Life insurance (or commonly life assurance, especially in the Commonwealth) is a contract between an insured (insurance policy holder) and an insurer or assurer, where the insurer promises to pay a designated beneficiary a sum of money (the “benefits”) in exchange for a premium, upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger payment. The policy holder typically pays a premium, either regularly or as a lump sum. Other expenses (such as funeral expenses) are also sometimes included in the benefits.
Life policies are legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; common examples are claims relating to suicide, fraud, war, riot, and civil commotion.
Life-based contracts tend to fall into two major categories:
- Protection policies – designed to provide a benefit in the event of specified event, typically a lump sum payment. A common form of this design is term insurance.
- Investment policies – where the main objective is to facilitate the growth of capital by regular or single premiums. Common forms (in the US) are whole life, universal life, and variable life policies.
Permanent life insurance
- Permanent life insurance is life insurance that remains active until the policy matures, unless the owner fails to pay the premium when due. The policy cannot be cancelled by the insurer for any reason except fraudulent application, and any such cancellation must occur within a period of time (usually two years) defined by law. A permanent insurance policy accumulates a cash value, reducing the risk to which the insurance company is exposed, and thus the insurance expense over time. This means that a policy with a million dollar face value can be relatively expensive to a 70-year-old. The owner can access the money in the cash value by withdrawing money, borrowing the cash value, or surrendering the policy and receiving the surrender value.
- The four basic types of permanent insurance are whole life, universal life, limited pay, and endowment.
Whole life coverage
- Whole life insurance provides lifetime death benefit coverage for a level premium in most cases. Premiums are much higher than term insurance at younger ages, but as term insurance premiums rise with age at each renewal, the cumulative value of all premiums paid across a lifetime are roughly equal if policies are maintained until average life expectancy. Part of the insurance contract stipulates that the policyholder is entitled to a cash value reserve, which is part of the policy and guaranteed by the company. This cash value can be accessed at any time through policy loans and are received income tax free. Policy loans are available until the insured’s death. If there are any unpaid loans upon death, the insurer subtracts the loan amount from the death benefit and pays the remainder to the beneficiary named in the policy.
- While the marketing divisions of some life insurance companies often explain whole life as a “death benefit with a savings component”, this distinction is artificial according to life insurance actuaries Albert E. Easton and Timothy F. Harris. The net amount at risk is the amount the insurer must pay to the beneficiary should the insured die before the policy has accumulated an amount equal to the death benefit. It is the difference between the current cash value amount and the total death benefit amount. Because of this relationship between the cash value and death benefit, it may be more accurate to describe the policy as a single, indivisible product, as no actual separation of the cash value and death benefit is possible.
- The advantages of whole life insurance are guaranteed death benefits, guaranteed cash values, fixed, predictable annual premiums, and mortality and expense charges that will not reduce the cash value of the policy. The disadvantages of whole life are inflexibility of premiums and the fact that the internal rate of return in the policy may not be competitive with other savings alternatives. The death benefit can also be increased through the use of policy dividends, though these dividends cannot be guaranteed and may be higher or lower than historical rates over time. According to internal documents from some life insurance companies, the internal rate of return and dividend payment realized by the policyholder is often a function of when the policyholder buys the policy and how long that policy remains in force. Dividends paid on a whole life policy can be utilized in many ways.
- The life insurance manual defines policy dividends as a refund of overpayment of premiums. It is not the same as stock dividends.
Universal life coverage
- Universal life insurance (UL) is a relatively new insurance product, intended to combine permanent insurance coverage with greater flexibility in premium payment, along with the potential for greater growth of cash values. There are several types of universal life insurance policies which include interest sensitive (also known as “traditional fixed universal life insurance”), variable universal life (VUL), guaranteed death benefit, and equity indexed universal life insurance.
- A universal life insurance policy includes a cash value. Premiums increase the cash values, but the cost of insurance (along with any other charges assessed by the insurance company) reduces cash values.
- Universal life insurance addresses the perceived disadvantages of whole life – namely that premiums and death benefit are fixed. With universal life, both the premiums and death benefit are flexible. Except with regards to guaranteed death benefit universal life, this flexibility comes with the disadvantage of reduced guarantees.
- Flexible death benefit means the policy owner can choose to decrease the death benefit. The death benefit could also be increased by the policy owner, but that would typically require the insured to go through a new underwriting. Another feature of flexible death benefit is the ability to choose from option A or option B death benefits, and to change those options during the life of the insured. Option A is often referred to as a level death benefit. Generally speaking, the death benefit will remain level for the life of the insured and premiums are expected to be lower than policies with an Option B death benefit. Option B pays the face amount plus the cash value. If cash values grow over time, so would the death benefit which is payable to the insured’s beneficiaries. If cash values decline, the death benefit would also decline. Presumably, option B death benefit policies would require higher premiums than option A policies.
- Another type of permanent insurance is Limited-pay life insurance, in which all the premiums are paid over a specified period after which no additional premiums are due to the policy in force. Common limited pay periods include 10-year, 20-year, and are paid out at the age of 65
- Endowments are policies in which the cumulative cash value of the policy equals the death benefit at a certain age. The age at which this condition is reached is known as the endowment age. Endowments are considerably more expensive (in terms of annual premiums) than either whole life or universal life because the premium paying period is shortened and the endowment date is earlier.
- In the United States, the Technical Corrections Act of 1988 tightened the rules on tax shelters (creating modified endowments). These follow tax rules in the same manner as annuities and IRAs.
- Endowment insurance is paid out whether the insured lives or dies, after a specific period (e.g. 15 years) or a specific age (e.g. 65).
- Accidental death is a limited life insurance designed to cover the insured should they die due to an accident. Accidents include anything from an injury and upwards, but do not typically cover deaths resulting from health problems or suicide. Because they only cover accidents, these policies are much less expensive than other life insurance policies.
- It is also very commonly offered as accidental death and dismemberment insurance (AD&D) policy. In an AD&D policy, benefits are available not only for accidental death, but also for the loss of limbs or bodily functions, such as sight and hearing.
- Accidental death and AD&D policies very rarely pay a benefit, either because the cause of death is not covered by the policy, or the coverage is not maintained after the accident until death occurs. To be aware of what coverage they have, an insured should always review their policy for what it covers and what it excludes. Often, it does not cover an insured who puts themselves at risk in activities such as parachuting, flying, professional sports, or involvement in a war (military or not).
- Accidental death benefits can also be added to a standard life insurance policy as a rider. If this rider is purchased, the policy will generally pay double the face amount if the insured dies due to an accident. This used to be commonly referred to as a double indemnity policy. In some cases, insurers may even offer triple indemnity cover.