Life insurance

Life insurance or life assurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a sum of money upon the occurrence of the insured individual's or individuals' death or other event, such as terminal illness or critical illness. In return, the policy owner agrees to pay a stipulated amount called a premium at regular intervals or in lump sums. There may be designs in some countries where bills and death expenses plus catering for after funeral expenses should be included in Policy Premium. In the United States, the predominant form simply specifies a lump sum to be paid on the insured's demise.

As with most insurance policies, life insurance is a contract between the insurer and the policy owner whereby a benefit is paid to the designated beneficiaries if an insured event occurs which is covered by the policy. To be a life policy the insured event must be based upon the lives of the people named in the policy.

Insured events that may be covered include:

Life policies are legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; for example claims relating to suicide, fraud, war, riot and civil commotion.

Life-based contracts tend to fall into two major categories:

Contents

Overview

Parties to contract

There is a difference between the insured and the policy owner (policy holder), although the owner and the insured are often the same person. For example, if Joe buys a policy on his own life, he is both the owner and the insured. But if Jane, his wife, buys a policy on Joe's life, she is the owner and he is the insured. The policy owner is the guarantee and he or she will be the person who will pay for the policy. The insured is a participant in the contract, but not necessarily a party to it.

The beneficiary receives policy proceeds upon the insured's death. The owner designates the beneficiary, but the beneficiary is not a party to the policy. The owner can change the beneficiary unless the policy has an irrevocable beneficiary designation. With an irrevocable beneficiary, that beneficiary must agree to any beneficiary changes, policy assignments, or cash value borrowing.

In cases where the policy owner is not the insured (also referred to as the cestui qui vit or CQV), insurance companies have sought to limit policy purchases to those with an "insurable interest" in the CQV. For life insurance policies, close family members and business partners will usually be found to have an insurable interest. The "insurable interest" requirement usually demonstrates that the purchaser will actually suffer some kind of loss if the CQV dies. Such a requirement prevents people from benefiting from the purchase of purely speculative policies on people they expect to die. With no insurable interest requirement, the risk that a purchaser would murder the CQV for insurance proceeds would be great. In at least one case, an insurance company which sold a policy to a purchaser with no insurable interest (who later murdered the CQV for the proceeds), was found liable in court for contributing to the wrongful death of the victim (Liberty National Life v. Weldon, 267 Ala.171 (1957)).

Contract terms

Special provisions may apply, such as suicide clauses wherein the policy becomes null if the insured commits suicide within a specified time (usually two years after the purchase date; some states provide a statutory one-year suicide clause). Any misrepresentations by the insured on the application is also grounds for nullification. Most US states specify that the contestability period cannot be longer than two years; only if the insured dies within this period will the insurer have a legal right to contest the claim on the basis of misrepresentation and request additional information before deciding to pay or deny the claim.

The face amount on the policy is the initial amount that the policy will pay at the death of the insured or when the policy matures, although the actual death benefit can provide for greater or lesser than the face amount. The policy matures when the insured dies or reaches a specified age (such as 100 years old).

Costs, insurability, and underwriting

The insurer (the life insurance company) calculates the policy prices with intent to fund claims to be paid and administrative costs, and to make a profit. The cost of insurance is determined using mortality tables calculated by actuaries. Actuaries are professionals who employ actuarial science, which is based in mathematics (primarily probability and statistics). Mortality tables are statistically-based tables showing expected annual mortality rates. It is possible to derive life expectancy estimates from these mortality assumptions. Such estimates can be important in taxation regulation.[1] [2]

The three main variables in a mortality table have been age, gender, and use of tobacco. More recently in the US, preferred class specific tables were introduced. The mortality tables provide a baseline for the cost of insurance. In practice, these mortality tables are used in conjunction with the health and family history of the individual applying for a policy in order to determine premiums and insurability. Mortality tables currently in use by life insurance companies in the United States are individually modified by each company using pooled industry experience studies as a starting point. In the 1980s and 90's the SOA 1975-80 Basic Select & Ultimate tables were the typical reference points, while the 2001 VBT and 2001 CSO tables were published more recently. The newer tables include separate mortality tables for smokers and non-smokers and the CSO tables include separate tables for preferred classes. [3]

