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Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



An Overview of Life Insurance

With more than $9 trillion of insurance in force, life insurance is one of the largest industries in the United States. While each household in America carries an average of $100,000 in life insurance, many people have difficulty understanding what life insurance is and how it works.

Life insurance provides financial security. Whether providing for replacement income due to the death of a breadwinner, meeting financial emergencies, sending a child to college, supplementing retirement income or paying for final expenses, people want the ability to pay for needs that may -- or will -- arise in the future.

Term versus permanent

There are two basic types of life insurance products: term and permanent insurance.

Term insurance is purchased for a specific period of time and provides benefits only if the insured person dies during the period covered by the policy. If the policy is purchased for one year, for example, and the insured is alive at the end of the year, no benefit is paid. After the term expires, the person who purchased the policy may have the option of renewing coverage, but it will be necessary to pay a higher premium. As the insured grows older, premiums will usually increase as the probability of death increases.

There are several types of permanent insurance, the most popular of which are universal life and traditional whole life. Universal life, a relatively new product, allows the policyholder a flexible premium payment schedule and the option to change the death benefit from time to time subject to certain restrictions. The product also allows the insurance company flexibility in adjusting rates at which interest is credited to the policy values. However, the mainstay of the industry remains traditional whole life insurance.

Traditional whole life offers insurance protection for the insured person's entire life at a fixed premium payment schedule. If a person buys a $50,000 policy, for example, that $50,000, called the "face value" of the policy, is the amount that generally will be paid out whenever the insured dies. As long as the policyholder pays the required premiums, the policy remains in effect.

Permanent life insurance also allows policyholders to receive financial benefits while they're alive because their insurance builds up a sum of money called the "cash value." In fact, more life insurance benefits are paid to people who are living than to their beneficiaries.

Cash value and how it works

Cash value is the amount of money policyholders would receive as a refund if they cancel their coverage and surrender their policies to the company. The cash value (also called the cash surrender value) continues to grow as long as the policyholders pay the premiums.

A policy's cash value is generally a result of the payment of "level premiums" throughout the payment period of the policy. Since mortality rates increase as people grow older, the actual cost of insurance also increases. If premiums were changed to match the cost of insurance each year, the result would be progressively higher premiums as people grew older. To avoid this dilemma, premiums are "leveled" which results in premiums being collected in the early years of a policy that are higher than necessary to pay current benefits.

The "excess" premium paid in the early years of the policy is held in a reserve which, together with accumulated interest and the payment of future level premiums, assures that sufficient funds will be accumulated to cover the increasing risk of death as the insured grows older.

The policyholders are entitled to their portion of this reserve if they should decide to cancel their insurance protection by surrendering the policy. This portion of their reserve is the cash value at any given time.

Policyholders often borrow from the cash value of their life insurance policies. During the Great Depression of the 1930s, for example, many people used the cash value of their policies to buy food, pay taxes and keep their farm or home from foreclosure. Today, people can use their cash value to pay tuition, make a major purchase, or provide for an unexpected emergency.

Whatever the reason for borrowing from the cash value of their policies, people should use caution. As long as the loan is repaid, the value of the policy rebuilds. But if the insured should die before the loan is repaid in full, the outstanding loan amount is subtracted from the death benefit, if a person has a policy with a death benefit of $50,000, for example, and the policyholder dies with a $5,000 outstanding loan balance, the actual death benefit would be $45,000.

Group life insurance

One of the most widely known types of insurance is group life insurance, which is really term life that is purchased for a number or "group" of people. Group life insurance makes up approximately 40 percent of all life insurance now in force in the United States and is usually offered as part of a company's or an organization's benefit plan.

In a group policy, a number of people are insured under a single contract, called a "master contract." This contract is actually an agreement between the insurance company and the group policyholder which is either the employer or the sponsoring organization. In most group policies, the group policyholder selects the amount of coverage each member is to receive or can elect to purchase.

Each insured member of the group selects his or her own beneficiary. If an insured member leaves the group, that person can, within a limited period of time, convert his or her group policy to individual coverage without presenting evidence of insurability.

Agents add value

Whether it's individual term or permanent insurance, group insurance, or a combination, a knowledgeable insurance agent is the best resource for selecting the right policy. Since the mid 1800s, life insurance agents have been helping people choose the best plans to meet their needs.

