing a portfolio and diversifying investments, a person can weather storms in one area by having some assets in other areas that go up or stay level.

Some life insurance policies are actually long-term investments, where the policy owner can contribute to and withdraw funds from before s/he dies. These so-called cash value policies and whole life and universal life insurance are actually savings accounts that accrue a cash value over time and also pay for protection. Although these policies don't command the highest interest rates that can be found, they are untaxed earnings, so an individual gets a higher return than simply putting money in a savings account on which s/he must pay taxes.

3) Life insurance as a tax shelter

Life insurance can play two roles as a tax-sheltered investment:

� The earnings on a cash-value policy are not taxed until they are withdrawn. � The proceeds of a death benefit settlement are not taxable to the survivors.

A cash value account yields tax-deferred income, which in effect increases the yields. Suppose that a woman currently earns $60,000 a year, and she buys a $180,000 life insurance policy to help her survivors through three years without her income. If she dies, her survivors get the full $180,000 and none of it is taxed.

Because proceeds of the death settlement and the earnings of a cash value life insurance policy are both tax-deferred, they serve as excellent tax shelters.

4) Life insurance as part of estate planning

The process of estate planning deals with how one distributes one's wealth after death. Currently the federal tax

laws state that the first $650,000 in inheritance is federally tax-exempt. Most states allow the same amount or they have no inheritance tax at all. Realistically most couples own their property and assets jointly, so surviving spouses are owners and don't have to pay inheritance taxes, even if the estate is greater than the amount allowed under the law.

But if a person's estate is worth more than the law allows, care should be taken to ensure that his/her wealth goes to the survivors and not to the government. That's where life insurance and life insurance trusts can be useful.

Briefly, what must be done is:

� An irrevocable life insurance trust is set up to which the insured contributes annually. The trust is in effect a life-insurance policy which goes to his/her survivors tax-free. The insured can't withdraw that money for any reason (hence the term irrevocable).

� The insured and his/her spouse each leave to their children whatever the law allows at the time, so that money is also tax-free.

� The insured wills the remaining amount to a qualified charity of his/her choice which, by definition, is exempt from inheritance taxes if the insured doesn't will direct the remaining amount to a charity, it is considered part of his/her estate in the heirs have to pay taxes on.

Thus the insured takes the IRS out of the picture. Using some of his estate, he buys a tax-free life-insurance policy so that his heirs get the same amount they would have before any estate taxes--the amount equivalent to his estate. Plus he donates a large portion of his estate to charity rather than to the government.

C. Advantages of Purchasing Life Insurance

� Cash is paid to the beneficiary at the death of the insured this is the primary reason for owning life-insurance the death benefit is usually significantly greater than the premiums paid.

� Policies allow for flexible payout of proceeds. There are many options, which can be chosen by either the owner or the beneficiary, for the payment of proceeds.

� The proceeds can avoid probate and public scrutiny by naming a beneficiary other than "the estate of the insured" on the insurance policy. Will and trust planning, by attorneys trained in this field, is the best way to avoid probate.

� Death benefits are received income-tax-free. This is an immense tax benefit for beneficiaries who receive the policy death proceeds without the shrinkage associated with most other sources of funds.

� In most states, life insurance is usually protected from the claims of creditors. � Some insurance policies likewise have a savings or investment element that can increase financial security

during the insureds lifetime.

D. Types of Life Insurance

The following types of life insurance will be discussed in the rest of this module:

� Term policies � Permanent or cash-value policies � Whole life policies � Universal life policies � Variable life policies � Special interest policies

Term Life Insurance

Module Overview

This module discusses, in depth, term life insurance:

� The what and why of term life insurance � The types of term life insurance � The types of term life insurance � The options available on term life insurance � The pros and cons of term life insurance

A. The What and Why of Term Life Insurance

Term insurance is the most basic form of life insurance and therefore the easiest to understand. At its simplest level term insurance provides life insurance for a defined period—usually a 1, 5, or 10 year term. For that insurance, the owner pays a monthly, quarterly, annual, or semiannual premium that remains constant during the specified term.

Term insurance provides only indemnification—only a death benefit—in the event of the death of the insured while the policy is in force. Term insurance is not an investment—the insured receives no benefits other than the security of knowing that if s/he dies, the insurance proceeds go to his/her beneficiaries.

Permanent or cash-value insurance, on the other hand, is designed to cover a longer or indeterminate period of time. Unlike term, permanent plans also provide a cash value—that is, a savings or investment element. Sections 3-7 of the module cover various forms of permanent insurance.

B. Types of Term Life Insurance

There are several common types of term life insurance:

1) Level term insurance

In level term insurance, both the death benefit and the premiums remain the same during the term of the contract.

2) Decreasing term insurance

Decreasing term insurance was created to provide a decreasing amount of protection over a specified period of time. The death benefit usually decreases at a constant rate. For example, a 10-year decreasing term policy with a face amount of $100,000 would usually decrease $10,000 each year until the end of the tenth year when the benefit would be zero.

