Using Insurance Products As An Investment
An Overview of Life Insurance
With more than $9 trillion of insurance in force,
life insurance is one of the largest industries in the
United States. While each household in America carries
an average of $100,000 in life insurance, many people
have difficulty understanding what life insurance is
and how it works.
Life insurance provides financial security.
Whether providing for replacement income due to the
death of a breadwinner, meeting financial emergencies,
sending a child to college, supplementing retirement
income or paying for final expenses, people want the
ability to pay for needs that may -- or will -- arise
in the future.
Term versus permanent
There are two basic types of life insurance
products: term and permanent insurance.
Term insurance is purchased for a specific period
of time and provides benefits only if the insured
person dies during the period covered by the policy.
If the policy is purchased for one year, for example,
and the insured is alive at the end of the year, no
benefit is paid. After the term expires, the person
who purchased the policy may have the option of
renewing coverage, but it will be necessary to pay a
higher premium. As the insured grows older, premiums
will usually increase as the probability of death
increases.
There are several types of permanent insurance,
the most popular of which are universal life and
traditional whole life. Universal life, a relatively
new product, allows the policyholder a flexible premium
payment schedule and the option to change the death
benefit from time to time subject to certain
restrictions. The product also allows the insurance
company flexibility in adjusting rates at which
interest is credited to the policy values. However,
the mainstay of the industry remains traditional whole
life insurance.
Traditional whole life offers insurance protection
for the insured person's entire life at a fixed premium
payment schedule. If a person buys a $50,000 policy,
for example, that $50,000, called the "face value" of
the policy, is the amount that generally will be paid
out whenever the insured dies. As long as the
policyholder pays the required premiums, the policy
remains in effect.
Permanent life insurance also allows policyholders
to receive financial benefits while they're alive
because their insurance builds up a sum of money called
the "cash value." In fact, more life insurance
benefits are paid to people who are living than to
their beneficiaries.
Cash value and how it works
Cash value is the amount of money policyholders
would receive as a refund if they cancel their coverage
and surrender their policies to the company. The cash
value (also called the cash surrender value) continues
to grow as long as the policyholders pay the premiums.
A policy's cash value is generally a result of the
payment of "level premiums" throughout the payment
period of the policy. Since mortality rates increase
as people grow older, the actual cost of insurance also
increases. If premiums were changed to match the cost
of insurance each year, the result would be
progressively higher premiums as people grew older. To
avoid this dilemma, premiums are "leveled" which
results in premiums being collected in the early years
of a policy that are higher than necessary to pay
current benefits.
The "excess" premium paid in the early years of
the policy is held in a reserve which, together with
accumulated interest and the payment of future level
premiums, assures that sufficient funds will be
accumulated to cover the increasing risk of death as
the insured grows older.
The policyholders are entitled to their portion of
this reserve if they should decide to cancel their
insurance protection by surrendering the policy. This
portion of their reserve is the cash value at any given
time.
Policyholders often borrow from the cash value of
their life insurance policies. During the Great
Depression of the 1930s, for example, many people used
the cash value of their policies to buy food, pay taxes
and keep their farm or home from foreclosure. Today,
people can use their cash value to pay tuition, make a
major purchase, or provide for an unexpected emergency.
Whatever the reason for borrowing from the cash
value of their policies, people should use caution. As
long as the loan is repaid, the value of the policy
rebuilds. But if the insured should die before the
loan is repaid in full, the outstanding loan amount is
subtracted from the death benefit, if a person has a
policy with a death benefit of $50,000, for example,
and the policyholder dies with a $5,000 outstanding
loan balance, the actual death benefit would be
$45,000.
Group life insurance
One of the most widely known types of insurance is
group life insurance, which is really term life that is
purchased for a number or "group" of people. Group
life insurance makes up approximately 40 percent of all
life insurance now in force in the United States and is
usually offered as part of a company's or an
organization's benefit plan.
In a group policy, a number of people are insured
under a single contract, called a "master contract."
This contract is actually an agreement between the
insurance company and the group policyholder which is
either the employer or the sponsoring organization. In
most group policies, the group policyholder selects the
amount of coverage each member is to receive or can
elect to purchase.
Each insured member of the group selects his or
her own beneficiary. If an insured member leaves the
group, that person can, within a limited period of
time, convert his or her group policy to individual
coverage without presenting evidence of insurability.
