Life insurance

The concepts of "pooling risks" and "the mathematical law of large numbers" are important in the operation of a life insurance company.

An example shows how the "pooling of risks" works. This year John Smith and Frank Jones each pay $250 for one year's premium on a $25,000 life insurance policy. Smith dies two months after the policy is issued and his widow collects $25,000. How can an insurance company pay out $25,000 after receiving two months' premiums, less than $50?

From the point of view of some, life insurance may seem like gambling. "Smith bet the insurance company $250 that his widow could collect $25,000. He (or his widow) won when he died," someone might say. This, however, ignores an important point. The purchase of insurance does not involve taking a risk that previously did not exist. The insured person simply accepted a certain cost (the premium) in order to avoid an uncertain but much larger loss (future earnings).

What one insured person gains is not the loss of others who are insured. Basically, the entire group of insured persons provides the funds which make possible the payment of all claims. Under the pooling of risk concept, a group of people decide to share the risks that all of them experience. Each person in the pool contributes an equitable amount. Most of the time, most of the people will not need to tap the fund set up by the group. But when one of the members of the pool dies, his or her heirs then are allowed to draw from the fund according to the contributions that have been made into it.

In the Smith Jones example, one member of the pool tapped the fund immediately after joining it. Jones, by comparison, may not tap the fund for years and years.

This is called sharing the risk. An insurance firm usually can estimate how many will tap the fund the first year, how many will tap the fund the second year and so on. These predictions are made possible because of the "law of large numbers."

The "law of large numbers" states: The larger the number of exposures considered, the more nearly the losses recorded will match the underlying probability of loss.

While a life insurance company cannot predict the death of any individual it can, with some degree of accuracy, estimate the number of deaths in a certain period for a large number of insureds through the use of mortality tables.

The premiums charged for life insurance reflect this predictable level of mortality. Life insurance policies usually have level premiums based on the age of the insured at the time when the policy is issued. This is done despite the fact that the mortality rate is very high at the older ages while very low at the younger ages. The level premium develops a reserve at the younger ages that is used to help pay the high claim costs in the later years. This reserve is the basis for a cash value in the whole life policy. The cash value is paid to a policy owner if he surrenders his policy.

Assets underlying the reserves are invested and earnings on these investments are used to cover some of the cost of insurance. All insurers seek the highest investment yield consistent with safety in order to minimize the cost of insurance for their policyholders. These earnings come from investments in a wide selection of financial ventures ranging from real estate to stocks or bonds. However, there are severe limitations on stock investments because large fluctuations in stock values could be inconsistent with the life insurance companies' promise of providing financial security.

The key purpose of buying life insurance is the death benefit realized by the survivors. One unique feature of life insurance is that you immediately create an estate that did not previously exist. Many consider life insurance important because they are unable to save enough money to take care of a widowed spouse or other dependents after a death. The money from a life insurance death benefit payable to a specified beneficiary is immediately and automatically available to the beneficiary. Unlike a savings account or stocks, the money cannot be impounded or tied up in probate. Some types of policies accumulate a cash value which is paid if the policy is surrendered or can be used to secure a loan either directly from the insurance company or from a bank.

Other typical personal uses of life insurance are:

• Paying off a home mortgage or other debts at time of death by way of a decreasing term policy.
• Providing lump sum payments to children when they reach a specified age through an endowment.
• Providing for an education or income for children. Making charitable bequests after death.
• Providing a retirement income. Accumulating savings. Establishing a regular income for survivors.
• Setting up an estate plan.
• Estate and Death tax payments. One of the few ways to provide liquidity at the time of death.

Credit life - These policies are used with purchases or small loans to give the lender or seller protection from the premature death of the consumer, which eases the extension of credit.

"Key person" insurance - A company can be indemnified for the serious hardship it suffers without the leadership of an executive who is invaluable to the operation of the firm.

Loan Guarantee or Indemnification - Some business owners must personally guarantee business loans. Life insurance is one means of indemnifying the family in case of death.

Ownership Continuation—partnerships - Buy-out insurance funds legally binding buy-out provisions. If one owner dies the partnership must purchase his interest from the spouse at a prearranged price.

Small Corporations - Especially closely held, have similar arrangements where life insurance is the funding vehicle for buy sell agreements.

Stock Redemption - Family held corporations are frequently very valuable, however, with very little liquidity. The forced sale of assets at the time of death could cause dissolution of the business or serious tax consequences to the family. Life insurance is used to fund and pay for estate taxes involving business valuation.

Sole Proprietorship - Considerable shrinkage in value of a sole proprietorship can occur at the time of death of the proprietor. This loss of value can be compensated for by life insurance so an orderly sale or continuation can be arranged.

Employee Welfare Plans - Many small businesses use forms of life insurance or annuities to fund employee welfare plans such as: Pension programs, profit sharing, programs, Keogh (H.R. 10) Plans, and individual retirement plans. The reason is that insurance companies' products usually provide a guaranteed return and most of the administrative work is handled by the insurance company.

Deferred Compensation - Some executives reach a tax bracket in which any additional salary or bonus is heavily taxed. Arrangements are made for the employee by legal agreement to defer part of his compensation to a later date, usually after retirement. Life insurance is often purchased and paid for by his company to fund the deferred income.