Recent US select mortality tables predict that roughly 0.35 in 1,000 non-smoking males aged 25 will die during the first year of coverage after underwriting.[2] Mortality approximately doubles for every extra ten years of age so that the mortality rate in the first year for underwritten non-smoking men is about 2.5 in 1,000 people at age 65.[3] Compare this with the US population male mortality rates of 1.3 per 1,000 at age 25 and 19.3 at age 65 (without regard to health or smoking status).[4]

The mortality of underwritten persons rises much more quickly than the general population. At the end of 10 years the mortality of that 25 year-old, non-smoking male is 0.66/1000/year. Consequently, in a group of one thousand 25 year old males with a $100,000 policy, all of average health, a life insurance company would have to collect approximately $50 a year from each of a large group to cover the relatively few expected claims. (0.35 to 0.66 expected deaths in each year x $100,000 payout per death = $35 per policy). Administrative and sales commissions need to be accounted for in order for this to make business sense. A 10 year policy for a 25 year old non-smoking male person with preferred medical history may get offers as low as $90 per year for a $100,000 policy in the competitive US life insurance market.

The insurance company receives the premiums from the policy owner and invests them to create a pool of money from which it can pay claims and finance the insurance company's operations. Contrary to popular belief, the majority of the money that insurance companies make comes directly from premiums paid, as money gained through investment of premiums can never, in even the most ideal market conditions, vest enough money per year to pay out claims. Rates charged for life insurance increase with the insurer's age because, statistically, people are more likely to die as they get older.

Given that adverse selection can have a negative impact on the insurer's financial situation, the insurer investigates each proposed insured individual unless the policy is below a company-established minimum amount, beginning with the application process. Group Insurance policies are an exception.

This investigation and resulting evaluation of the risk is termed underwriting. Health and lifestyle questions are asked. Certain responses or information received may merit further investigation. Life insurance companies in the United States support the Medical Information Bureau (MIB) [4], which is a clearinghouse of information on persons who have applied for life insurance with participating companies in the last seven years. As part of the application, the insurer receives permission to obtain information from the proposed insured's physicians.[5]

Underwriters will determine the purpose of insurance. The most common is to protect the owner's family or financial interests in the event of the insurer's demise. Other purposes include estate planning or, in the case of cash-value contracts, investment for retirement planning. Bank loans or buy-sell provisions of business agreements are another acceptable purpose.

Life insurance companies are never required by law to underwrite or to provide coverage to anyone, with the exception of Civil Rights Act compliance requirements. Insurance companies alone determine insurability, and some people, for their own health or lifestyle reasons, are deemed uninsurable. The policy can be declined (turned down) or rated. Rating increases the premiums to provide for additional risks relative to the particular insured.

Many companies use four general health categories for those evaluated for a life insurance policy. These categories are Preferred Best, Preferred, Standard, and Tobacco. Preferred Best is reserved only for the healthiest individuals in the general population. This means, for instance, that the proposed insured has no adverse medical history, is not under medication for any condition, and his family (immediate and extended) have no history of early cancer, diabetes, or other conditions.[5] Preferred means that the proposed insured is currently under medication for a medical condition and has a family history of particular illnesses. Most people are in the Standard category. Profession, travel, and lifestyle factor into whether the proposed insured will be granted a policy, and which category the insured falls. For example, a person who would otherwise be classified as Preferred Best may be denied a policy if he or she travels to a high risk country. Underwriting practices can vary from insurer to insurer which provide for more competitive offers in certain circumstances.

Life insurance contracts are written on the basis of utmost good faith. That is, the proposer and the insurer both accept that the other is acting in good faith. This means that the proposer can assume the contract offers what it represents without having to fine comb the small print and the insurer assumes the proposer is being honest when providing details to underwriter.