Agents add value
Whether it's individual term or permanent
insurance, group insurance, or a combination, a
knowledgeable insurance agent is the best resource for
selecting the right policy. Since the mid 1800s, life
insurance agents have been helping people choose the
best plans to meet their needs.
The agent starts with a good understanding of each
customer's future objectives or "needs." After
reviewing the person's financial circumstances, such as
social security benefits, group life insurance
programs, investment plans and savings accounts, the
agent can help determine an insurance program to assist
in achieving the financial objectives for the customer
and his or her family.
Life insurance companies manage risks
To provide financial security, a life insurance
company must successfully manage risks.
The company must predict as accurately as possible
the mortality risks faced by an individual or group, so
it can determine when it will need to pay benefits and
how much those benefits will be. Then, to assure that
the funds will be available to pay all benefits, the
company must control its financial risks by safely
investing the premiums it receives and controlling its
costs.
The rate of mortality is the rate at which insured
people are expected to die. Expected mortality is
based upon a company's own experience as well as data
from published mortality tables which contain
statistics on the average lifespan of millions of
people. This information, together with other
variables such as health history, enable insurance
actuaries to predict the risk of insuring any person of
a given age and thus determine the premium, called the
"risk premium," required to assume that risk. An older
person, for example, or someone who smokes, is assumed
to be at a higher risk than a younger person or a
nonsmoker of the same age. This prediction has nothing
to do with the actual life span of any specific
individual, but does provide a fairly accurate estimate
of when someone of similar age and circumstance might
die.
The determination of total premiums paid by the
policyholder also includes provisions for operating
costs, including commissions and underwriting expenses,
profit and the investment income that insurance
companies earn from the investment of reserves.
Insurance companies invest the reserves according to
state insurance laws and regulations. These
investments may include qualified municipal, state and
federal obligations, corporate bonds, real estate, and
mortgages.
Insurance companies must always look ahead,
carefully monitoring mortality rates, investing wisely
and controlling expenses to gain the resources they
need to pay benefits to policyholders or their
beneficiaries and to earn a profit. In return for
their premiums, policyholders are assured the ability
to provide for tomorrow's needs. Instead of risk, they
find security, and brighter prospects for themselves
and their families.
Whole Life Policies
Whole Life Insurance is sometimes called
"permanent insurance" or "ordinary life" and is
designed to stay in force throughout one's lifetime.
Generally, the annual premiums (payments) for this
type of policy remain the same throughout the life of
the insured. The premiums are higher in the early
years when compared to a straight term life policy.
However, due to the buildup of the cash values during
those early years, whole life policies tend to remain
in force when the premiums for the term life policies
have become prohibitively high.
If the owner of the policy decides to stop paying
the premiums, he or she can terminate the policy and
take the built up cash values or purchase a paid-up
policy (with a reduced face amount), or purchase a term
policy of the same face amount, but for a set number of
years. The number of years would depend on the
insured's age and amount of the cash values available
at the time.
Historically, whole life insurance has provided
several remarkable tax benefits:
- There is a tax-free build up of the cash
values attributable to favorable investment experience
of the insurance company.
- The owner can borrow against the cash values
at relatively low interest rates and without a tax.
- At time of death, the beneficiary collects the
proceeds free of income tax.
- By transferring ownership of the policy to
another, the proceeds can also escape Federal Estate
Taxes.
Although tax reformers have periodically tried to
eliminate or reduce these benefits, for most whole life
contracts, they have been unable to do so.
This type of policy is very well suited for an
insurance need which does not diminish with the years,
such as the payment of the costs of Federal Estate
Taxes, probate and other administration expenses.
Universal Life Insurance
Universal Life Insurance contracts differ from
traditional Whole Life policies by separating the
"protection element," the "expense element" and the
"cash value element. The separation of these three
elements enables the insurance company to build a
higher degree of flexibility into the contract. The
owner can change the face amount or the premium, within
certain guidelines, to adjust to changes in his or her
situation.
A monthly charge for the "protection element" as
well as the "expense element" are deducted from the
account balance, allowing the balance of the premium to
be invested in the "cash value element."
Therefore, unlike traditional Whole Life policies,
complete disclosure of the internal charges against the
"cash value element" of the policy are provided to the
policyholder in the form of an annual report.
Major Benefits:
- Policyholder has a versatile and flexible tool
to accommodate ever changing business, financial and
family circumstances.
- Low term rates and a competitive yield on the
"cash value element" combined with tax benefits
reinforced by recent tax reform in many instances make
the Universal Life contract a viable alternative to
more conventional investment vehicles.
