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In life insurance, an insured pays a premium to an insurance company, and in return, the insurance company assumes the risk of that person dying prematurely. The premium (a small certain loss) is exchanged for a large uncertain loss. The insurance company is insuring many lives, so it is spreading the risk of premature death among a large group of lives.
While life insurance is not usually thought of as property in the same way as real estate and other personal property, it has value like other property in the following ways:
Insureds who are the breadwinners of their families will have different income needs at various stages of their lives. The needs that are protected with insurance can be divided into 3 different income periods. Today, with the wide variety of types of policies and riders available, it is possible to structure an insurance program to satisfy all of these needs. As an insurance producer, it is your responsibility to assist the insured in developing such a program. The 3 income periods that most insureds are exposed to are the following:
The type of information that needs to be gathered falls under 4 categories:
These costs would take into account the final medical expenses of the insured, funeral expenses, and day to day expenses of maintaining the family including rent or mortgage payments, car payments, utilities, groceries, etc.
Other needs and objectives would include estate taxes, day care, insurance premiums, and similar expenses.
Debt Cancellation — Insurance may be used to create a fund to pay off debts of the insured such as home mortgage or auto loans.
Emergency Reserve Funds — Insurance proceeds may be used to assist in paying for sudden expenses following the death of the insured, such as travel expenses and lodging for family members coming from a distance.
Education Funds — Insurance proceeds may be used to pay for children's education expenses so they can remain in school, or sometimes a surviving spouse who has worked in the home caring for children will need to receive education or training in order to re-enter the job market.
Retirement Fund — Insurance proceeds may be used as a source of retirement income.
Bequests — An insured may wish to leave funds to their church, school, or other organization at the time of their death.
Unless funded by insurance, the surviving spouse who was the caregiver of the children may have to train to enter the job market. If they do work outside the home, expense for day care needs to be considered.
Selling assets, or liquidation, is a method of raising capital. Retention is the retaining of assets. If the principal asset is the home, selling the home would require that the survivors then pay rent. Under the retention of capital approach, enough insurance is purchased so that when added to other liquid assets, there is enough to pay income benefits without invading the principal.
A person may create an estate through earnings, savings, and investments, but all of these methods require disciplined action and a significant period of time. The purchase of life insurance creates an immediate estate. Estate creation is especially important for young families that are getting started and have not yet had time to accumulate assets. When an insured purchases a life insurance policy, that creates an estate of at least that amount the moment the first premium is paid. There is no other legal method by which an immediate estate can be created at such a small cost.
Life insurance also provides funds that are available when needed. For example, some life policies (those that provide permanent protection, such as whole life) accumulate cash value that is available to the policyowner during the policy term.
As a result of the cash accumulation feature, some life insurance policies provide liquidity to the policyowner. That means the policy's cash values can be borrowed against at any time and used for immediate needs.
Life insurance proceeds may be used to pay inheritance taxes and federal estate taxes so that it is not necessary for the beneficiaries to sell off the assets.
The human life value approach (HLVA) gives the insured an estimate of what would be lost to the family in the event of the premature death of the insured. It calculates an individual's life value by looking at the insured's wages, inflation, the number of years until retirement, and the time value of money.
Let's assume that a 40-year-old insured earns $50,000 a year and is expected to earn the same amount until he retires at age 65. Out of his annual income, $40,000 is spent on family needs, and the remaining $10,000 goes to the insured's personal expenses. This means that the human life value of this insured to his family is $1,000,000 ($40,000 a year spent on family needs x 25 years to retirement). Based on this assumption, and taking interest and inflation into consideration, the insurance company will determine the right amount of insurance to produce the same annual amount of income for the family if the insured were to die.
The needs approach is based on the predicted needs of a family after the premature death of the insured. Some of the factors considered by the needs approach are income, the amount of debt (including mortgage), investments, and other ongoing expenses.
Businesses use life insurance for the same reason individuals use life insurance: it creates an immediate payment upon the death of the insured.