The agent starts with a good understanding of each customer's future objectives or "needs." After reviewing the person's financial circumstances, such as social security benefits, group life insurance programs, investment plans and savings accounts, the agent can help determine an insurance program to assist in achieving the financial objectives for the customer and his or her family.

Life insurance companies manage risks

To provide financial security, a life insurance company must successfully manage risks.

The company must predict as accurately as possible the mortality risks faced by an individual or group, so it can determine when it will need to pay benefits and how much those benefits will be. Then, to assure that the funds will be available to pay all benefits, the company must control its financial risks by safely investing the premiums it receives and controlling its costs.

The rate of mortality is the rate at which insured people are expected to die. Expected mortality is based upon a company's own experience as well as data from published mortality tables which contain statistics on the average lifespan of millions of people. This information, together with other variables such as health history, enable insurance actuaries to predict the risk of insuring any person of a given age and thus determine the premium, called the "risk premium," required to assume that risk. An older person, for example, or someone who smokes, is assumed to be at a higher risk than a younger person or a nonsmoker of the same age. This prediction has nothing to do with the actual life span of any specific individual, but does provide a fairly accurate estimate of when someone of similar age and circumstance might die.

The determination of total premiums paid by the policyholder also includes provisions for operating costs, including commissions and underwriting expenses, profit and the investment income that insurance companies earn from the investment of reserves. Insurance companies invest the reserves according to state insurance laws and regulations. These investments may include qualified municipal, state and federal obligations, corporate bonds, real estate, and mortgages.

Insurance companies must always look ahead, carefully monitoring mortality rates, investing wisely and controlling expenses to gain the resources they need to pay benefits to policyholders or their beneficiaries and to earn a profit. In return for their premiums, policyholders are assured the ability to provide for tomorrow's needs. Instead of risk, they find security, and brighter prospects for themselves and their families.

Whole Life Policies

Whole Life Insurance is sometimes called "permanent insurance" or "ordinary life" and is designed to stay in force throughout one's lifetime.

Generally, the annual premiums (payments) for this type of policy remain the same throughout the life of the insured. The premiums are higher in the early years when compared to a straight term life policy. However, due to the buildup of the cash values during those early years, whole life policies tend to remain in force when the premiums for the term life policies have become prohibitively high.

If the owner of the policy decides to stop paying the premiums, he or she can terminate the policy and take the built up cash values or purchase a paid-up policy (with a reduced face amount), or purchase a term policy of the same face amount, but for a set number of years. The number of years would depend on the insured's age and amount of the cash values available at the time.

Historically, whole life insurance has provided several remarkable tax benefits:

  1. There is a tax-free build up of the cash values attributable to favorable investment experience of the insurance company.

  2. The owner can borrow against the cash values at relatively low interest rates and without a tax.

  3. At time of death, the beneficiary collects the proceeds free of income tax.

  4. By transferring ownership of the policy to another, the proceeds can also escape Federal Estate Taxes.

Although tax reformers have periodically tried to eliminate or reduce these benefits, for most whole life contracts, they have been unable to do so.

This type of policy is very well suited for an insurance need which does not diminish with the years, such as the payment of the costs of Federal Estate Taxes, probate and other administration expenses.




Universal Life Insurance

Universal Life Insurance contracts differ from traditional Whole Life policies by separating the "protection element," the "expense element" and the "cash value element. The separation of these three elements enables the insurance company to build a higher degree of flexibility into the contract. The owner can change the face amount or the premium, within certain guidelines, to adjust to changes in his or her situation.

A monthly charge for the "protection element" as well as the "expense element" are deducted from the account balance, allowing the balance of the premium to be invested in the "cash value element."

Therefore, unlike traditional Whole Life policies, complete disclosure of the internal charges against the "cash value element" of the policy are provided to the policyholder in the form of an annual report.

Major Benefits:

  1. Policyholder has a versatile and flexible tool to accommodate ever changing business, financial and family circumstances.

  2. Low term rates and a competitive yield on the "cash value element" combined with tax benefits reinforced by recent tax reform in many instances make the Universal Life contract a viable alternative to more conventional investment vehicles.