- Future premiums, based on interest rates and
past premiums, may be increased, decreased, or even
skipped, without causing the policy to lapse.
- Unlike alternative investment vehicles, the
cash value can be accessed through no-penalty,
non-taxed loans, withdrawals or partial surrenders.
Funds that have been borrowed against continue to
accrue interest, however, usually at a lower rate. The
rate charged on these borrowed funds is usually far
less than the market rate.
- The "cash value element" accumulates on a
tax-free basis, making it a valuable alternative for
college funding or as a retirement supplement.
- Withdrawals from the "cash value element" can
be TAX-FREE if structured properly.
Tax reform has left life insurance in an enviable
position. Tax-free accumulation and a potential
tax-free payout make life insurance a very strong
financial tool, and Universal Life provides the owner
with more flexibility and higher yields than
traditional Whole Life policies.
Variable Life Insurance
Variable Life Insurance is similar to Whole Life
in that premium payments are level and there is a
minimum guaranteed death benefit. Expense charges are
deducted from each premium and mortality charges are
deducted monthly. The policyholder selects one or more
"accounts" or "funds" to deposit the account balance
into. These can be money market funds, mutual funds,
bond funds, and others.
The death benefit and cash value of a Variable
Life policy increase and decrease based on the
performance of the funds chosen. The death benefit
however, will not drop below the initial guaranteed
amount.
Major Benefits:
- Creative approach to protecting one's family or
business, allowing the policyholder the selection of
the investment vehicle(s).
- Policyholder has the advantage of professional
management as well as investment diversification which
can reduce the overall risk.
- Policyholder receives an annual report
disclosing all fees, charges and credits to the
account.
- Cash values may be reallocated to other funds
up to five times annually, with a minimum of 10% in any
one fund. This provides a greater degree of control
over the end result to the policyholder than with Whole
Life or Universal Life.
- Some Variable Life contracts provide an
exchange option during the first 12-24 months to a
fixed contract (Whole Life/Universal Life).
- Cash value can be accessed through no-penalty,
non-taxed loans, withdrawals, or partial surrenders.
These loans are generally available at rates far below
the market rate.
- Withdrawals from the cash account can be
TAX-FREE if structured properly.
Tax reform has left life insurance in an enviable
position. Tax-Free accumulation and potential tax-free
income make life insurance a very strong financial
tool, and Variable Life provides the owner with
complete discretion over investment diversification, a
feature not available with Whole Life or Universal Life
contracts.
Variable Universal Life Insurance
This type of policy contains a combination of
features found in "variable life" and in "universal
life" policies.
As with universal life contracts, the owner of the
policy can, within certain limits, change the face
amount and the amount and timing of premiums paid to
meet his or her situation.
The prominent feature from the variable life
contract is the ability for the policy owner to
determine where the funds will be invested. Typically,
he or she can choose among a number of accounts, like:
Growth stock accounts
Bond accounts
Balanced accounts
Real estate accounts
Money market accounts, etc.
The ultimate value of the account, at either death
or retirement, will depend on the type of investments
chosen, the general market conditions and the abilities
of the money managers.
Once the costs are met for insurance protection
and a portion of company expenses, the balance of the
premiums go directly into the selected investment
options where they comdollar on a tax-deferred basis.
As with other permanent life insurance contracts,
the owner can borrow against the cash values of the
policy. The interest rate is generally more favorable
than from a regular lending institution and need for a
credit check is not a requirement. The future death
benefit will, of course, be reduced by the amount of
the loan unless it is repaid.
The Securities and Exchange Commission requires
this type of policy to be accompanied by a prospectus.
Modified Endowment Contracts
Life insurance policies issued after June 21, 1988
may be defined as modified endowment contracts (MEC),
if the cumulative premiums paid during the first seven
years at any time exceed the total of the "net level
premiums" for the same period.