This is a question that must be answered by the person buying the policy. There are three basic approaches to this problem:

• The first is the "human life value" approach. This concept is based on the thought that a person has an earning capacity that, roughly, can be calculated by estimating annual net income (earnings minus all taxes), estimating the remaining years of wage earning, and subtracting the interest that would be earned if all the income were received in a lump sum. This approach has a fault in that it does not take into consideration all of the possible needs of the survivors.

• The second method, the "human needs" approach, takes into account the factors of estate clearance costs, the income the family needs to readjust to a new lifestyle, income for the family until the children leave the home, life income for the surviving spouse, special needs of the family such as college education for the children and other needs. In taking this approach, income from all sources, such as Social Security, veterans' benefits or trust funds are subtracted from the total needs.

• The third method is the "retirement needs" approach. This calls for coordinating life insurance and/or annuity purchases with other sources of revenue Social Security, pensions or investments to achieve a predetermined retirement income.

You do not know whether you will live to retirement or die earlier. A good insurance program will be designed to provide for both the "human" and the "retirement" needs.

An insurance agent can provide a family or person detailed advice on the question of how much insurance and annuity benefits to buy.

All in all the purchase of life insurance in a free capitalist society is a personal one. It involves balancing your "needs" with your "wants" or desires," and buying only that amount of insurance you are willing and able to pay for.

Term - Term insurance is so named because it provides financial protection for a limited, specified period of time. If death occurs within the time limits on the policy, the face amount of the policy is paid. Nothing is paid if the insured person survives the length of the term policy. Unlike other types of policies, term insurance does not generate investment, savings or cash values. It is for this reason that term insurance may be the least expensive means of protection.

Some people on limited incomes buy term insurance for basic financial protection and, as their incomes rise, convert the policy to other forms of life insurance.

Three types of term insurance are commonly recognized:

• Level term insurance provides a constant amount of insurance for a specified period of time, such as a $10,000 death benefit for 10 years.

• Decreasing term insurance provides a decreasing amount of insurance over a specified time. This may be used, for example, to cover the decreasing amount of a home mortgage. Or it may be used by families whose children will be leaving the home, which could diminish the family's financial responsibilities. The rate at which the death benefit decreases in value each year can be considerably different from one company to another. However, premiums usually remain level during the period of coverage.

• Increasing term insurance can be sold as a simple policy or more commonly as a rider to an existing policy. The amount of the death benefit starts at one level and increases at stated intervals by some specific amount or percentage.

Renewable or convertible options may be included in a term life policy. A renewable policy permits the owner of the policy to automatically extend the policy length regardless of the health or occupation of the insured. A convertible policy permits the owner to change the insurance into a whole life or other permanent insurance plan regardless of the health or occupation of the insured.

Permanent or Whole Life or Ordinary - Whole life insurance differs from term insurance in that life insurance protection is provided throughout a lifetime. Thus, it lasts for the "whole" life of a person and can be called a "permanent" life insurance policy.

Premiums may be paid over a specified period, such as 20 or 30 years or to age 65. This type of whole life policy is called a "limited payment" life policy because of the limited years of payment of premiums.

• A "straight or ordinary" life policy calls for premiums to be paid for as long as the insured lives. The premium rate is lower than other types of whole life policies because the premiums are spread over a longer period. The premium payments can be discontinued in later years with the cash value providing a lump sum cash payment, retirement income or paid up insurance either for the same amount for a limited period (called "extended term insurance") or for a reduced amount for the balance of the insured's life (called "reduced paid up insurance").

• A permanent or whole life policy accrues cash value. If the insured dies, the death benefit is payable. If the policy is surrendered before the insured dies, the cash value is paid. Loans may be made from the insurance company against the cash value of the policy at a rate guaranteed in the policy. Loans also can be made from a bank using the cash value of the policy as security. However, the loan usually can be made much more quickly and simply from the insurance company. Furthermore, the maximum loan rate guaranteed in the policy may be much lower than that available from a bank.

• Regardless of whom the loan is secured from, if the insured dies prior to the loan being repaid, the amount of the loan must be repaid from the death benefit amount.

• During the Depression of the 1930s, the cash value of life policies remained stable and was one of the few personal assets that did not lose its value. This loan benefit helped many families and small businesses meet serious financial emergencies.

Variable Life - Variable life insurance is a policy in which the death benefit varies in relation to the investment experience of the assets underlying the policy. A high rate of capital gains and investment income will cause the death benefits to increase, while a low or negative rate will cause the death benefits to decrease. The insured directs the investment of his contributions among several investment accounts of the insurance company. Typical choices are common stock accounts, bond accounts, mortgage accounts, money market accounts, and the general investments of the insurer.

The policy is a security and is within the jurisdiction of the Securities and Exchange Commission (SEC). A person selling a variable life insurance policy must meet the licensing and registration requirements of a securities salesperson in addition to life insurance licensing requirement.

Endowment - An endowment policy offers insurance protection for a specified period of time, such as 10 or 20 years, or to age 65. It enables a policy owner to accumulate a sum of money which is paid to him at the date named in the policy (called the "maturity" date). This money can be paid in a lump sum or in installments. If the insured dies before the end of the maturity date, the face amount is paid to the beneficiary.