Decreasing term policies have traditionally been used to cover mortgage loans, which by nature decrease with time. While mortgage lenders offer policies that provide the exact balance due on the mortgage in the event of a premature death, a regular decreasing term policy will possibly be a better choice for the owner, both from a cost and a flexibility standpoint. The insured should buy enough term insurance to match the remaining principal due on the mortgage and make his/her heir, not the lender, the beneficiary. The heir, usually a surviving spouse, will be able to decide at the time of receipt of the death benefit if it is advisable or not to pay off the mortgage loan.

3) Increasing term insurance

Increasing term insurance is usually a rider to another policy rather than a separate policy. Premiums are higher than the other forms of term because there's a greater death benefit as the insured get older. And because premiums are calculated on the basis of age, the individual will pay more.

C. Other Options on Term Insurance

1) The option to renew

The most frequent option on term policies is the right to renewal the policy. Since the major characteristic of term insurance is the fact that the coverage lasts for specified term only, at the end of that term the policy stops. Insurers realize that sometimes there's a need for continuing coverage beyond the original term. The option to renew the policy guarantees that the insured will be able to continue the contract. The premiums may be higher, but this is fair, because the insured will be older then and premiums increase with age.

Generally there is a limit on how long the policy can be renewed, such as to age 65, or 20 years. However some policies will be renewed to much more advanced ages, although at quite high premiums.

2) The option to convert

The second, an option is the right to convert a term policy into a permanent policy without new evidence of insurability. This involves risk on the insurance company's part and there's a cost associated with that conversion privilege. Many term plans are convertible as a right of the policy, and the premium is built into the overall term plan premium. Others show the cost of the right of conversion as an optional rider.

The right to convert usually can be exercised in one of two ways: attained age or original age conversion. The attained age conversion allows the insured to purchase the new permanent policy at the premium rate applicable at your currently attained age. The original age conversion, on the other hand, allows the insured to go back to the premium rate charged for the permanent plan at the younger age when s/he first bought the term. However, an additional sum is paid in to make up for the premium differential over those years.

3) The option to re-enter

Renewable term insurance may have a provision called re-entry, which means that the insurance company can ask then insured to undergo a medical exam before it will renew the policy after the term expires. If the insured person's health isn't good and the re-entry clause permits it, the company can cancel the insurance.

The re-entry clause may prohibit the company from canceling the insurance, but it may allow it to charge the insured higher premiums. Some re-entry policies limit the maximum premium that can be charged.

D. Pros and Cons of Term Life Insurance

1) Advantages

When the insured is young, term insurance is considerably less expensive than cash value policies are.

� All the money paid goes toward the death benefit policy; none goes to cash value.

� Only a small percentage of the premiums go toward commissions. � Term insurance is simple to understand and does exactly what it is meant to do: protect the insured’s

beneficiaries.

2) Disadvantages

� Term insurance becomes more expensive as one ages. � If the insured outlives the term, the policy has no cash value.

There is no tax advantage to term insurance. In addition, due to inflation, a death benefit that remains constant actually declines in purchasing value because the dollars buys less later on.

Module Summary

At the completion of this module, the learner should be able to discuss, in some depth, term life insurance:

� The what and why of term life insurance � The types of term life insurance � The options available on term life insurance � The pros and cons of term life insurance

Whole Life Insurance

Module Overview

This module discusses, in depth, whole life insurance:

� The what and why of whole life insurance � Some important concepts that apply to whole life insurance: cash value, premiums, loans against the

policy, and termination of insurance � The types available of whole life insurance � The pros and cons of whole life insurance

A. The What and Why of Whole Life Insurance

Whole life insurance covers the insured for his/her entire life, not for just a specific period of time. The death benefit remains the same and so does the premium. With term insurance, the premium increased as the insured aged to cover the increased health risk. Insurance companies keep both the premium and the death benefit constant during the life of a whole life policy. They do this by charging the insured a premium that is higher than the cost of the insurance when s/he's young and using some of that profit to pay for the higher cost of the insurance when s/he's older.

B. Some Important Concepts

1) Cash value

Whole life insurance policy remains in full force and effect for the life of the insured, with premium payments being made for the same. The premiums stay the same every year, and the death benefit is fixed. Since the amount of the premium is much more than what is needed to pay death benefits in the early years, the extra money is deposited into the account inside the policy which earns interest and grows tax-deferred. This is the policy’s cash value.

Cash value means that the life insurance policy has a greater value than just the death benefit, the face value of the insurance policy, that goes to the insured’s beneficiaries when s/he dies. In a term policy, the value is only the amount of the death benefit that the insured has contracted for. In a whole life policy, a portion of the premium goes toward the life insurance itself, another portion goes toward the cash value of the policy, and the rest goes to administrative costs and commissions. The insurance company invests the cash value portion, and in return, the insured gets some of the profits. In a sense then, this portion is an investment.

