"Information from Human Environmental Sciences Extension.""Family economics."Revised 5/00/5M

Metzen, Edward J.

University of Missouri: MOspace

We all must face the inevitabil-ity of death and the econom-ic hardship that others mightface when we die. Buying life insuranceis one way to ease the burden of thateconomic risk. We can protect survivingfamily members by paying a relativelysmall amount, called the premium, toan insurance company. Then, the insur-ance company will pay a relativelylarge sum of money to the beneficiariesof the policy when the insured persondies.In other words, the risk of a largefinancial loss that may result from thedeath of an individual can be trans-ferred to the insuring organization —the insurance company. Life insuranceis a means of providing an instantestate for the survivors at the death ofan insured person. While the basic con-cept of insurance is quite simple, manyof the details of life insurance canseem complex.Protection with lifeinsuranceBecause families depend on cashfor day-to-day survival, there is a realneed for protection from financial disas-ter if the source of cash is removed.Life insurance is one way to providesecurity if part or all of the family'sincome is cut off because of death. Itcan also provide funds to replace theservices that a member of the familyprovides — child care, for example.Protection and savings?The major purpose of life insuranceis protection — the instant estate tomeet survivor needs. Some policiesinclude a savings feature, but there aremany other ways to save money andmake investments. When buying lifeinsurance, your primary concern shouldbe providing adequate protection; thepossible savings feature is a secondaryconsideration.Even when protection needs havebeen met, it is a good practice to con-sider other forms of saving and invest-ment plans for a family. Whether tosave or invest through life insurance orother saving or investment media is afamily choice, based on needs, prefer-ences, and ability to manage finances.It is a saving/investment decision, notan insurance decision.You may get a better return on yourmoney through other saving or invest-ment vehicles. In addition, a variety ofsaving and investment opportunitiesare available that do not require payingany commission, or require a commis-sion that is lower than that for savingthrough life insurance.Earnings on the saving or invest-ment element of life insurance are tax-deferred; but there are a variety ofother saving/investment media that alsoprovide deferral of taxes on earnings.However, earnings in a life insurancepolicy that are part of the proceedspaid to a beneficiary after the death ofthe insured are not subject to incometax at all.Assessing needsFamilies should consider total finan-cial needs and other resources avail-able when determining their need forlife insurance. Needs depend upon: The number and ages of depen-dents (wife, children, parents, etc.); The standard of living desired fordependents if the income earnershould die; The amount of other financialresources a family has (SocialSecurity, savings, investments,dependents' earning capacity, etc.).Considerationswhen buyingThe financial needs of survivingfamily members may include: Expenses in connection with thedeath (funeral expenses, final med-ical expenses not covered by healthinsurance, expenses for estate set-tlement, and possibly readjustmentexpenses such as relocation of thefamily, etc.)FAMILY ECONOMICSLifeInsurancePurposes and Basic PoliciesEdward J. MetzenDepartment of Consumer and Family EconomicsPublished by MU Extension, University of Missouri-Columbia GH 3422 Information fromHumanEnvironmental SciencesExtension Arhiv ver io -- See extensi n.mi soi.edu Day-to-day living expenses of surviv-ing dependents (food, clothing, etc.). Payments on debts (a mortgagedhome or farm debt, car loan, etc.). Special needs (securing a loan,assuring children's educationalexpenses, gifts to family, friends ororganizations). Retirement income for the survivingspouse, and perhaps for otherdependents. (See MU publication, GH 3421,Determining Life Insurance Needs.)Principles for buying When buying life insurance, a familyshould develop a plan and select poli-cies that fit their particular financialneeds. They should use life insuranceto provide for financial needs that arenot met in other ways. This plan should fit the family's abil-ity to pay for the insurance,because premiums must be paid tokeep the insurance in force. A family should select the premiumperiod that provides the most eco-nomical rate (usually annually). Thistakes planning and must be includ-ed as an item in the monthly bud-get. Families should read each policycarefully. Policy owners shouldassure themselves they are makingthe best use of their insurance dol-lars for the financial security of sur-vivors of the insured person. The family insurance programshould be reviewed periodically andrevised to meet changing needs.Basic policies:pure protection (term)and cash valueTerm insuranceTerm insurance is a type of lifeinsurance that provides pure protectiononly. It insures an individual against therisk of financial loss in case of death. Itdoes not include a savings plan; it isstrictly an insurance protection con-tract, similar to auto, home, or healthinsurance. The owner buys a certainamount of coverage and pays an annu-al premium based on the insured's age.As the name suggests, this policy cov-ers the insured for a certain term orperiod of time. At the end of the term,the coverage stops, unless the policy isrenewed. The simplest form of lifeinsurance protection is annually renew-able term insurance. The owner of aterm life insurance policy can continueprotection for additional terms, but ashe or she