The most common use of life insurance by businesses is as an employee benefit, which serves as a protection for employees and their beneficiaries. There are also other forms of life insurance that can serve business owners and their survivors, and even protect the business itself. These include funding business continuation agreements, compensating executives, and protecting the business against financial loss resulting from the death or disability of key employees.
A business can suffer a financial loss because of the premature death of a key employee – someone who has specialized knowledge, skills or business contacts. A business can lessen the risk of such loss by the use of key person insurance. Key person insurance may be issued as term or permanent life, with whole life and universal life policies being used most often.
With this coverage, the key employee is the insured, and the business is all of the following:
In the event of death of a key employee, the business would use the money for the additional costs of running the business and replacing the employee. The business cannot take a tax deduction for the expense of the premium. However, if the key employee dies, the benefits paid to the business are usually received tax free. No special agreements or contracts are needed except that the employee(s) would need to give permission for this coverage.
Key person insurance may be term or permanent. An employer may have more than one key person policy.
A buy-sell agreement is a legal contract that determines what will be done with a business in the event that an owner dies or becomes disabled. This is also referred to as a business continuation agreement.
There are several types of buy-sell agreements that can be used for partnerships and corporations:
Here is an example of a cross-purchase buy-sell agreement: Partnership AB has two partners, Partner A and Partner B. The value of the business is $1,000,000. The partners each have an equal interest ($500,000 each). Partner A buys a life policy on Partner B for $500,000, and Partner B buys a life policy on Partner A for $500,000. If Partner A dies, Partner B gets 100% ownership of the business and A's heirs receive $500,000.
Business overhead expense (BOE) insurance is a unique type of policy that is sold to small business owners who must continue to meet overhead expenses, such as rent, utilities, employee salaries, installment purchases, or leased equipment, following a disability. The business overhead expense policy reimburses the business owner for the actual overhead expenses that are incurred while the business owner is totally disabled. This policy does not reimburse the business owner for their salary, compensation, or other form of income that is lost as a result of disability. There is usually an elimination period of 15 to 30 days and benefit payments are usually limited to one or two years. The benefits are usually limited to covered expenses incurred or the maximum monthly benefit stated in the policy. The premiums paid for BOE insurance are tax deductible to the business as a business expense. However, the benefits received are taxable to the business as received.
Executive bonus is an arrangement where the employer offers to give the employee a wage increase in the amount of the premium on a new life insurance policy on the employee. The employee owns the policy and, therefore, has full rights to the policy. Since the employer treated the premium payment as a bonus, that amount is tax deductible to the employer and income taxable to the employee. It is assumed that if the employee were not willing to accept these conditions, the employer would not provide the benefit. Executive bonus plans are not subject to plan limits established by the IRS for qualified plans, so it is considered a nonqualified benefit plan.
Deferred compensation funding refers to any employer retirement, savings, or other deferred compensation plan that is not a qualified retirement plan. Funding involves a contractual commitment between the employer and employee to pay compensation in future years. Usually, funding is made with cash deposits to a life insurance and/or annuity contract.
Deferred compensation funding falls into two major classes:
These plans are typically made with selected employees to provide additional retirement benefits.
Business continuation plan is an arrangement between business owners that provides for shares owned by any one of them who dies or becomes disabled to be sold to, and purchased by, the other co-owners or the business.
A split-dollar plan is an arrangement where the employer and employee agree to purchase and fund life insurance on an employee. In the most common form, the employer pays the part of the premiums that equals the annual increase in the cash value of the policy, while the employee pays the balance. Should the employee die, the employer recovers the total of its payments from the policy proceeds, with the balance being paid to the employee's beneficiary.
The limit of liability is the face value/amount or death benefit of an individual life insurance policy, subject to any exclusions or riders as applicable, minus any outstanding policy loans and interest payments due to the insurer.
Face Amount − (Outstanding Policy Loan + Loan Interest) = Limit of Liability