Death proceeds

Upon the insured's death, the insurer requires acceptable proof of death before it pays the claim. The normal minimum proof required is a death certificate and the insurer's claim form completed, signed (and typically notarized). If the insured's death is suspicious and the policy amount is large, the insurer may investigate the circumstances surrounding the death before deciding whether it has an obligation to pay the claim.

Proceeds from the policy may be paid as a lump sum or as an annuity, which is paid over time in regular recurring payments for either a specified period or for a beneficiary's lifetime.

Insurance vs. assurance

Outside the United States, the specific uses of the terms "insurance" and "assurance" are sometimes confused. In general, in these jurisdictions "insurance" refers to providing cover for an event that might happen (fire, theft, flood, etc.), while "assurance" is the provision of cover for an event that is certain to happen. However, in the United States both forms of coverage are called "insurance", principally due to many companies offering both types of policy, and rather than refer to themselves using both insurance and assurance titles, they instead use just one.

Types of life insurance

Life insurance may be divided into two basic classes – temporary and permanent or following subclasses - term, universal, whole life, variable, variable universal and endowment life insurance.

Temporary (Term)

Term life insurance or 'term assurance' provides for life insurance coverage for a specified term of years for a specified premium. The policy does not accumulate cash value. Term is generally considered "pure" insurance, where the premium buys protection in the event of death and nothing else. (See Theory of Decreasing Responsibility and buy term and invest the difference.)

The three key factors to be considered in term insurance are: face amount (protection or death benefit), premium to be paid (cost to the insured), and length of coverage (term).

Various (U.S.) insurance companies sell term insurance with many different combinations of these three parameters. The face amount can remain constant or decline. The term can be for one or more years. The premium can remain level or increase. A common type of term is called annual renewable term. It is a one year policy but the insurance company guarantees it will issue a policy of equal or lesser amount without regard to the insurability of the insured and with a premium set for the insured's age at that time. Another common type of term insurance is mortgage insurance, which is usually a level premium, declining face value policy. The face amount is intended to equal the amount of the mortgage on the policy owner’s residence so the mortgage will be paid if the insured dies.

A policy holder insures his life for a specified term. If he dies before that specified term is up, his estate or named beneficiary(ies) receive(s) a payout. If he does not die before the term is up, he receives nothing. In the past these policies would almost always exclude suicide. However, after a number of court judgments against the industry, payouts do occur on death by suicide (presumably except for in the unlikely case that it can be shown that the suicide was just to benefit from the policy). Generally, if an insured person commits suicide within the first two policy years, the insurer will return the premiums paid. However, a death benefit will usually be paid if the suicide occurs after the two year period.

Permanent

Permanent life insurance is life insurance that remains in force (in-line) until the policy matures (pays out), unless the owner fails to pay the premium when due (the policy expires OR policies lapse). The policy cannot be canceled by the insurer for any reason except fraud in the application, and that cancellation must occur within a period of time defined by law (usually two years). Permanent insurance builds a cash value that reduces the amount at risk to the insurance company and thus the insurance expense over time. This means that a policy with a million dollars face value can be relatively expensive to a 70 year old. The owner can access the money in the cash value by withdrawing money, borrowing the cash value, or surrendering the policy and receiving the surrender value.

The three basic types of permanent insurance are whole life, universal life, and endowment.

Whole life coverage

Whole life insurance provides for a level premium, and a cash value table included in the policy guaranteed by the company. The primary advantages of whole life are guaranteed death benefits, guaranteed cash values, fixed and known annual premiums, and mortality and expense charges will not reduce the cash value shown in the policy. The primary disadvantages of whole life are premium inflexibility, and the internal rate of return in the policy may not be competitive with other savings alternatives. Riders are available that can allow one to increase the death benefit by paying additional premium. The death benefit can also be increased through the use of policy dividends. Dividends cannot be guaranteed and may be higher or lower than historical rates over time. Premiums are much higher than term insurance in the short-term, but cumulative premiums are roughly equal if policies are kept in force until average life expectancy.