grows older, the premium perunit ($1,000) of coverage will increasefor each new term.Some term policies are for five, tenor twenty years. The annual premiumremains the same over the term. It isalso possible to buy a term policy thatwill cover the insured for the sameannual premium from the time of thepurchase to age 65. The actual cost ofprotection increases each year, but thiscost is averaged out to provide a levelpremium during the term of the policy.This is known as level premium terminsurance.Another form of term insurance isdecreasing term. In this form, theamount of protection declines as theinsured grows older, so the annual pre-mium can stay level.Because term insurance providespure protection, it provides the mostcoverage for the premium dollar spent.Cash value insuranceCash value life insurance policiesconsist of two elements — a decreas-ing amount of actual insurance protec-tion over time, combined with a savingscomponent that increases over time —which is funded by premium paymentsand earnings on the saving element inthe policy (see Figures 1 and 2).There are two basic types of cashvalue life insurance policies. They aredesigned to provide coverage through-out life (whole life policies) — straightlife and limited payment.Straight life insuranceThis policy provides a certainamount of coverage throughout life. Itcombines a decreasing amount of pro-tection with an increasing amount ofsavings. But the total coverage provid-ed by the policy (the face value of thepolicy) — including both the protectionand the savings elements — remainsthe same.Because the owner is building up2 Human Environmental Sciences ExtensionProtectionSavings(cash surrender value)Startof policyTimeFace Value $Terminationof policy(age 100)Figure 1. Straight life policy.savings as well as buying protectionthrough this plan, the premium is high-er than the premium for term insurance.As with all life insurance policies, thepremium is based on the age of theinsured when the policy is purchased.The premium for straight life insurancethen remains the same through the lifeof the policy. This is because the policy-holder is paying more than the cost ofpure protection during the early yearsof the policy. The excess portion of thepremiums, above the cost of pure pro-tection, is what builds up the savingselement of the policy. Because the pro-tection element decreases over time asthe savings element increases, thelevel premium continues to be ade-quate to cover the cost of the policy asthe insured grows older.The face value is the amountpayable at the death of the insured. Itincludes both the protection and thesavings value of the policy, if there isany. The cash surrender value is theamount of savings that has built upwithin the policy. This amount increasesduring the time the policy is in force.The insured may redeem the policy forits cash value at any time, but this ter-minates the policy. Or, the insured mayborrow the cash value from the compa-ny; however, this reduces the total cov-erage until the policy loan is repaid.Interest is charged on the loan until it isrepaid.If the insured continues premiumpayments to age 100, he or she hasmade sufficient premium payments tobuild up the cash value to make it equalto face value at that point. Therefore, asof that date, the policy consists entirelyof the savings element, and there is noactual insurance protection componentremaining. As with a savings account ina bank or elsewhere, the insured can atthat point collect the face value of thepolicy while he/she is alive, because theentire policy value now consists ofhis/her savings element.Limited payment life insuranceThis policy is similar to the straight lifepolicy, except that the policyholder paysthe total premiums on the policy in a lim-ited number of years, usually 20 to 30, orby age 65. After that, the policy remainsin force for the rest of the insured's lifeunless the cash value is withdrawn, atwhich time coverage stops.The premium on limited payment lifeinsurance is higher than for a straightlife policy because you pay all the pre-miums into the policy in a given num-ber of years. This means the policy-holder is actually building up saving(cash value) within the policy at a con-siderably faster rate than would be truewith the straight life insurance policy,and thus reducing the protection ele-ment in the policy faster.This policy has limited use exceptfor families that have very high incomesin their early years (for example, a pro-fessional athlete whose income may bedecreased in later years). The typicalfamily has more stress on its budget inthe early years and, because of thehigher premiums, will probably find itimpossible to afford sufficient coveragewith limited payment life insurance. Andhaving enough protection to provide fordetermined needs in event of death ofthe insured is the most important con-sideration in buying life insurance.The price per $1,000 of actual lifeinsurance protection rises as theinsured gets older, in a cash value typepolicy as in a term policy. In a cashvalue policy, the increasing cost of pro-tection is not obvious, because as thesavings component created by thehigher premium increases, the amountof the actual insurance protection com-ponent decreases.Tax treatmentCash value policies are frequentlymarketed as a tax sheltered form ofsaving. While this is a consideration,the advantages of the tax shelter arefrequently overstated. The shelter of acash value policy is that the interestearned on the cash value (savings por-tion) is tax-deferred as long as the policyis in force. If the policy is surrenderedto obtain the cash value, income tax ispaid only on the portion of the cashvalue that exceeds the total premiumspaid on that policy. And, as