edward j. metzendepartment of consumption and family economy
We all must face the inevitability of death and the financial difficulties that others may face when we die. Buying life insurance is one way to ease the burden of that financial risk. We can protect surviving family members by paying a relatively small amount, called a premium, to an insurance company. then the insurance company will pay a relatively large sum of money to the beneficiaries of the policy when the insured person dies.
In other words, the risk of a large financial loss that may result from the death of a person can be transferred to the insuring organization – the insurance company. Life insurance is a means of providing an instant estate for survivors of the death of an insured person. Although the basic concept of insurance is quite simple, many of the details of life insurance can seem complex.
Reading: What is the primary purpose of life insurance
protection with life insurance
Because families depend on cash for day-to-day survival, there is a real need for protection against financial disaster if the source of cash is eliminated. Life insurance is a way to provide security if some or all of a family’s income is interrupted due to death. may also provide funds to replace services provided by a family member, for example, child care.
protection and savings?
The main objective of life insurance is protection: instant wealth to meet the needs of the survivor. Some policies include a savings feature, but there are many other ways to save money and make investments. When shopping for life insurance, your primary concern should be providing adequate protection; the potential savings feature is a secondary consideration.
Even when protection needs have been met, it is good practice to consider other forms of savings and investment plans for a family. Whether to save or invest through life insurance or other means of saving or investing is a family choice, based on needs, preferences, and ability to manage finances. it is a savings/investment decision, not an insurance decision.
You can get a better return on your money through other savings or investment vehicles. In addition, a variety of savings and investment opportunities are available that do not require paying any commission, or require a lower commission than saving through life insurance.
earnings in the savings or investment element of life insurance are tax-deferred; but there are a variety of other savings/investment vehicles that also offer tax deferral on earnings. however, earnings on a life insurance policy that are part of the proceeds paid to a beneficiary after the insured’s death are not subject to income tax at all.
Families should consider total financial needs and other available resources when determining their need for life insurance. needs depend on:
- the number and ages of dependents (spouse, children, parents, etc.);
- desired standard of living for dependents if income earner dies;
- the amount of other economic resources a family has (social security, savings, investments, earning capacity of dependents, etc.).
- daily living expenses of surviving dependents (food, clothing, etc.).
- debt payments (a mortgaged home or farm debt, car loan, etc.).
- special needs (securing a loan, insuring children’s educational expenses, gifts to family, friends or organizations).
- retirement income for the surviving spouse and perhaps other dependents.
- When shopping for life insurance, a family should develop a plan and select policies that fit their particular financial needs. they must use life insurance to meet financial needs that are not otherwise met.
- This plan must fit the family’s ability to pay for the insurance, because premiums must be paid to keep the insurance in force.
- A family should select the premium period that provides the lowest rate (usually annual). this requires planning and should be included as an item in the monthly budget.
- Families should read each policy carefully. Policy owners must ensure that they are making the best use of their insurance money for the financial security of the insured person’s survivors.
- The family insurance program should be reviewed periodically and revised to meet changing needs.
- beneficiarythe person named in the policy to receive the insurance proceeds upon the death of the insured.
- cash surrender valuethe amount of money to be paid to a policyholder who purchased insurance with a savings element, when he or she fails to pay premiums before the due date of the insurance policy. policy.
- face valuethe amount indicated on the title page of the policy that will be paid in the event of the death of the insured or upon expiration of the contract. dividend additions or additional amounts payable in the event of accidental death or other special provisions are above face value.
- insuredthe person on whose life an insurance policy is issued.
- life insurancea shared risk plan to cover financial loss and other financial needs experienced by dependents following the death of an individual.
- limited payment life insurancewhole life insurance in which premiums are payable for a specified number of years or until death if death occurs before the end of the specified period.
- policythe printed document that establishes the terms of the insurance contract issued to the policyholder by the company.
- policy loana loan made by an insurance company to a policyholder on the security of the policy’s cash value.
- premiumthe payment, or a periodic payment, that an insured makes for an insurance policy.
- normal life insurancewhole life insurance in which premiums are payable during the life of the insured, at whose death face value is paid to dependents.
- term insuranceinsurance payable to a beneficiary upon the death of the insured while the policy is in force.
- lang, terry r. and you take h. Gillespie, Personal Finance Strategy, Third Edition, McGraw Hill, Inc., New York, 1984.
considerations when buying
Financial needs of surviving family members may include:
principles to buy
basic policiespure protection (term) and cash valueterm insurance
term insurance is a type of life insurance that provides only pure protection. insures an individual against the risk of financial loss in the event of death. does not include savings plan; it is strictly an insurance protection contract, similar to car, home or health insurance. the owner purchases a certain amount of coverage and pays an annual premium based on the insured’s age. As its name indicates, this policy covers the insured for a certain term or period of time. at the end of the term, coverage ceases, unless the policy is renewed. The simplest form of life insurance protection is annually renewable term insurance. The owner of a term life insurance policy can continue protection for additional terms, but as you age, the premium per unit ($1,000) of coverage will increase for each new term.
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Some term policies are for five, ten or twenty years. the annual premium remains the same during the term. It is also possible to purchase a term policy that covers the insured for the same annual premium from the time of purchase until age 65. the actual cost of protection increases each year, but this cost is averaged to provide a level premium over the term of the policy. this is known as level premium term insurance.
Another form of term insurance is decreasing term. in this way, the amount of protection decreases as the insured gets older, so the annual premium can be kept level.