For example, assume that the net level premium for
a policy is $1,000 per year and the following payments
are made by two different policy owners:
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º º (CAN'T EXCEED)º POLICY OWNER "A" º POLICY OWNER "B" º
º º CUMULATIVE NETº ANNUAL ³CUMULATIVE º ANNUAL ³CUMULATIVE º
º YEARº LEVEL PREMIUMSº PREMIUM ³ PREMIUMS º PREMIUM ³ PREMIUMS º
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º 1 º $1,000 º $1,000 ³ $1,000 º $1,000 ³ $1,000 º
º 2 º 2,000 º 500 ³ 1,500 º 1,000 ³ 2,000 º
º 3 º 3,000 º 1,000 ³ 2,500 º 1,000 ³ 3,000 º
º 4 º 4,000 º 1,500 ³ 4,000 º 1,500 ³ 4,500 º
º 5 º 5,000 º 1,000 ³ 5,000 º 500 ³ 5,000 º
º 6 º 6,000 º 1,000 ³ 6,000 º 1,000 ³ 6,000 º
º 7 º 7,000 º 1,000 ³ 7,000 º 1,000 ³ 7,000 º
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NOTES: In the POLICY OWNER "A" example above, even though the
premium paid during the fourth year exceeds the annual net level
premium of $1,000, the cumulative premiums do not exceed four
times (for the four years) the net level premium, and, therefore,
this is not a Modified Endowment Contract.
In the POLICY OWNER "B" example above, however, the premiums
paid in the fourth year cause the cumulative premiums paid to
exceed the cumulative net level premiums allowed and thus cause
this contract to become a Modified Endowment Contract.
Taxation of modified endowment contracts:
Withdrawals from "modified endowment contracts" (including
loans) will be taxed as current income until all of the policy
earnings have been taxed. There is also a 10% penalty tax if the
owner is under age 59 1/2, unless payments are due to disability
or are annuity type payments.
Well-designed premium payment schedules can avoid the
"modified endowment contract" treatment and retain the benefits,
which are unique to the life insurance contract.
How To Buy Insurance At The Best Prices
Insurance Price Comparison Service is a specialized
organization focusing on the specific needs of astute consumers
who take an active role in their insurance planning. As a self-
directed consumer, you can save both time and money by taking
advantage of this independent resource.
Whether you are purchasing for the first time, supplementing
existing coverage, or searching for a lower-cost alternative,
they will work with you to find insurance coverage that meets
your particular objectives, avoid buying mistakes, and locate
safe insurance companies.
This service gives its customers instant quotes, proposals
and financial stability ratings from a continually-updated
database of more than 400 leading insurance companies.
Most insurance brokers and agents don't want you to know
about a system like this because they're too busy selling for
just one or two favorite companies. Using the Insurance Price
Comparison Service puts you first. It gives you the most
complete picture of the marketplace whenever you want it, before
you buy or renew an insurance policy.
Without having to spend days calling insurance agents who
are trying to sell you something, you can find out if you are
eligible to receive the lowest rates being offered by America's
leading insurance companies, HMO's and Blue Cross & Blue Shield
plans. The computerized price tracking service keeps track of
thousands of high-quality policies (and their ever-changing
prices) which are offered by America's safest companies.
Nobody likes to buy insurance. It's almost always bought
out of necessity. But you need the best factual information
before you buy, and the price tracking service makes it possible
to keep on top of changing market conditions to an extent never
before possible.
Based upon the coverages that you are looking for, their
computer will electronically scan the marketplace and pinpoint
those policies that meet or exceed your request. The qualifying
companies are then ranked and listed by lowest cost in a
complete, simple report format.
The price comparison report will show insurance company
names, policy names, latest ratings and premiums for all of the
qualifying policies. You'll have complete market knowledge about
available coverages and prices -- without having wasted any time.
You will be equipped to make insurance decisions based upon
market facts.
Price comparisons are available for individual and family
medical insurance, for term insurance for individuals, for long-
term care insurance, for medicare supplement insurance, for group
medical & group dental insurance (especially useful if you have a
small business and need to insure several employees), and for
single premium deferred annuity quotes. Comparisons are not
available for property or automobile insurance, because these are
dependent upon neighborhood pricing and there is no national
calculation of the rates.
How To Buy Life Insurance in One Shot
There are essentially two ways to buy cash value life
insurance. The most common method is to pay premiums over a
period of time. But there's a different route you may decide to
take: you may purchase the same amount of life insurance
protection you are able to receive with level payments by making
a one-time payment.
Not surprisingly, this method is often called "single-
premium life insurance."
There are several reasons why you may consider single-
premium life insurance as an alternative to regular premium
payments.
You receive instant cash value in the policy.
You may be able to acquire the life insurance coverage at
a discount.
Single-premium insurance may be used for sophisticated
estate planning techniques (for example, to maximize wealth for
beneficiaries with a minimum of estate tax erosion).