notedabove, if the face value of the policy ispaid to a beneficiary at death of theUniversity of Missouri-Columbia 3ProtectionSavings(cash surrender value)Startof policyTime Terminationof policy(age 100)Face Value $Figure 2. Limited payment policy.insured, the earnings on the savingselement are not taxed at all.The tax treatment, however, is aminor factor to consider when deter-mining the type of insurance to pur-chase. It is a far less importantconsideration than the protection pro-vided by the policy (the instant estatecreated at death of the insured).Policy selectionconsiderationsCash value life insurance is oftenpromoted as an avenue for savingbecause the premium paymentsinclude a saving element. However,there are several factors and hazardsthat must be taken into account whenconsidering cash value policies. Thefirst, and most important, is that fami-lies sometimes purchase higher-premi-um policies with a savings element andprovide inadequate protection to meettheir needs. So if the insured dies, theyhave spent their premium dollars on toolittle protection and their financial needsare not adequately covered. A secondfactor is that when families commit tohigh-premium policies, if they faceincreased living expenses or a financialemergency, the insurance premiumsmay put too much stress on theirincome, and they drop the pollicy —thus leaving them without life insur-ance. In this case, they are not onlywithout protection, but have a furtherloss because of the higher commis-sions paid to acquire this type of policy.Finally, if the family considers a cashvalue life insurance policy as a savingmedium, it should compare the rate ofreturn earned on the saving element,the commission to acquire the policy,and other factors, with alternativeavenues for saving and investing.It is important to keep in mind thatthere are a variety of media for saving,but the protection feature of life insur-ance is the only medium for creating aninstant estate at the death of theinsured. If a man age 25 saves $150one day and dies the next, that $150will be part of his estate. But if he is ingood health, for that $150 he can pur-chase a one-year renewable term lifeinsurance policy that will provide about$100,000 to his beneficiaries or estateif he dies the next day. This illustratesthe instant estate concept, and the dif-ference between a savings plan, inwhich the principal is yours whetheryou live or die, and an insurance pro-tection plan, in which you are paying amodest-size premium to provide a largedollar amount of protection which will bepaid only in event of your death. Theprotection concept is similar to the insur-ance you buy for a defined time periodto cover your home or automobile.Life insurance provides financialprotection for survivors of theinsured, and may meet other finan-cial objectives, as well (a gift tocharity, for example). Familiesshould review their life insuranceprogram and policies regularly andmake adjustments to meet changesin circumstances and needs.Definition of termsBeneficiary. The person named inthe policy to receive the insurance pro-ceeds at the death of the insured.Cash surrender value. The amountof money payable to a policyholder whopurchased insurance with a savingselement in it, when he or she stopspaying premiums before the maturitydate of the policy.Face value. The amount stated onthe face of the policy that will be paid incase of death of the insured or at thematurity of the contract. Dividend addi-tions or additional amounts payableunder accidental death or other specialprovisions are above the face value.Insured. The person on whose lifean insurance policy is issued.Life insurance. A risk-sharing planto cover the financial loss, and otherfinancial needs, experienced by depen-dents upon the death of an individual.Limited payment life insurance.Whole life insurance on which premi-ums are payable for a specified numberof years or until death if death occursbefore the end of the specified period.Policy. The printed document statingterms of the insurance contract issued tothe policyholder by the company.Policy loan. A loan made by aninsurance company to a policyholder onthe security of the policy’s cash value.Premium. The payment, or a peri-odic payment, a policyholder makes foran insurance policy.Straight life insurance. Whole lifeinsurance on which premiums arepayable for the life of the insured, atwhose death the face value is paid tothe dependents.Term insurance. Insurance payableto a beneficiary at the death of theinsured while the policy is in force.There are numerous variations, rid-ers, provisions and options to thesebasic policies. For a brief overview ofthe most common , refer to MU publica-tion GH 3426, Life Insurance: PolicyVariations, Riders, Provisions andOptions.$.50 GH 3422 Revised 5/00/5M Issued in furtherance of Cooperative Extension Work Acts of May 8 and June 30, 1914, in cooperation with the United States Departmentof Agriculture. Ronald J. Turner, Director, Cooperative Extension, University of Missouri and Lincoln University, Columbia, MO 65211.  University Outreach and Extension does not discriminate on the basis of race, color, national origin, sex, religion, age, disability or statusas a Vietnam era veteran in employment or programs.  If you have special needs as addressed by the Americans with Disabilities Act andneed this publication in an alternative format, write ADA Officer, Extension and Agricultural Information, 1-98 Agriculture Building, Columbia,MO 65211, or call (573) 882-8237. Reasonable efforts will be made to accommodate your special needs.OUTREACH & EXTENSIONUNIVERSITY OF MISSOURICOLUMBIA

Life insurance : purposes and basic policies (2000)

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