What Is It and How Is It Useful?

Planning for the financial consequences of a premature death is an essential part of every financial plan. Generally, the consequences are simply too large to ignore and cannot be totally covered with your own resources.

Life insurance protects your family against the risk of the premature death of you (or your spouse). Life insurance planning should consider your family's short term needs (for example, your funeral or medical expenses) and long-term needs (for example, replacing your income).

How Do You Assess Your Needs?

Premature Death

What are the financial stakes?  Can you afford to take the risk?

These needs will vary over time as your personal goals, needs and resources change.

The starting point for an effective life insurance plan is to identify whether a risk exists and to define the financial impact of a premature death as a specific dollar cost. Several methods are used to quantify this amount.

Rule of Thumb. This method calculates your need for life insurance as a multiple of your annual salary or earnings. Clearly, this method is very simple; however, it may not allow you to address all of your individual financial goals. In addition, different advisors suggest different multiples. This makes the calculation of a precise amount difficult.

Income Replacement.  This method focuses on the replacement of some percentage of salary or earnings for a specified period of time. The value of the income replacement can be calculated and compared to the assets you currently have. Any difference between needs and resources can be funded with life insurance. 

While this method is not difficult to calculate, it may not adequately fund all of your financial goals if your present income does not fully fund these goals. Do you know the value of your income replacement need?

This table shows the amount of capital or insurance proceeds required to replace a given amount of income at a given age:

Financial Needs.  This method focuses on the expected financial needs of the survivors, including:

• Family income needs.
• Emergency funds.
• Estate settlement and administration costs.
• Family educational costs.
• Paying off debts.
• Survivor retirement needs.

This method requires that you estimate the amount of the specific needs that are relevant to you. If you are married, you would consider the financial impact of the death of either spouse. Plus, you would evaluate how long each need will last and whether each need will increase or decrease over time. Knowing the duration of each need can help you select an appropriate insurance product. You would also factor in the impact of inflation on long-term needs.

Once you calculate the financial impact of a premature death, you can compare the amount to the resources you currently have available. If there is a difference, you can decide which needs to address first and begin to explore alternative ways to fund any shortfall.

What does this mean to you?

Focus first and spend your premium dollars on those needs with the greatest financial impact and the most immediate time frames.

What Product Are Available?

It's easy to become confused with the vast array of different life insurance products -- variable life, universal life, decreasing term, credit life, single premium, whole life, endowment policies and so forth. Is there a simple way to categorize all these kinds of policies?

Generally, life insurance products can be grouped into two broad categories:

• Term insurance.
• Permanent insurance.

Let's look at the main features of these two categories of insurance.

As you consider different types of insurance policies, keep in mind they all deal with shifting risk. The different features focus on different pieces of the risk-shifting process. Are you shifting the risk of death for a year or a lifetime? Are you shifting the risk of insurability or are you retaining that risk by having to satisfy the insurance company that you are insurable on a regular basis?

What does this mean to you?

There is no right or wrong type of insurance policy; however, there are appropriate policy types based upon your goals, needs and resources.

Did you know?

The average amount of life insurance per household in 1993 was $111,600. How much does your household have? Is it enough?

Term insurance illustrates simply how you can shift risk with life insurance. For a specified premium payment, you can shift some of the financial impact of your premature death to an insurance company. Basic term insurance focuses solely on risk shifting. Such policies include neither any form of savings nor a lot of policy enhancements or features. The insured's death must occur within the time specified in the policy for proceeds to be paid to the beneficiary. At the end of the policy term, the coverage and the risk shifting end.

Term policies do offer additional features with respect to premium costs, renewability, and the ability to change the policy into other kinds of coverage. These features do not necessarily make the policy better; they only allow you to better determine which types of risk you want to shift to the insurance company.