2) Premiums

There are two types of whole life policies. In the first, the insured pays the same level premiums into old age, where s/he can borrow against the policy to get extra cash in retirement years. In the second, vanishing premiums, the insured pays premiums for a fixed number of years only. After that, the cash value in the account pays for the premiums.

3) Death benefit

With whole life, just as with term insurance, the beneficiaries receive only the death benefit—the face value of the policy, meaning the protection purchased—when the insured dies, even though the premiums paid also contributed to a cash value. With whole life, none of the cash value accrued adds to the death benefit, because the cash value goes toward paying the higher cost of the insurance as the insured ages.

4) Dividends

Over and above the guaranteed rate of return, some companies offer policy-holders the opportunity to benefit from the company's success, just like shareholders do. The company pays dividends, based on how well the company did the previous year. Policies with this benefit are called participating policies, often referred to as par policies as opposed to non-par policies—that is, ones that don't pay dividends.

The amount of dividend depends on a number of factors:

� The company's overall financial success � How well the company anticipated interest rates � The number of claims the company had to pay � How well the company did in its investments � The specific terms of the policy � Dividends can be used in three ways: � Dividends can be used to reduce premiums. � Dividends can accumulate at interest, thus increasing the cash value and the death benefit of the policy.

Compound interest can make the accumulation significant over time. � Dividends can be used to purchase paid-up additions to the policy. This has the effect a buying more

permanent insurance and therefore increasing the cash value. Some contracts also allow the owner to purchase one-year term insurance, thereby significantly increasing the death benefit.

5) Loans against the policy

An additional benefit of whole life policies is the ability to borrow against the cash value of the policy, usually at an interest-rate significantly lower than market rates. The rates are low because the lender is assuming absolutely no risk—if the owner doesn't pay back the loan, the insurance company can take the money from the account. When the owner borrows against the policy, s/he pays no fees and can usually get the money quickly. If s/he dies before paying back the loan, the outstanding amount is deducted from the death benefit.

6) Termination

If an owner terminates a whole life insurance policy, he is entitled to receive a surrender value, basically the amount of the accrued a cash value of the policy. The surrender value continues to increase as the owner continues to contribute to the policy, but the amount increases at a progressively slower rate.

C. Types of Whole Life Insurance

1) Standard whole life insurance

Standard whole life insurance has been described above. However, several variations on a whole life insurance have developed over the years, each suited to a particular market or to a particular need. For example, limited-payment whole life policies appeal to owners who need protection for life, but who don't want to be burdened with premiums for life. The whole life policy can be reconfigured to allow a shorter premium-paying schedule.

2) Single-premium life

In a single-premium whole life policy, the owner purchases the policy by paying one large sum for a specified death benefit. S/he doesn't pay any annual premiums and the death benefit either remains constant or increases, depending on the kind of policy purchased. The insurance company takes the money up front, invests it, and pays a small return, similar to what is earned with other whole life policies.

Like other whole life policies, a cash value accrues, usually with a guaranteed minimum return. When the insured dies, the death benefit plus any accrued cash value goes to the beneficiaries.

The single premium whole life policy was a popular form of investment vehicles during the 1980's, usually desired for its tax-free accumulation of cash values rather than its death benefit. However, Congress passed the Technical and Miscellaneous Revenue Act in 1988, which dramatically changed these products by redefining life insurance. Single premium life policies were redefined as modified endowment contrast (MECs) and were denied the favorable tax treatment accorded to life insurance.

Advantages of single premium whole life:

� A substantial discount on the cost of the insurance itself. The lump-sum payment is less than the accumulated cost of annual premiums on comparable whole life policies.

� Ability to immediately borrow against the cash value of the account. If the owner only borrows what the cash value itself earns, then he will likely pay approximately the same interest as cash value earns as well. Thus, by storing some money in the insurance company's offers, he can borrow at virtually no interest.

4) Modified Life

Modified life allows the insured to purchase permanent insurance today even though s/he cannot pay much in premiums at first. The premium structure is modified during the first several years, usually five, with premiums closer to term rates. After that, the company charges a premium for life that slightly higher than traditional whole life. This higher premium in the later years pays back the company for the earlier lower premiums earlier.

5) Graded premium life

The graded premium life policy is similar to modified premium except that the lower premiums are step-rated to permit a gradual transition to full whole life premiums.

6) Interest-sensitive products

Interest-sensitive whole life insurance is a whole life policy in which the owner is paid an adjustable or variable interest rate, rather than a guaranteed rate. Like an adjustable-rate mortgage, the rate is often tied into an economic indicator such as the Treasury bill rate.

Premiums, death benefits, and cash value are all aligned with a variable interest rate so that policyholders have various options. When interest rates rise, owners can maintain the same death benefit and percentage that goes toward the cash value, but lower the premiums. Or the owner can hold the premium and death benefit steady while increasing the cash value. In some policies, the death benefit can increase while the premiums and cash value rate of return are steady.