Cash value can be accessed at any time through policy "loans". Since these loans decrease the death benefit if not paid back, payback is optional. Cash values are not paid to the beneficiary upon the death of the insured; the beneficiary receives the death benefit only. If the dividend option: Paid up additions is elected, dividend cash values will purchase additional death benefit which will increase the death benefit of the policy to the named beneficiary.

Universal life coverage

Universal life insurance (UL) is a relatively new insurance product intended to provide permanent insurance coverage with greater flexibility in premium payment and the potential for a higher internal rate of return. There are several types of universal life insurance policies which include "interest sensitive" (also known as "traditional fixed universal life insurance"), variable universal life insurance, and equity indexed universal life insurance.

A universal life insurance policy includes a cash account. Premiums increase the cash account. Interest is paid within the policy (credited) on the account at a rate specified by the company. This rate may have a guaranteed minimum (for fixed ULs) or no minimum (for variable ULs). Mortality charges and administrative costs are then charged against (reduce) the cash account. The surrender value of the policy is the amount remaining in the cash account less applicable surrender charges, if any.

With all life insurance, there are basically two functions that make it work. There's a mortality function and a cash function. The mortality function would be the classical notion of pooling risk where the premiums paid by everybody else would cover the death benefit for the one or two who will die for a given period of time. The cash function inherent in all life insurance says that if a person is to reach age 95 to 100 (the age varies depending on state and company), then the policy matures and endows the face value of the policy.

Actuarially, it is reasoned that out of a group of 1000 people, if even 10 of them live to age 95, then the mortality function alone will not be able to cover the cash function. So in order to cover the cash function, a minimum rate of investment return on the premiums will be required in the event that a policy matures.

Universal life insurance addresses the perceived disadvantages of whole life. Premiums are flexible. Depending on how interest is credited, the internal rate of return can be higher because it moves with prevailing interest rates (interest-sensitive) or the financial markets (Equity Indexed Universal Life and Variable Universal Life). Mortality costs and administrative charges are known. And cash value may be considered more easily attainable because the owner can discontinue premiums if the cash value allows it. And universal life has a more flexible death benefit because the owner can select one of two death benefit options, Option A and Option B.

Option A pays the face amount at death as it's designed to have the cash value equal the death benefit at maturity (usually at age 95 or 100). With each premium payment, the policy owner is reducing the cost of insurance until the cash value reaches the face amount upon maturity.

Option B pays the face amount plus the cash value, as it's designed to increase the net death benefit as cash values accumulate. Option B offers the benefit of an increasing death benefit every year that the policy stays in force. The drawback to option B is that because the cash value is accumulated "on top of" the death benefit, the cost of insurance never decreases as premium payments are made. Thus, as the insured gets older, the policy owner is faced with an ever increasing cost of insurance (it costs more money to provide the same initial face amount of insurance as the insured gets older).

Both death benefit options - A (level) and B (increasing) - are subject to the same IRS rules and guidelines concerning premium payments and tax-favored treatment of cash values. In order for the policy to keep its tax favored life insurance status, it must stay within a corridor specified by state and federal laws that prevent abuses such as attaching a million dollars in cash value to a two dollar insurance policy. The interesting part about this corridor is that for those people who can make it to age 95-100, this corridor requirement goes away and your cash value can equal exactly the face amount of insurance. If this corridor is ever violated, then the universal life policy will be treated as, and in effect turn into, a Modified Endowment Contract (or more commonly referred to as a MEC).

But universal life has its own disadvantages which stem primarily from this flexibility. The policy lacks the fundamental guarantee that the policy will be in force unless sufficient premiums have been paid and cash values are not guaranteed.

Early universal life policies are sometimes erroneously referred to as self-sustaining policies. In the 1980s, when interest rates were high, the cash value accumulated at a more accelerated rate, and universal life coverage was often sold by agents as a policy that could be self-paying. Many policies did sustain themselves for a prolonged period, but the combination of lower interest rates and an increasing cost of insurance as the insured ages meant that for many policies, the cash option was diminished or depleted.