Some related term policies are:

• Level Term - fixed amount of insurance with fixed premiums for a certain number of years, generally up to 10 years.
• Annually Renewable - fixed amount of insurance with increasing premiums renewable on an annual basis.
• Increasing/Decreasing Term - amount of insurance increases or decreases over the term, but premiums remain the same.
• Group Term - usually purchased through an employer or professional association; sometimes easier for insureds to qualify for coverage.

What does this mean to you?

Term insurance is relatively inexpensive in your younger years, but the cost increases as you grow older. The annual cost increases more quickly as you reach your 50's and 60's.

Thus, term insurance is often a major part of a risk management program when:

• You are younger and your need for insurance may be greatest because your financial goals are not well funded and resources available for making premium payments may be limited.
• The need for insurance will last for a relatively short period of time.
• The need for insurance will decrease over time.

Whole life or permanent insurance. As the name implies, this product is designed for a longer term and perhaps for your entire life. Premium payments purchase protection against the risk of premature death and also allow you to build a cash reserve -- the savings element.

In your younger years, the portion of your premium payment that pays the cost of the death benefit is relatively small, and a larger portion of the premium may be available to add to the savings element. In later years when the premium you pay does not cover the full cost of the insurance, a portion of the accumulated savings may be needed to fund the actual insurance cost.

Generally, the face amount of the policy and the annual premium are fixed and the cash value of your policy increases, so the amount of pure risk protection decreases over time. You could look at a whole life policy as a combination of decreasing term life insurance and an increasing savings fund. Part of your premium goes for the death benefit and the rest is like an addition to an investment account.

Did you know?

Whole life accounts for 75% of the policies but just over 50% of the total life insurance coverage in force. What types of policies do you own? Do they fit your needs and budget?

Savings Element

Unlike a savings account, the savings element of a life insurance policy is usually not immediately available to you. You may have to pay surrender charges if you withdraw funds early in the life of the policy. You should carefully consider how much you are paying for the "savings" part of the policy and how soon you might need these funds.

Under current income tax laws, the earnings on the savings element of a whole life insurance policy are not subject to income tax as they accumulate over the life of the policy. This ability to have a tax deferred savings element is an advantage for life insurance savings over non tax-deferred savings accounts.

Death Benefit

The portion of your premium that does not go into the savings element pays for insurance risk of your death during the term of the policy, as actuarially determined by the insurance company.

Actuarial Science. Insurance companies rely on mortality tables and theories of probability to calculate their premiums. Actuaries statistically determine the rate of death for men and women at each given age based on the insurance company's past experience and incorporate this information into a mortality table. With this information, the company can reasonably estimate the number of claims and the amount it will have to pay. It can then set the premiums to cover those claims and its administrative and selling expenses and to make a reasonable profit.

There are various types of whole or permanent life insurance policies. In recent years, some variations have grown in popularity. Many of these variations have focused on giving you, the policyholder, more flexibility with respect to the amount of insurance coverage and the investment of your savings element. If you are considering a permanent life insurance product, keep in mind the concept of risk shifting and your reasons for buying life insurance in the first place.

The benefits of flexibility may come with a cost -- the cost of retaining some type of risk. For example, a policy that allows for flexible premiums may not guarantee future premium rates.

Listed below are different types of life insurance:

• Traditional Whole Life. Provides level premiums and level insurance coverage. It generally costs more than term in the earlier years of the policy and less in later years. Nontaxable dividends may be paid on the policy.
• Universal Life.  Combines term insurance with an investment fund that generally has a minimum earnings rate. Within limits you can vary the premium payments from year to year. You may even skip premium payments as long as the cash value is sufficient to cover all of the costs of the insurance. You can raise or lower the death benefit, although increases in death benefit may require proof of insurability.
• Variable Life.  Is a whole life policy under which the policy owner "directs" the investment of cash values. This product has a guaranteed minimum face amount and fixed premiums similar to traditional whole life. However, there is no minimum guaranteed rate of investment return or cash value, and the death benefit is variable based on investment performance.
• Variable Universal Life - A combination of the flexibility of premium payments of the universal life policy, with the investment direction feature of the variable life policy.
• Survivor Life.  Also called "second-to-die," survivorship life insurance pays a death benefit only after both of the insured individuals have died. Premiums are lower than for equivalent coverage in two separate policies. This product is often used to help pay estate taxes.
• Single Premium Life.  Requires a single, large, front-end premium payment to keep the coverage in force for the life of the insured. Because of the high single premium, this type of policy provides the maximum allowable tax-free (or tax-deferred, depending on how proceeds are received) investment buildup permitted in a life insurance policy. The insurance portion must meet a minimum level so that the product continues to qualify as "insurance" (vs. an "investment" which would be subject to current tax). Before 1988, these policies were marketed as "tax shelters" because the cash values were invested on a tax-free basis and could be withdrawn tax-free after a certain period of time. However, in 1988, Congress significantly curbed the tax benefits for policies issued on or after June 21, 1988, by restricting the ability of insureds to receive distributions from these policies free of tax.

Similarly, a policy that allows you to earn more by making your own investment decisions may not protect you from your poor investment choices.

Some of the situations in which people purchase permanent or whole life insurance policies include the time needed to shift the risk is over 15 years.  

For example, providing for the income security of a surviving spouse could involve a time period of over 50 years.

In these situations, permanent insurance should be considered because the cost of term coverage in later years can be prohibitively expensive.

• The amount of the need remains relatively constant or increases over time.
• The family wants or needs to take advantage of a forced savings program. (Some people correctly recognize that they do not have the financial discipline to save without being "forced" to do so.)

Premium and Policy Considerations

Besides the agent's commission and the mortality rates what makes up your life insurance premium dollar? Some factors affecting life insurance premium are:

• Mortality Rates - Based upon life expectancies and the probability of death in a given year, this rate is the cost of pure risk shifting. It is a key component of the annual premium and will increase each year as one's probability of death increases.
• Insurance Company Expenses - the company's administrative burden and selling costs are part of the premium dollar.
• Insurance Company Investment Performance - how well the insurance company's investment portfolio performs may have a significant impact on rates and policy costs.
• Amount of Coverage - how much insurance you buy can affect the rate, with very large policies often having the lowest premium cost per thousand dollars of coverage.
• Policy Provisions - includes grace periods, reinstatement provisions, loan provisions, incontestability provisions, conversion privileges and renewability provisions.

Key life insurance policy features include: premium cost, term of coverage and savings/investment aspects.

In addition, you should analyze the "rate of return" on your policy, considering costs like commissions, surrender charges and administrative costs. Life insurance policy provisions include:

• the ability to assign a part or all of the policy to someone.
• the grace period for paying premiums.
• the grace period for repaying policy loans.
• the frequency of premium payment and automatic checking debit.
• automatic premium payments from cash value.
• simultaneous death presumptions if the insured and the beneficiary are in a common accident.
• suicide provisions.
• incontestability clause guaranteeing payment upon death after some period.
• waivers of premium payment in the event of disability.
• accidental death clauses that increase value of coverage.
• cash value of non-forfeitability.

Other Considerations

Your Insurance Carrier

The life insurance company that issues your policy is important for several reasons. You want to be assured that your death benefits will be paid. If your policy is whole life, you also have to consider the risk that your "savings" may be in jeopardy if the life insurance company fails.

Buying a life insurance product is like investing in the company. Life insurance policies are only as good as the underlying mortality, expense, and investment assumptions made by the company. Payment of your death benefit will depend on the company's financial strength.You can evaluate financial strength of insurance companies by reviewing and assessing the ratings of major rating services, such as A.M. Best, Moody's, Duff & Phelps, Standard & Poor's and Weiss Research.

Because your insurance needs will substantially change as your personal and financial circumstances do, you should monitor and review your policy regularly. With an "in force illustration" you can compare the future projected costs, actual policy terms and performance to date with those assumed when you bought the policy and check to see if premiums are meeting the schedule projected.