Naturally the opposite options are also available. When interest rates are on the decline, cash value return decreases while premiums and death benefit are constant. Or premiums rise so that cash value return and death benefit remain the same. Or death benefit decreases while cash value return and premiums stay at the same levels.

D. Pros and Cons of Whole Life Insurance

1) Advantages and Disadvantages

Advantages

� An increasing amount of the money paid goes toward cash value. � The premiums remain constant for the entire time the insured is covered, unless s/he chooses a variable

premium policy. � Life-insurance coverage can be totally paid after only a few years by the profits from the cash value. � Life-long coverage and no medical exam. � Tax-deferred cash value earnings, and when cash is moved out, the premiums paid reduce the gain.

Disadvantages

� Earnings will most likely be fairly low, probably just a bit more than the amount guaranteed. � Higher premium than term insurance because the owner is also contributing toward a cash value and the

insurance agent’s higher commission, and because the early premiums subsidize the higher cost of insurance when the owner is older.

� Not appropriate to use as an investment due to the poor rate of return. � Death benefit coverage becomes unnecessary later in life when the individual has no dependent

beneficiaries. � Returns aren't as high as other tax-deferred plans such as IRAs and 401Ks.

Module Summary

After completing this module, the learner should be able to discuss, in depth, whole life insurance:

� The what and why of whole life insurance � Some important concepts that apply to whole life insurance: cash value, premiums, loans against the

policy, and termination of insurance � The types available of whole life insurance

� The pros and cons of whole life insurance

Universal Life

The What and Why of Universal Life

1.Definition

Universal life insurance, a form of whole life insurance, takes the trend toward flexibility to the next level. Like whole life, universal life has two components: a term insurance policy and an investment account from which the term insurance premiums are paid. But with universal life the owner must make choices. The policyholder knows how the premiums may change the death benefit and cash value and it’s much clearer how much of the premiums go toward insurance protection, how much toward cash value, and how much toward administrative expenses including commissions.

In other words, universal life insurance is adjustable life insurance under which premiums and protection are flexible, not fixed, and insurance company expenses and other charges are specifically disclosed. This type of policy is referred to as unbundled life insurance because its three basic elements--investment earnings, pure cost of protection, and company expenses--are separately identified both in the policy and in an annual report to the policy owner.

2.How it works

The policyholder first decides on a planned death benefit, and then determines, with the insurance agent, the planned premium, based on how much he or she can afford and the cost of the insurance. The company subtracts an expense charge based on its fees, usually a fixed percentage of the premiums. What's left is the cash value that generates interest. From the cash value, the company subtracts the current cost of insurance (the mortality charge), including the charges for any options (riders), and monthly administrative expenses. Then the company adds any interest the investment money earns. The ending cash value is the accumulated value that belongs to the policyholder when s/he cashes out or to the beneficiaries when s/he dies.

The insurance company issues an annual report to the policyholder that shows the status of the policy: death benefit option selected, specified amount of insurance in force, cash value, surrender value, and the transactions made each month (premiums received, expenses charged, guaranteed and excess interest credited to the cash value account, pure cost of insurance to deducted, and cash value balance).

Other aspects of universal life to consider:

� All the earnings in the investment account are tax-deferred. � If the policyholder stops paying premiums, the company continues to pay the premiums for him by

deducting them from the policy’s cash value and continues to do so until no cash value is left. This is one way to continue coverage without paying premiums.

� The interest-rate is a fixed-rate, although it may be a tiered interest rate, in which part is paid at one rate while the balance is paid at a higher rate.

� The owner can withdraw money that is accumulated in the cash value, and thereby decrease the death benefit, which depends partially upon the accumulated cash value.

� The policyholder can borrow against the cash value of the policy at a fixed rate, generally below market rates.

� It coverage is increased, the policyholder may have to be re-qualified by taking a medical exam. � A termination fee or surrender charge must be paid if the policy is cancelled, thus reducing the cash value

to the surrender value.

Death Benefit Options

With universal life insurance, the policyholder chooses how much death benefit is to be paid. There are two options, and with either the premium remains the same throughout the term of the policy, but the death benefit and surrender value differ.

1) Fixed death benefit

With a fixed death benefit, the policyholder determines what amount goes to his survivors, for example $50,000. In actuality the face value of the policy, the initial $50,000, decreases by the amount accumulated in the cash value account. But the death benefit remains the same, because the decreased face value and the increased cash value add up to the total amount determined.

2) Increased death benefit

Within limits of insurability, a policyholder may increase the amount of the death benefit. Reasons for doing so may be increased family size or significant debt. There are several ways to increase the amount of coverage. The term element within the policy itself can be increased or a term rider can be requested.

3) Decreased death benefits

Decreasing the death benefit has the obvious advantage of increasing the cash value of the policy, because less money would be allocated to mortality charges. A change in family obligations or debt might be a reason for decreasing the protection levels.