Of course, single-premium life insurance can also provide
many of the same benefits available to policy holders who make
regular premium payments on a cash value policy. For example:
- The policy guarantees a substantial death benefit for your
family.
- The cash value grows without any current tax erosion.
- There is no income tax when the beneficiaries receive the
life insurance proceeds.
- With certain limitations, you may be able to borrow
against the cash value of the policy.
Of course, single-premium insurance is not for everyone.
Whether or not it makes sense for you may depend upon your
financial objectives (for example, college savings for a child).
In some cases, you may want to invest in a tax-deferred annuity
instead. Be sure to get professional guidance in this area.
Borrowing Against Cash Value Insurance
Zero Net Cost Loans
One of the benefits of life insurance policies which build
cash values is the ability to borrow against these funds.
The loan is actually made from the general funds of the
insurance company with the policy cash values used as collateral
assuring that the loan will be repaid.
Some polices permit the owner of the policy to borrow
against his or her policy at an interest rate which is equal to
the amount which the company is crediting on his or her cash
values.
If a policy is being used as a supplemental retirement plan,
zero net cost loans can make a significant difference in the
amount that can be borrowed from a policy, creating TAX-FREE
INCOME during retirement years.
For example, if at retirement age, a policy has $500,000 of
cash value and that cash would generate a TAX-FREE annual income
of $47,000 the chart below illustrates the effect of increasing
the interest rate charged by the insurance company on the loan.
It can have a dramatic effect on either the percentage of income
lost over the same time period or the number of years the fund
would last were the payments to stay level.
In the above example, increasing from a "Zero Net" to a "1%
Net" cost of borrowing, the effect could be looked at two ways.
Either the $47,000 annual income for 20 years would be reduced by
9% to $42,770 OR... the $47,000 annual income would only last 16
years. The ultimate total cost of this "extra spread" would be
$47,000 X 4 yrs or $188,000.
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º INTEREST ³ INTEREST ³ PERCENT LOST ³ YEARS OF LEVEL º
º CREDITED ON ³ CHARGED ON ³ AS LOAN RATE ³ INCOME AT VARIOUS º
º LOANED FUNDS ³ LOANED FUNDS ³ INCREASES ³ NET INTEREST RATES º
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º 4.0% ³ 4.0% ³ 0.0% ³ 20 º
º 4.0% ³ 4.5% ³ 5.5% ³ 18 º
º 4.0% ³ 5.0% ³ 9.0% ³ 16 º
º 4.0% ³ 5.5% ³ 13.3% ³ 15 º
º 4.0% ³ 6.0% ³ 17.4% ³ 14 º
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NOTE: Interest rates vary from one insurance company to another
and consideration should be given to these factors.
Low Interest Loans
Some polices permit the owner of the policy to borrow
against his or her policy at an interest rate which is only
slightly higher than the amount which the company is crediting on
his or her cash values.
If a policy is being used as a supplemental retirement plan,
low net cost loans can make a significant difference in the
amount that can be borrowed from a policy, creating TAX-FREE
INCOME during retirement years.
For example, if at retirement age, a policy has $500,000 of
cash value and that cash would generate a TAX-FREE annual income
of $44,000, the chart below illustrates the effect of increasing
the interest rate charged by the insurance company on the loan.
It can have a dramatic effect on either the percentage of income
lost over the same time period or the number of years the fund
would last were the payments to stay level.
In the above example, increasing from a ".5% Net" to a "1.5%
Net" cost of borrowing, the effect could be looked at two ways.
Either the $44,000 annual income for 20 years would be reduced by
9% to $40,040 OR... the $44,000 annual income would only last 16
years. The ultimate total cost of this "extra spread" would be
$44,000 X 4 yrs or $176,000.
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º INTEREST ³ INTEREST ³ PERCENT LOST ³ YEARS OF LEVEL º
º CREDITED ON ³ CHARGED ON ³ AS LOAN RATE ³ INCOME AT VARIOUS º
º LOANED FUNDS ³ LOANED FUNDS ³ INCREASES ³ NET INTEREST RATES º
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º 4.0% ³ 4.5% ³ 5.5% ³ 18 º
º 4.0% ³ 5.0% ³ 9.0% ³ 16 º
º 4.0% ³ 5.5% ³ 13.3% ³ 15 º
º 4.0% ³ 6.0% ³ 17.4% ³ 14 º
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NOTE: Interest rates vary from one insurance company to another
and consideration should be given to these factors.