If your health has improved or you've stopped smoking, you should find out whether or not your premiums could decrease.   You may be able to save money on premium costs as a result! Insurance can be a complex product to purchase.  It requires careful thought and expert advice.

Do you want to analyze your life insurance coverage?

If you have Term Life:

• The cost of the term insurance goes up with age. Consider any advantages from switching from "annually renewable term" (which starts out low but increases as you get older) to "level premium" (which guarantees the premium for 10,15,20 years). If you plan to have the coverage for more than 15 years, consider converting to whole or permanent "cash value" policies (which combine term or whole insurance with an investment feature and can provide level premiums for life).

If you have Whole Life:

• Obtain an "in force" illustration to determine the period over which premiums will be due versus what was projected when you bought the policy. If interest rates have declined, you may have to make premium payments for a longer period than originally claimed.

You may also want to see how long the policy would last at a rate slightly lower (perhaps 1% to 2% lower) than its present interest rate and policy charges - increasing the payment or cutting the death benefit will extend the length of time that the policy is in force.

Help and More Information

Enjoy the following special features and information sources that Deloitte & Touche OnLine has put together to guide you through your insurance planning!

Books

Consumer Reports Life Insurance Handbook, by Jersey Gilbert & Ellen Schultz (Consumer Reports Books, Inc., Yonkers, NY 1994).

How to Buy the Right Insurance at the Right Price, by Bailard, Biehl & Kaiser (Dow Jones-Irwin, Homewood, IL 1989)

Personal Financial Planning, by G. Victor Hallman & Jerry S. Rosenbloom (McGraw-Hill, Inc., New York, NY 1993).

Policy Wise (an AARP book), by Nancy H. Chasen (Scott, Foresman & Company, Glenview, IL 1983).

Survivors, published by the U.S. Department of Health and Human Services (September 1993).

The Guide to Buying Insurance: How to Secure the Coverage You Need at an Affordable Price, by David Scott (The Globe Pequot Press, Old Saybrook, CT 1994).

The Life Insurance Buyer's Guide, by William D. Brownlie (McGraw-Hill, Inc., New York, NY 1989).

Your Life Insurance Options, by Alan Lavine (John Wiley & Sons, Inc., New York, NY 1993).

Periodicals

Are You Really Insured?: Questions You Should Really Ask About Your Coverage and Benefits, Business Week (August 5, 1991)

Life Insurance, Consumer Reports (July 1993)

Life Insurance, Part 2, Consumer Reports (August 1993)

Life Insurance, Part 3, Consumer Reports (September 1993)

Life Insurance Sense and Nonsense, The CPA Journal (September 1992)

When to Drop That Life Insurance Policy, Medical Economics (January 6, 1992)

Jumps to the Internet

Insurance Information Institute: This organization seeks to improve the public's understanding of property/casualty insurance by providing information and analysis to the media, individuals and organizations. The III publishes a number of helpful consumer guides (available at no cost) such as 12 Ways to Lower Your Homeowners Insurance Costs.

Insurance News Network: This organization provides unbiased consumer information about auto, home and life insurance, including premium costs by state and insurance company ratings from Standard & Poor's.

National Association of Insurance Commissioners: This is an organization of insurance regulators from the 50 states whose primary purpose is to protect the interests of insurance consumers. The NAIC publishes a number of consumer guides including 1995 Guide to Health Insurance for People with Medicare, Consumer's Guide to Home Insurance and Consumer's Guide to Auto Insurance.

SafeTnet: A comprehensive set of links to insurance-related Internet sites.

Click here to see State Insurance Departments.

Insurance Organizations

Insurance Information Institute
110 Williams Street, 4th Floor
New York, NY 10038
(212) 669-9200 or (800) 942-4242

National Insurance Consumer Helpline
(800) 942-4242

National Consumers League
815 15th Street, NW, Suite 928
Washington, DC 20005
(202) 639-8140

National Insurance Consumer Organization
121 North Payne Street
Alexandria, VA 22314
(703) 549-8050