4) Pre-funded death benefit

If cash values are sufficiently large, the death benefit can be prepaid with these funds. This option is rarely invoked because it reduces the flexibility of the policy.

Premium Options

In universal life insurance, the amount of death benefit, accumulated cash value, and premium are all interrelated. If the premiums are high, then either more protection is bought or more cash value is built. The more protection that’s bought, the higher the premiums or the lower the cash value. And the more cash value that’s built, the higher the premium or the less protection is bought.

1) Determine the premium

Because the primary goal in buying insurance is protection, the main consideration should be the amount of the death benefit. Cash value and premium costs should be secondary factors. But clearly, the premium should be in line with how much the policyholder can afford to pay.

If an individual wants a universal life policy and can afford the premium, s/he needs to balance the following three considerations to determine the cash value:

� Determine how much s/he can afford from a monthly budget. � Decide how much protection s/he wants to purchase. � Balance the amount of protection wanted with the amount of premium that can be afforded.

2) Increase premiums

The policyholder may increase the premiums. There are, however, limits on the amount of premium increase the policyholder may initiate himself.

3) Decrease premiums

Decreasing premiums would be inadvisable if the actual interest earned on the cash value of the policy is less than projected results. But if the interest earned exceeds the projected rate, the policyholder can decrease the premiums without long-term adverse effects.

4) Discontinue premiums

The ability to continue coverage while discontinuing premiums is very useful when money is needed, for example when jobs are changed or lost, emergencies arise, basements leak, children go to college, or parents need support. The length of time the premiums can be discontinued will depend on how long the policy has been owned and how much cash value is intact to draw against.

5) Pre-pay premiums

With universal life insurance, the policyholder can buy in up front by putting a significant sum into the account, which allows cash value to increase more because the account is starting at a higher level. Prepaying also allows the policyholder to lower premiums, because the accumulated cash value is earning more, which means that more earnings can contribute to the cost of the insurance. On the other hand, prepaying also means that a lump sum of cash must be taken from somewhere else.

D. Cash Options

1) Borrow cash

Cash may be borrowed from a policy. Typically the loan limit is 90% of the cash value fund. 10% is held back to ensure enough to pay interest on the policy loan and to continue the contract in force. Again, this is an asset that should be considered part of the liquid portion of one's financial statement, in the same category as bank accounts, CDs, and money-market funds.

2) Withdraw cash

Cash may be withdrawn from the policy. As opposed to a policy loan, withdrawal is a permanent removal of cash from the contract. The policyholder will be required to leave enough in the contract to keep it in force.

3) Surrender policy

The policy may be surrendered for cash. The "cash out" option is always available, so long as the policyholder has cash left in the contract. Most companies impose a surrender charge against the contract in the early years, which is a charge levied against the cash value at the time of surrender, and designed to reimburse the insurer for expenses it chose to amortize over several years and which have not yet been recovered.

E. Pros and Cons of Universal Life Insurance

1) Advantages

� A great deal of flexibility in determining premiums, cash value, and death. � Premium remains constant for the entire time of coverage, and s/he can opt for either a fixed or an

increasing death benefit. � Coverage is totally paid after only a few years by the profits from the cash value, and most of the premiums

are going to the policyholder. � Lifetime coverage and no medical exam (unless changes are made to the policy). � Tax-deferred cash value or earnings, and when the policyholder cashes out, the premiums paid reduce the

gain.

2) Disadvantages

� Complicated terms and options. � Premiums are considerably higher than for term insurance, and if the death benefit remains fixed, the

policyholder actually reduces the accumulated cash value. � Whether from your monthly budget to your accumulated cash value, the policyholder is still paying the

premium. Not appropriate as an investment due to poor rate of return. � Death benefit coverage becomes unnecessary later in life when there are fewer or no dependent

beneficiaries.

Variable Life

A. The What and Why of Variable Life Insurance

1) Definition

Variable life insurance is investment-oriented whole life insurance that provides a return linked to an underlying portfolio of securities. Because of its investment features, variable life insurance is registered with securities regulators. The portfolio typically is a group of mutual funds established by the insurer as a separate account, with the policyholder given some investment discretion in choosing the mix of assets among, say, a common stock fund, a bond fund, and a money-market fund. Variable life insurance offers fixed premiums and a minimum death benefit. The better the total return on the investment portfolio, the higher the death benefit or surrender value of the variable life policy.

2) How it works

With a whole life, adjustable life, and even universal life, the insurance company accepts the owner’s premium and assumes full responsibility for the successful investment of the portion not used to pay for expenses and for the cost of insurance. With variable life, however, the insurance company deducts the same mortality charges and operational expenses and then puts the policyholder in charge of investing the funds wisely.

Under the terms of this form of insurance, the policyholder maintains a cash value from which the term insurance premiums are paid. What makes this type of policy different is that the cash value is invested in mutual funds and the amount of the death benefit is tied to the mutual funds' performance.