Interest-Sensitive Universal Life Insurance An interest sensitive UL policy was the first attempt at creating a flexible premium life insurance policy and was created in the 1980s. Interest-sensitive UL policies guarantee, to some extent, the death proceeds, but not the cash function - thus the flexible premiums and interest returns. If interest rates are high, then the investment returns help reduce the required premiums needed to keep the policy in force. If interest rates are low, then the customer would have to pay additional premiums in order to keep the policy in force. When interest rates are above the minimum required or minimum guaranteed interest rate, then the customer has the flexibility to pay less as investment returns cover the remainder to keep the policy in force.

Equity-Indexed Universal Life Insurance

Equity-Indexed Universal Life Insurance or "EIUL" for short, is a fixed universal life insurance policy that was created in the mid 1990s to address concerns about market volatility and provide an alternative to the low interest rates being offered by interest-sensitive UL policies.

EIULs differ from interest-sensitive UL policies in that they credit interest to the policy's cash values based on the upward movement of a particular stock market index - usually the S&P500. The insurance company can then credit the gains in the stock market according to one of several different crediting methods. The most popular is the "point-to-point" method. When the policy is issued, the insurance company "pegs" the stock market's value. At the anniversary of the policy, the insurance company checks the value of the underlying stock index and credits the cash value with the difference up to a cap (specified by the company).

For example, if a policy owner purchased an EIUL on January, and the insurance company used the S&P500 as the underlying index when crediting interest to policy cash values, and the company set a 12 % cap, the process would work like this:

If the S&P500 was 1,100 in January, the insurance company would record the value of the index. On the anniversary of the policy (the next January), the insurance company would record the new value of the S&P500. If the new value of the index was 1,188, that would represent a gain of 8%. The insurance company would credit the policy cash values with 8% for that year.

If the S&P500 lost value (i.e. the value went from 1,100 to 980), the insurance company would simply record a "0", and the policy would show a year of no growth. The policy owner would not; however, lose any money (principal or interest from a previous year) as a result of a negative return on the S&P500.

If the S&P500 was 1,100 in January, the insurance company would record the value of the index. On the anniversary of the policy (the next January), the insurance company would record the new value of the S&P500. If the new value of the index was 1,320, that would represent a gain of 20%. The cap set by the insurance company is 12%, so the insurance company would credit the policy cash values with 12% for that year.

Since the insurance company is assuming the risk for any losses, it represents a trade off for the policy owner: The policy owner gets most of the upside potential of the stock market without any of the downside risks associated with an investment in the stock market.

To accomplish this feat, the insurance company uses a precise mix of bonds and index call options.[6] Most of the premium received for this type of policy is used to buy bonds. A small portion of the premium is used to buy stock options (call options) on an underlying stock index. When the value of the stock index rises, the underlying stock option increases by a multiple of 5, 7, or 10. This produces the gains necessary to credit the policy with the "upside potential" of the stock market without actually having the policy owner invest directly in the stock market.

Variable Universal Life Insurance (VUL) is another type of universal life insurance. There are typically no guarantees associated with this type of life insurance policy. The cash account within a VUL is held in the insurer's "separate account" (generally in mutual funds, managed by a fund manager). The policy owner then chooses the investments he or she wishes to invest in. If those investments do well, the insurance company credits the policy's cash values accordingly. If the underlying investments do poorly, the policy owner can lose their cash value. If the investments do poorly enough, it could cause the policy to lapse due to insufficient funds to cover the costs of insurance.

Limited-pay

Another type of permanent insurance is Limited-pay life insurance, in which all the premiums are paid over a specified period after which no additional premiums are due to keep the policy in force. Common limited pay periods include 10-year, 20-year, and paid-up at age 65.

Endowments

Main article: Endowment policy

Endowments are policies in which the cash value built up inside the policy, equals the death benefit (face amount) at a certain age. The age this commences is known as the endowment age. Endowments are considerably more expensive (in terms of annual premiums) than either whole life or universal life because the premium paying period is shortened and the endowment date is earlier.

In the United States, the Technical Corrections Act of 1988 tightened the rules on tax shelters (creating modified endowments). These follow tax rules as annuities and IRAs do.

