If you are considering including estate planning in your financial plans, it is pretty much imperative that you look into life insurance. As the main purpose of life insurance is the protection of your family after you pass away, it is an obvious tool recommended by attorneys, financial planners, life insurance agents, financial reporters and even bloggers whether or not they have any financial incentive to recommend it.
Why? Because in the majority of cases, your family will receive more than is paid in, they will get it quickly and without any immediate tax burden. It is a flexible tool that can be bought in many different forms, and is also not limited to the wealthy.
However, it can be a pretty complex topic, and without your full attention, you can get involved with an expensive policy that could behave very differently than you intended. So let’s try to look at life insurance a bit differently to help you avoid that possibility.
Here are the key terms you need to know:
- Premium – the amount paid to the life insurance provider
- Duration – the length of time the life insurance policy is in force
- Face amount – the lump sum of money (or “death benefit”) paid to the beneficiary if death occurs while the insured person is still covered.
A life insurance policy is a contract between the person covered, the provider and the eventual beneficiary. Premiums are paid for the duration of the policy, and in exchange, the provider will pay the face amount to the named beneficiary if the insured dies while still being covered.
All life insurance is some variation on this theme.
There is also the ability to use life insurance as an investment (which is commonly known as “cash value”). To properly discuss this option, let’s first discuss the notion of “pure insurance”.
Pure Insurance Portion
For literally thousands of years now, people have developed mortality tables. These fun instruments keep track of how many deaths occur each year per age group, disease, location, etc. The Center for Disease Control annually publishes their mortality tables – the 2007 version can be found here.
Interestingly, pretty much all insurance providers base their rates from the same mortality data. The variance in charges between providers comes from their own histories, experience and the kind of clientele they seek.
Every insurance policy starts with a “pure insurance” element that is based on the insured’s age group, health, residence, etc. Those purchasing “term insurance” are purchasing only this element.
On the other hand, “permanent insurance” policies have an additional investment, or “cash value”, component. Technically, cash value refers to the amount of money you would receive if you decided to stop paying for the policy while you are alive. In most cases, if the policy is still active when you die, your beneficiary is paid the face value – any cash value remains with the insurance provider.
So where does the cash value come from? Remember from above that all insurance policies have a pure insurance element. Any premiums paid in excess of the pure insurance amount constitutes the cash value, or savings, you have built up in the policy.
As you get older, your pure insurance amount will begin to increase (since mortality rates are higher as you get older), even to the point where it exceeds your premium payment. However, this is all right because the cash value is then used to cover this difference. The policy is calculated so that the cash value and the face value are equal when the permanent policy expires.
Depending on the type of life insurance you purchase, the cash value can be invested conservatively or more aggressively. Any unanticipated growth in your cash value from positive investing can be used to purchase a higher face value, to directly pay premiums, or can be borrowed from the provider.
Let’s say Mr. Shepherd is a healthy 35 year-old with a pure insurance value of $1 per year for every $1,000 of face value. Provider A will charge him $10 per $1,000 for every year that he owns it. After the first year, after Mr. Shepherd pays the $10, he will have $9 of cash value in the policy. In the second year, Mr. Shepherd’s pure insurance value may rise to $1.05 per year per $1,000. After he pays the $10, he will then have $17.95 ($9 plus $8.95) of cash value plus any earnings or dividends on it.
Since Mr. Shepherd’s pure insurance rates rise relatively slowly each year, he can build cash value of hundreds of dollars per $1,000 before the years when his pure insurance rate begins to exceed his $10 per $1,000 premium per year.
The different categories of life insurance are simply variations on the amount and timing of premium payments, durations of coverage, face amounts, and the use and investment of cash value.
In a follow up post, we’ll investigate these differences.
- An Introduction to Life Insurance (www.getrichslowly.org)
- Life Insurance (en.wikipedia.org)
- Gene Simmons Enters the Life Insurance Business (lawprofessors.typepad.com)