3) Who needs it

Variable life is most suitable for people with a need for control over their cash values and the need for increasing death benefits. It's for people with better-than-basic understanding of investments and who are willing to assume the burden of the risk for investment results.

The opportunity for extraordinary growth of the cash values and the death benefit is the greatest appeal of the product. Most of the money invested in variable life and variable universal life policies has been invested in equities, and equities over the long term have shown significantly higher returns than fixed asset investments characteristic of insurance company portfolios.

Variable life and variable universal life should be viewed as long-range insurance policies with investment characteristics. They are not appropriate as a short- or intermediate-term solution to life-insurance needs.

B. Variable Life Investments

Typically the stockholder has the choice of investing the cash value in a common stock mutual fund, a bond fund, a money-market fund, or any combination of funds. S/he maintains the control. With some variable life-insurance policies, the owner can change funds, but is always limited to the insurance company's funds. How well these funds do depends on how successful the insurance company's investment managers are. The approach is analogous to a family of funds, a group of funds under the management of the same company. The funds usually have different advisers, but the parent company is the same. This allows for ease of moving from one fund to another and ease of administration. Some companies offer variable life and variable annuities that include a variety of fund managers from different families under one contract.

The investment results of the various funds determine the performance of the entire contract. This means that the cash value account could actually decrease from one year to another if the investments go down in value. Again, the policy owner decides how to invest the funds. The insurance company is just the expediter of his/her decisions.

The cash values are invested in separate accounts of the company, as opposed to the general account. This means they're not part of the general assets of the company and, therefore, are not subject to the general claims of creditors and policy owners.

C. Variable Life Insurance Death Benefits

The amount of death benefit with a variable life policy varies but is typically never below the face value. If the investments go up, so does the death benefit. If they decrease, so does the death benefit.

However, some variable life policies have a minimum guaranteed death benefit. With such a guaranteed death benefit, variable life can be excellent insurance because, if the investments are successful, the cash value can go up much more than a policy with a fixed rate of return.

D. Straight vs. Universal Variable Life

There are two different kinds of variable life policies:

� straight variable in which the premium is fixed and the death benefit rises and falls as the investments go up and down.

� variable universal, in which the premiums vary, the death benefit is either fixed or increases, and the cash value goes up and down with the investments.

With a straight variable, if the value of the investment exceeds a specified minimum, usually 4%, the death benefit goes up by that amount. If the investments’ value decreases, so does the death benefit. With most policies, the death benefit will never decrease below the original face value.

E. Other Options of Variable Life

Most of the other terms of variable life policies are the same as the universal life policy:

� The policyholder can borrow against the cash value. � The policyholder can choose to have an increasing or fixed death benefit. � The cash value earnings are all tax-deferred.

F. Pros and Cons of Variable Life

For many people, variable life insurance is an excellent product because it combines flexibility and bigger returns.

1) Advantages

� Control. The policyholder has control over the cash values, premiums, and death benefits, especially with the variable universal life.

� Increasing death benefits. Assuming investments perform well, the death benefits increase too. And with variable universal life, the death benefits can be changed to meet the policyholder’s needs, which may change with time.

� Free switching between funds. As in a mutual fund family, the policy owner may switch between funds without incurring a charge or triggering a taxable event, even if there is a gain within the fund family.

� Accessible cash values. They may be used to pay premiums, accumulate, and withdraw for emergencies or income.

� Tax advantage. The products are considered life insurance and therefore enjoy a favorable tax treatment.

2) Disadvantages

� Variable life is considerably more costly than term or whole life insurance. The premiums are much higher in part because the expenses charged are much higher. The investments pay not only for the cost of the term life insurance, but also for the cost of the company's investment managers.

Another drawback of variable life is the possible consequences of shifting the investment risk to the policyholder. Poor performance means lower death benefits, cash values, and future income capabilities.

Special Interest Policies

This section deals with several variations on ordinary life insurance.

A. Group Life

Life insurance, like any other commodity, is cheaper when you buy a lot of it and cheaper when a lot of people by it. When tens, hundreds, or thousands of people agreed to purchase policies from one company, that company can offer rates considerably less than if an individual buys a policy on his/her own.

Typically group life insurance is arranged through an employer or an organization in which the policyholder is member. One of the key things to remember about group life policies is that the policyholder doesn't own the policy. Although s/he is covered, the policy belongs to the employer or organization, not the individual. If that person changes jobs, retires, or no longer belongs to the organization that purchased the insurance, s/he is no longer by the covered by the insurance.

Also, there may be tax consequences if an employer pays for a life insurance. The insurance premium paid by an employer is, in effect, income. You may be responsible for paying taxes on that income. Under the current tax rules, employers are allowed to provide up to $50,000 in term life insurance for employees without their facing any tax consequence. Any premium paid for a policy above that maximum is considered additional income, for which the employee must pay taxes.

B. Endowment Policies

Endowment insurance is life insurance under which an insured receives the face value of a policy if the individual survives the endowment period. If the insured does not survive, a beneficiary receives the face value of the policy.