  3. Future premiums, based on interest rates and past premiums, may be increased, decreased, or even skipped, without causing the policy to lapse.

  4. Unlike alternative investment vehicles, the cash value can be accessed through no-penalty, non-taxed loans, withdrawals or partial surrenders. Funds that have been borrowed against continue to accrue interest, however, usually at a lower rate. The rate charged on these borrowed funds is usually far less than the market rate.

  5. The "cash value element" accumulates on a tax-free basis, making it a valuable alternative for college funding or as a retirement supplement.

  6. Withdrawals from the "cash value element" can be TAX-FREE if structured properly.

Tax reform has left life insurance in an enviable position. Tax-free accumulation and a potential tax-free payout make life insurance a very strong financial tool, and Universal Life provides the owner with more flexibility and higher yields than traditional Whole Life policies.




Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



Variable Life Insurance

Variable Life Insurance is similar to Whole Life in that premium payments are level and there is a minimum guaranteed death benefit. Expense charges are deducted from each premium and mortality charges are deducted monthly. The policyholder selects one or more "accounts" or "funds" to deposit the account balance into. These can be money market funds, mutual funds, bond funds, and others.

The death benefit and cash value of a Variable Life policy increase and decrease based on the performance of the funds chosen. The death benefit however, will not drop below the initial guaranteed amount.

Major Benefits:

  1. Creative approach to protecting one's family or business, allowing the policyholder the selection of the investment vehicle(s).

  2. Policyholder has the advantage of professional management as well as investment diversification which can reduce the overall risk.

  3. Policyholder receives an annual report disclosing all fees, charges and credits to the account.

  4. Cash values may be reallocated to other funds up to five times annually, with a minimum of 10% in any one fund. This provides a greater degree of control over the end result to the policyholder than with Whole Life or Universal Life.

  5. Some Variable Life contracts provide an exchange option during the first 12-24 months to a fixed contract (Whole Life/Universal Life).

  6. Cash value can be accessed through no-penalty, non-taxed loans, withdrawals, or partial surrenders. These loans are generally available at rates far below the market rate.

  7. Withdrawals from the cash account can be TAX-FREE if structured properly.

Tax reform has left life insurance in an enviable position. Tax-Free accumulation and potential tax-free income make life insurance a very strong financial tool, and Variable Life provides the owner with complete discretion over investment diversification, a feature not available with Whole Life or Universal Life contracts.




Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



Variable Universal Life Insurance

This type of policy contains a combination of features found in "variable life" and in "universal life" policies.

As with universal life contracts, the owner of the policy can, within certain limits, change the face amount and the amount and timing of premiums paid to meet his or her situation.

The prominent feature from the variable life contract is the ability for the policy owner to determine where the funds will be invested. Typically, he or she can choose among a number of accounts, like:

Growth stock accounts
Bond accounts
Balanced accounts
Real estate accounts
Money market accounts, etc.

The ultimate value of the account, at either death or retirement, will depend on the type of investments chosen, the general market conditions and the abilities of the money managers.

Once the costs are met for insurance protection and a portion of company expenses, the balance of the premiums go directly into the selected investment options where they compound on a tax-deferred basis.

As with other permanent life insurance contracts, the owner can borrow against the cash values of the policy. The interest rate is generally more favorable than from a regular lending institution and need for a credit check is not a requirement. The future death benefit will, of course, be reduced by the amount of the loan unless it is repaid.

The Securities and Exchange Commission requires this type of policy to be accompanied by a prospectus.




Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



Modified Endowment Contracts

Life insurance policies issued after June 21, 1988 may be defined as modified endowment contracts (MEC), if the cumulative premiums paid during the first seven years at any time exceed the total of the "net level premiums" for the same period.