Endowment Insurance is paid out whether the insured lives or dies, after a specific period (e.g. 15 years) or a specific age (e.g. 65).

Accidental death

Accidental death is a limited life insurance that is designed to cover the insured when they pass away due to an accident. Accidents include anything from an injury, but do not typically cover any deaths resulting from health problems or suicide. Because they only cover accidents, these policies are much less expensive than other life insurances.

It is also very commonly offered as "accidental death and dismemberment insurance", also known as an AD&D policy. In an AD&D policy, benefits are available not only for accidental death, but also for loss of limbs or bodily functions such as sight and hearing, etc.

Accidental death and AD&D policies very rarely pay a benefit; either the cause of death is not covered, or the coverage is not maintained after the accident until death occurs. To be aware of what coverage they have, an insured should always review their policy for what it covers and what it excludes. Often, it does not cover an insured who puts themselves at risk in activities such as: parachuting, flying an airplane, professional sports, or involvement in a war (military or not). Also, some insurers will exclude death and injury caused by proximate causes due to (but not limited to) racing on wheels and mountaineering.

Accidental death benefits can also be added to a standard life insurance policy as a rider. If this rider is purchased, the policy will generally pay double the face amount if the insured dies due to an accident. This used to be commonly referred to as a double indemnity coverage. In some cases, some companies may even offer a triple indemnity cover.

Related life insurance products

Riders are modifications to the insurance policy added at the same time the policy is issued. These riders change the basic policy to provide some feature desired by the policy owner. A common rider is accidental death, which used to be commonly referred to as "double indemnity", which pays twice the amount of the policy face value if death results from accidental causes, as if both a full coverage policy and an accidental death policy were in effect on the insured. Another common rider is premium waiver, which waives future premiums if the insured becomes disabled.

Joint life insurance is either a term or permanent policy insuring two or more lives with the proceeds payable on the first death.

Survivorship life or second-to-die life is a whole life policy insuring two lives with the proceeds payable on the second (later) death.

Single premium whole life is a policy with only one premium which is payable at the time the policy is issued.

Modified whole life is a whole life policy that charges smaller premiums for a specified period of time after which the premiums increase for the remainder of the policy.

Group life insurance is term insurance covering a group of people, usually employees of a company or members of a union or association. Individual proof of insurability is not normally a consideration in the underwriting. Rather, the underwriter considers the size and turnover of the group, and the financial strength of the group. Contract provisions will attempt to exclude the possibility of adverse selection. Group life insurance often has a provision that a member exiting the group has the right to buy individual insurance coverage.

Senior and preneed products

Insurance companies have in recent years developed products to offer to niche markets, most notably targeting the senior market to address needs of an aging population. Many companies offer policies tailored to the needs of senior applicants. These are often low to moderate face value whole life insurance policies, to allow a senior citizen purchasing insurance at an older issue age an opportunity to buy affordable insurance. This may also be marketed as final expense insurance, and an agent or company may suggest (but not require) that the policy proceeds could be used for end-of-life expenses.

Preneed (or prepaid) insurance policies are whole life policies that, although available at any age, are usually offered to older applicants as well. This type of insurance is designed specifically to cover funeral expenses when the insured person dies. In many cases, the applicant signs a prefunded funeral arrangement with a funeral home at the time the policy is applied for. The death proceeds are then guaranteed to be directed first to the funeral services provider for payment of services rendered. Most contracts dictate that any excess proceeds will go either to the insured's estate or a designated beneficiary.

These products are sometimes assigned into a trust at the time of issue, or shortly after issue. The policies are irrevocably assigned to the trust, and the trust becomes the owner. Since a whole life policy has a cash value component, and a loan provision, it may be considered an asset; assigning the policy to a trust means that it can no longer be considered an asset for that individual. This can impact an individual's ability to qualify for Medicare or Medicaid.

Investment policies

With-profits policies

Main article: With-profits policy

Some policies allow the policyholder to participate in the profits of the insurance company these are with-profits policies. Other policies have no rights to participate in the profits of the company, these are non-profit policies.