Endowment policies are unique because they're both savings plan that build cash value and term life-insurance policies that expire if you don't die. People who want the proceeds of their insurance to go to some organization, such as a college or charity, may take out endowment policies.

C. Industrial Life

Industrial life, also called burial life, is a fairly uncommon specialized kind of policy. As its name implies, the policy pays a small amount to the policyholder’s beneficiaries for burial expenses. The premiums are quite low because the policy's face value, the cost of burial, is fairly low. In essence, industrial life is another term life policy, but the death benefit is specifically tied to the cost of burial.

D. Mortgage Insurance

Mortgage insurance is, essentially, another term insurance program designed specifically to pay the balance of the policyholder’s home mortgage. As s/he pays off the mortgage, the balance declines, and so does the mortgage insurance death benefit.

The Insurance Contract

Life-insurance policies are contracts, agreements governed by the laws of the state where the insured resides and enforceable in a court of law. The contract is designed to protect the policy owner while still giving the insurance company the latitude to run a profitable business.

A. Key Terms and Concepts

Contracts must satisfy certain requirements in order to be valid and binding. Every insurance contract consists of an offer and acceptance, consideration, legal purpose, and competent parties. There must be an offer by one party and an acceptance by another. This is a fundamental principle of contract law. Consideration is something of value given in exchange for the promise of the other party. The premium is the consideration in return for a promise to pay a death benefit.

When the policyholder fills out an application for life insurance and submits it with a check to an agent, s/he is making an offer to the company. If the company issues a policy, they accepted the offer. If the application is not prepaid, the company makes an offer when they send a policy. The policyholder then accepts by paying a premium.

B. Characteristics of Insurance Contracts

There are several characteristics common to all life insurance contracts:

Executory means that the death benefit is based on the occurrence of some future event, namely the death of the insured.

Unilateral. The policy is one-sided because the insurance company is obligated to pay the death benefit if the premium has been paid and the claim submitted with a proof of death. But there is no obligation on the part of the policy owner to pay the premium.

Aleatory means the contract depends on chance. An insurance contract is aleatory because there is the element of chance involved that the premiums paid over the life of the contract may not be enough to reimburse the company for the death benefit.

Valued because the contract owner agrees to pay a specified premium without regard to the potential loss.

Utmost good faith means that both the policyholder and the insurance company are entitled to know all the important facts and information. There can be no attempt to hide, disguise, or distort the facts.

Insurable interest means that the applicant must have an interest in the continued life of the insured. This prevents the policy from being a gaming or wagering contract. The policyholder can't take a policy out on the life of a stranger, hoping to receive more benefits than paid in premiums. The insurable interest range includes relatives, business associates, and the like.

Adhesion. A life-insurance policy is a contract of adhesion because the policy is a contract drawn entirely by one side, the insurance company. There's no negotiation; the policyholder can either accept or reject it.

C. Parties Involved in a Life Insurance Contract

The insured is the person whose life is being insured and on whose death, the death benefit is paid.

The insurance company: the company that issued the policy to ensure the life of the insured. It has the primary responsibility to pay the death benefit and cash values even if it has contracted to another insurer to share the risk, called reinsurance.

The policyholder: the policy owner or party possessing the right to exercise the rights in the contract (may be a different person than the insured).

The beneficiary: the person designated by the owner to receive the proceeds of the policy upon the death of the insured.

D. Provisions and Options

1) Ownership options

Every life-insurance policy should contain a paragraph about each of the important policyholder rights in the contract. The most important are:

The right to change the beneficiary.

The right to decide how the death benefits will be paid to the beneficiary.

The right to surrender the policy.

The right to borrow against the policy.

The right to change the dividend use.

The right to transfer the policy ownership.

The right to cancel the policy, either through written notice or by ceasing to make premium payments.

The right to exercise any options the policy includes.

2) Death benefit payment options

Many people assume that when a person who has life insurance dies, the beneficiaries automatically get a check in the mail as payment on the insured person's death benefit. Nothing can be further from the truth. The insurance company must be notified that one of its policyholders has died; usually that notification must be in the form of a certified copy of a legal death certificate with an embossed seal. (See Filing a Claim below.)