For example, assume that the net level premium for a policy is $1,000 per year and the following payments are made by two different policy owners:

YEAR (CAN'T EXCEED) CUMULATIVE NET LEVEL PREMIUMS
POLICY OWNER "A"
POLICY OWNER "B"
ANNUAL PREMIUM CUMULATIVE PREMIUMS ANNUAL PREMIUM CUMULATIVE PREMIUMS
1 $1,000 $1,000 $1,000 $1,000 $1,000
2 2,000 500 1,500 1,000 2,000
3 3,000 1,000 2,500 1,000 3,000
4 4,000 1,500 4,000 1,500 4,500
5 5,000 1,000 5,000 500 5,000
6 6,000 1,000 6,000 1,000 6,000
7 7,000 1,000 7,000 1,000 7,000

NOTES: In the POLICY OWNER "A" example above, even though the premium paid during the fourth year exceeds the annual net level premium of $1,000, the cumulative premiums do not exceed four times (for the four years) the net level premium, and, therefore, this is not a Modified Endowment Contract.

In the POLICY OWNER "B" example above, however, the premiums paid in the fourth year cause the cumulative premiums paid to exceed the cumulative net level premiums allowed and thus cause this contract to become a Modified Endowment Contract.

Taxation of modified endowment contracts:

Withdrawals from "modified endowment contracts" (including loans) will be taxed as current income until all of the policy earnings have been taxed. There is also a 10% penalty tax if the owner is under age 59 1/2, unless payments are due to disability or are annuity type payments.

Well-designed premium payment schedules can avoid the "modified endowment contract" treatment and retain the benefits, which are unique to the life insurance contract.




Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



How To Buy Insurance At The Best Prices

There are a number of insurance price comparison services available focusing on the specific needs of astute consumers who take an active role in their insurance planning. As a self-directed consumer, you can save both time and money by taking advantage of this independent resource.

Whether you are purchasing for the first time, supplementing existing coverage, or searching for a lower-cost alternative, they will work with you to find insurance coverage that meets your particular objectives, avoid buying mistakes, and locate safe insurance companies.

This service gives its customers instant quotes, proposals and financial stability ratings from a continually-updated database of more than 400 leading insurance companies.

Most insurance brokers and agents don't want you to know about a system like this because they're too busy selling for just one or two favorite companies. Using the Insurance Price Comparison Service puts you first. It gives you the most complete picture of the marketplace whenever you want it, before you buy or renew an insurance policy.

Without having to spend days calling insurance agents who are trying to sell you something, you can find out if you are eligible to receive the lowest rates being offered by America's leading insurance companies, HMO's and Blue Cross & Blue Shield plans. The computerized price tracking service keeps track of thousands of high-quality policies (and their ever-changing prices) which are offered by America's safest companies.

Nobody likes to buy insurance. It's almost always bought out of necessity. But you need the best factual information before you buy, and the price tracking service makes it possible to keep on top of changing market conditions to an extent never before possible.

Based upon the coverages that you are looking for, their computer will electronically scan the marketplace and pinpoint those policies that meet or exceed your request. The qualifying companies are then ranked and listed by lowest cost in a complete, simple report format.

The price comparison report will show insurance company names, policy names, latest ratings and premiums for all of the qualifying policies. You'll have complete market knowledge about available coverages and prices -- without having wasted any time. You will be equipped to make insurance decisions based upon market facts.

Price comparisons are available for individual and family medical insurance, for term insurance for individuals, for long-term care insurance, for medicare supplement insurance, for group medical & group dental insurance (especially useful if you have a small business and need to insure several employees), and for single premium deferred annuity quotes. Comparisons are not available for property or automobile insurance, because these are dependent upon neighborhood pricing and there is no national calculation of the rates.




Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



How To Buy Life Insurance In One Shot

There are essentially two ways to buy cash value life insurance. The most common method is to pay premiums over a period of time. But there's a different route you may decide to take: you may purchase the same amount of life insurance protection you are able to receive with level payments by making a one-time payment.

Not surprisingly, this method is often called "single-premium life insurance."

There are several reasons why you may consider single-premium life insurance as an alternative to regular premium payments.

  1. You receive instant cash value in the policy.

  2. You may be able to acquire the life insurance coverage at a discount.

  3. Single-premium insurance may be used for sophisticated estate planning techniques (for example, to maximize wealth for beneficiaries with a minimum of estate tax erosion).

Of course, single-premium life insurance can also provide many of the same benefits available to policy holders who make regular premium payments on a cash value policy. For example:

  • The policy guarantees a substantial death benefit for your family.

  • The cash value grows without any current tax erosion.

  • There is no income tax when the beneficiaries receive the life insurance proceeds.