Because term insurance provides pure protection, it provides the most coverage for the dollar spent on premium.
cash value insurance
Cash value life insurance policies consist of two elements: a decreasing amount of actual insurance protection over time, combined with a savings component that increases over time, which is funded by payments of premiums and earnings from the savings element of the policy (figures 1 and 2).
There are two basic types of cash value life insurance policies. they are designed to provide coverage throughout life (whole life policies): normal life and limited payment.
Figure 1Straight life policy.
Figure 2Limited payment policy.
whole life insurance
This policy provides a certain amount of coverage throughout life. combines a decreasing amount of protection with an increasing amount of savings. but the total coverage provided by the policy (the face value of the policy), including the protection and savings elements, remains the same.
Because the homeowner is building savings and purchasing protection through this plan, the premium is higher than the term insurance premium. As with all life insurance policies, the premium is based on the age of the insured when the policy is purchased. the normal life insurance premium remains the same for the life of the policy. This is because the policyholder is paying more than the cost of pure protection during the early years of the policy. the excess portion of the premiums, above the cost of pure protection, is what builds the savings element of the policy. Because the protection element decreases over time as the savings element increases, the premium level remains adequate to cover the cost of the policy as the insured ages.
The face value is the amount payable at the death of the insured. includes both the protection and the savings value of the policy, if any. the cash surrender value is the amount of savings that has been accumulated within the policy. this amount increases during the term of the policy. the insured may redeem the policy for its cash value at any time, but this terminates the policy. Or, the insured can borrow the cash value from the company; however, this reduces the total coverage until the policy loan is paid off. interest is charged on the loan until it is paid off.
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If the insured continues to pay the premium until age 100, he or she has made enough premium payments to build up the cash value to equal the face value at that time. therefore, as of that date, the policy consists entirely of the savings element and no actual insurance protection component remains. Just like with a savings account at a bank or elsewhere, the insured can then collect the face value of the policy while he or she is alive, because the entire value of the policy now consists of his or her savings element.
limited payment life insurance
This policy is similar to a regular life policy, except that the policyholder pays the full policy premiums over a limited number of years, typically 20 to 30 years, or age 65. after that, the policy remains in force for the life of the insured unless the cash value is withdrawn, at which time coverage ceases.
The premium for limited payment life insurance is higher than for a regular life policy because you pay all the premiums for the policy over a set number of years. This means that the policyholder is actually accumulating savings (cash value) within the policy at a considerably faster rate than would be the case with the normal life insurance policy, and therefore reduces the element of protection in the policy faster.
This policy has limited use except for families who have very high incomes in their early years (for example, a professional athlete whose income may decline in later years). The typical family has more stress on their budget in the early years and, due to higher premiums, may find it impossible to afford sufficient coverage with limited-pay life insurance. and having enough protection to meet certain needs in the event of the insured’s death is the most important consideration in purchasing life insurance.
The price per $1,000 of real life insurance protection increases as the insured ages, in both a cash value type policy and a term policy. In a cash value policy, the rising cost of protection is not obvious, because as the savings component created by the higher premium increases, the amount of the actual protection component of insurance decreases.
Cash value policies are often marketed as a form of tax-protected savings. While this is a consideration, the benefits of the tax haven are often overstated. The shelter of a cash value policy is that the interest earned on the cash value (savings portion) is tax-deferred while the policy is in force. If the policy is surrendered for cash value, income tax is paid only on the portion of the cash value that exceeds the total premiums paid on that policy. and, as noted above, if the face value of the policy is paid to a beneficiary upon the insured’s death, the earnings from the savings item are not taxed at all.
tax treatment, however, is a minor factor to consider when determining the type of insurance to purchase. it is a much less important consideration than the protection provided by the policy (the instant estate created at the death of the insured).
policy selection considerations
Cash value life insurance is often promoted as a way to save because premium payments include a savings element. however, there are several factors and perils that must be considered when considering cash value policies. First and foremost, families sometimes purchase higher premium policies with a savings element and provide inadequate protection to meet their needs. therefore, if the insured dies, he has spent his premium money on very little protection and her financial needs are not adequately covered. A second factor is that when families commit to high-premium policies, if they face increased living expenses or a financial emergency, the insurance premiums can put too much pressure on their income and they cancel the policy, thus leaving them without life insurance. In this case, not only are they left without protection, but they have an additional loss due to the higher commissions they pay for acquiring this type of policy. Finally, if the family is considering a cash value life insurance policy as a means of savings, it should compare the rate of return earned on the savings element, the fee to purchase the policy, and other factors, with alternative avenues for saving. and invest.
It is important to note that there are a variety of ways to save, but the protection feature of life insurance is the only way to create an instant estate upon the insured’s death. If a 25-year-old man saves $150 one day and dies the next, that $150 will be part of his estate. But if he’s in good health, for that $150 he can buy a one-year renewable term life insurance policy that will provide about $100,000 to his beneficiaries or estate if he dies the next day. this illustrates the concept of instant wealth and the difference between a savings plan, where the principal is yours whether you live or die, and an insurance protection plan, where you’re paying a modestly sized premium for provide a large amount of protection dollars that will be paid only in the event of your death. the concept of protection is similar to the insurance you buy for a defined period of time to cover your home or car.
Life insurance provides financial protection for the insured’s survivors and can also meet other financial goals (a donation to charity, for example). Families should review their life insurance program and policies regularly and make adjustments to accommodate changing circumstances and needs.
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