Payments to beneficiaries may be made in several ways:

a) Lump-sum payment

The lump-sum payment is the most common but death benefits are paid to beneficiaries in other ways too.

b) Installment payments

The policyholder can designate that beneficiaries are to be paid the death benefit a little at a time, over a period of years. These payments can be made over a specific period of time, or a specific amount can be distributed in each payment until the total death benefit runs out. Any money that hasn't yet been paid generates interest. In most instances, this income is not taxable to the beneficiary, although the policyholder and the beneficiary should check with a tax adviser before making that assumption.

c) Maintaining the principle (interest-only payments)

The policyholder can specify that the beneficiary get a periodic payment of the interest on the death benefits cash value. Because the beneficiary earns interest on the account, s/he must claim the benefit as a taxable income. An interest-only payment option is a means of budgeting the funds while maintaining the investment. Beneficiaries usually have the option of withdrawing the principal (although generally not all at once), but this defeats the purpose of this payment option. Or they can borrow against the principle by using it as collateral and get a better rate than they get from a bank loan. Usually the life insurance contract specifies a minimum interest rate.

d) Payments for life

As in the interest-only option, the beneficiary gets a periodic payment from the death benefit, which is a means budgeting the funds while maintaining an investment. However, the amount the beneficiary receives is based on the terms set up by the policyholder, the total amount of the death benefit and cash value, and the length of time specified for the payments. With this option, the beneficiary can't withdraw the funds but is guaranteed payment for a specified period of time or for his/her lifetime.

3) Provisions

Thanks to the National Association of Insurance Commissioners (NAIC), there are now standard provisions in all life insurance policies. Some of those provisions are explained briefly below.

a) Incontestability clause

A key provision in most life insurance policies is the incontestability clause. This provision states that, except for nonpayment of premiums, the company will not contest the of the policy or the waiver of premium costs after the policy has been in force for a specified period, usually two years. So if the company discovers an error in the application after that period, it can't go back and void the policy. This provision covers the policyholder even if she misrepresented herself on the application, unless the misinformation concerned age or sex.

b) Age and sex

This provision is a way for the insurance company to cover itself in the event that it or the policyholder misrepresents the sex or age of the insured. These two factors are cited because they're the two critical elements in determining what to charge for the protection. If an error is made, the insurance company adjusts the policy benefits for the correct age or sex.

c) Entire contract clauses

The entire contract clause states that the policy and the application for insurance that is attached make up the entire contract. This protects the policyholder, because the company cannot rely on any other documents to make up the contract. Also, the insurance company must regard the statements made in the application as representations, nothing more. This means that the statements are true to the best of the applicant’s knowledge, but the applicant does not warrant, or guarantee, that the statements are true.

d) Insuring clause

The insuring clause is the insurance company's promise to pay.

e) Premium and grace period provisions

The policy must specify how the premiums are payable and when they are due. The policy must also specify whether the policyholder has a grace period and, if so, how long it is. This provision is extremely important as it protects the policyholder from losing the benefits of the policy just because of a late premium.

During a grace period, usually 30 days, the insurance company extends the coverage. If the premium is not paid by the end of the grace period, the insurance company will first try to cover the cost with any dividends owed. If there are no dividends or if the dividends are insufficient, the policy lapses and the coverage ceases. The policyholder remains covered until the insurance is officially terminated.

If the insured dies during the grace period, the insurer will subtract the premium from the death benefit.

f) Reinstatement clause

If the insurance policy lapses due to non-payment of premiums, the company will allow the owner to reinstate the policy if s/he does the following:

Specifically requests reinstatement

Pay all the back premiums with interest

Pay any outstanding loans against the policy

Submit proof of insurability.

g) Assignment clause

The assignment clause allows the policy owner to transfer the ownership of the contract to another party, temporarily or permanently. All policies require that the insurance company be notified in writing of the

assignment.

h) Termination

The policy states when the death benefit, all riders, and the waiver of premium benefit will end.

4) Exclusions

Every insurance contract has a number of paragraphs, essential for the policyholder to read and understand, that list all the reasons the insured would not be covered; that is, reasons that the beneficiaries would not get any of the funds specifically provided for them.

a) Suicide

Almost every life-insurance application contains a suicide exclusion. This specifies that if the insured dies as a result of suicide within two years of the issue date of the policy, death benefits will not be paid. Most policies also specify that if the insured does commit suicide within the two-year period, beneficiaries will receive an amount equal to the premiums paid on the policy from the starting date, called the date of issuance, to the date of death by suicide.

b) War

Although some policies specifically exclude paying death benefits when the insured dies from injuries sustained during a war, whether belonging to the military or not, many policies do not. On the other hand, policies often exclude the waiver of premium benefit if you become totally disabled as a result of war.

c) Dangerous activities

If the insured dies while engaging in inherently dangerous activities such as sky diving or hang gliding, the policy may not pay.

d) Non-commercial aviation

Many policies exclude the death benefit if the insured dies as a result of the non-commercial airplane crash, meaning an airplane ride for which no fares are required.

E. Filing a Claim

When the insured dies, filing a claim with the insurance company is a necessary, and not difficult process. Following are the steps the beneficiary must take in order to file a claim on a life insurance policy:

Find the written policy, if possible.

Call the insurance agent who sold the policy. If no agent is listed, call the insurance company or any local agent of the company.

Fill out the papers and forms as instructed by the agent. The forms are fairly simple. If the policyholder hasn’t already specified a payment plan, they will probably require that the beneficiary determine how payment of the death benefit is to be made.

Get a copy of the death certificate.

Submit the claim form with the death certificate.

Payment should be issued within a week or two.