  • With certain limitations, you may be able to borrow against the cash value of the policy.

Of course, single-premium insurance is not for everyone. Whether or not it makes sense for you may depend upon your financial objectives (for example, college savings for a child). In some cases, you may want to invest in a tax-deferred annuity instead. Be sure to get professional guidance in this area.




Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



Borrowing Against Cash Value Insurance

Zero Net Cost Loans

One of the benefits of life insurance policies which build cash values is the ability to borrow against these funds.

The loan is actually made from the general funds of the insurance company with the policy cash values used as collateral assuring that the loan will be repaid.

Some polices permit the owner of the policy to borrow against his or her policy at an interest rate which is equal to the amount which the company is crediting on his or her cash values.

If a policy is being used as a supplemental retirement plan, zero net cost loans can make a significant difference in the amount that can be borrowed from a policy, creating TAX-FREE INCOME during retirement years.

For example, if at retirement age, a policy has $500,000 of cash value and that cash would generate a TAX-FREE annual income of $47,000 the chart below illustrates the effect of increasing the interest rate charged by the insurance company on the loan. It can have a dramatic effect on either the percentage of income lost over the same time period or the number of years the fund would last were the payments to stay level.

In the above example, increasing from a "Zero Net" to a "1% Net" cost of borrowing, the effect could be looked at two ways. Either the $47,000 annual income for 20 years would be reduced by 9% to $42,770 OR... the $47,000 annual income would only last 16 years. The ultimate total cost of this "extra spread" would be $47,000 X 4 yrs or $188,000.

INTERST CREDITED ON LOANED FUNDS INTEREST CHARGED ON LOANED FUNDS PERCENT LOST AS LOAN RATE INCREASESYEARS OF LEVEL INCOME AT VARIOUS NET INTEREST RATES
4.0% 4.0% 0.0% 20
4.0% 4.5% 5.5% 18
4.0% 5.0% 9.0% 16
4.0% 5.5% 13.3% 15
4.0% 6.0% 17.4% 14

NOTE: Interest rates vary from one insurance company to another and consideration should be given to these factors.

Low Interest Loans

Some polices permit the owner of the policy to borrow against his or her policy at an interest rate which is only slightly higher than the amount which the company is crediting on his or her cash values.

If a policy is being used as a supplemental retirement plan, low net cost loans can make a significant difference in the amount that can be borrowed from a policy, creating TAX-FREE INCOME during retirement years.

For example, if at retirement age, a policy has $500,000 of cash value and that cash would generate a TAX-FREE annual income of $44,000, the chart below illustrates the effect of increasing the interest rate charged by the insurance company on the loan. It can have a dramatic effect on either the percentage of income lost over the same time period or the number of years the fund would last were the payments to stay level.

In the above example, increasing from a ".5% Net" to a "1.5% Net" cost of borrowing, the effect could be looked at two ways. Either the $44,000 annual income for 20 years would be reduced by 9% to $40,040 OR... the $44,000 annual income would only last 16 years. The ultimate total cost of this "extra spread" would be $44,000 X 4 yrs or $176,000.

INTERST CREDITED ON LOANED FUNDS INTEREST CHARGED ON LOANED FUNDS PERCENT LOST AS LOAN RATE INCREASESYEARS OF LEVEL INCOME AT VARIOUS NET INTEREST RATES
4.0% 4.5% 5.5% 18
4.0% 5.0% 9.0% 16
4.0% 5.5% 13.3% 15
4.0% 6.0% 17.4% 14

NOTE: Interest rates vary from one insurance company to another and consideration should be given to these factors.




Using Insurance Products As An Investment
An Overview of Life Insurance Universal Life Insurance
Variable Life Insurance Variable Universal Life Insurance
Modified Endowment Contracts How To Buy Insurance At The Best Prices
How To Buy Life Insurance In One Shot Borrowing Against Cash Value Insurance



About the Author
For twenty years Adam Starchild has been writing books about these subjects, and they are published by a variety of publishers.

For more information on asset protection, see Asset Protection & Becoming Judgment Proof.

Copyright © 1995 by Adam Starchild
The Investor's Library has reprinted this copyrighted article with the permission of the author.


 
 
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