With-profits policies are used as a form of collective investment to achieve capital growth. Other policies offer a guaranteed return not dependent on the company's underlying investment performance; these are often referred to as without-profit policies which may be construed as a misnomer.

Insurance/Investment Bonds

Main article: Insurance bond

Pensions

Pensions are a form of life assurance. However, whilst basic life assurance, permanent health insurance and non-pensions annuity business includes an amount of mortality or morbidity risk for the insurer, for pensions there is a longevity risk.

A pension fund will be built up throughout a person's working life. When the person retires, the pension will become in payment, and at some stage the pensioner will buy an annuity contract, which will guarantee a certain pay-out each month until death.

Annuities

Main article: annuity

An annuity is a contract with an insurance company whereby the purchaser pays an initial premium or premiums into a tax-deferred account, which pays out a sum at pre-determined intervals. There are two periods: the accumulation (when payments are paid into the account) and the annuitization (when the insurance company pays out). For example, a policy holder may pay £10,000, and in return receive £150 each month until he dies; or £1,000 for each of 14 years or death benefits if he dies before the full term of the annuity has elapsed. Tax penalties and insurance company surrender charges may apply to premature withdrawals (if indeed these are allowed; in most markets outside the U.S. the policy owner has no right to end the contract prematurely).

Tax and life insurance

Taxation of life insurance in the United States

Premiums paid by the policy owner are normally not deductible for federal and state income tax purposes.[7]

Proceeds paid by the insurer upon death of the insured are not included in gross income for federal and state income tax purposes;[8] however, if the proceeds are included in the "estate" of the deceased, it is likely they will be subject to federal and state estate and inheritance tax.

Cash value increases within the policy are not subject to income taxes unless certain events occur. For this reason, insurance policies can be a legal and legitimate tax shelter wherein savings can increase without taxation until the owner withdraws the money from the policy. On flexible-premium policies, large deposits of premium could cause the contract to be considered a "Modified Endowment Contract" by the Internal Revenue Service (IRS), which negates many of the tax advantages associated with life insurance. The insurance company, in most cases, will inform the policy owner of this danger before applying their premium.

Tax deferred benefit from a life insurance policy may be offset by its low return in some cases. This depends upon the insuring company, type of policy and other variables (mortality, market return, etc.). Also, other income tax saving vehicles (i.e. Individual Retirement Account (IRA), 401K or Roth IRA) may be better alternatives for value accumulation. This will depend on the individual and their specific circumstances.

The tax ramifications of life insurance are complex. The policy owner would be well advised to carefully consider them. As always, the United States Congress or the state legislatures can change the tax laws at any time.

Taxation of life assurance in the United Kingdom

Premiums are not usually allowable against income tax or corporation tax, however qualifying policies issued prior to 14 March 1984 do still attract LAPR (Life Assurance Premium Relief) at 15% (with the net premium being collected from the policyholder).

Non-investment life policies do not normally attract either income tax or capital gains tax on claim. If the policy has as investment element such as an endowment policy, whole of life policy or an investment bond then the tax treatment is determined by the qualifying status of the policy.

Qualifying status is determined at the outset of the policy if the contract meets certain criteria. Essentially, long term contracts (10 years plus) tend to be qualifying policies and the proceeds are free from income tax and capital gains tax. Single premium contracts and those run for a short term are subject to income tax depending upon your marginal rate in the year you make a gain. All (UK) insurers pay a special rate of corporation tax on the profits from their life book; this is deemed as meeting the lower rate (20% in 2005-06) liability for policyholders. Therefore a policyholder who is a higher rate taxpayer (40% in 2005-06), or becomes one through the transaction, must pay tax on the gain at the difference between the higher and the lower rate. This gain is reduced by applying a calculation called top-slicing based on the number of years the policy has been held. Although this is complicated, the taxation of life assurance based investment contracts may be beneficial compared to alternative equity-based collective investment schemes (unit trusts, investment trusts and OEICs). One feature which especially favors investment bonds is the '5% cumulative allowance' – the ability to draw 5% of the original investment amount each policy year without being subject to any taxation on the amount withdrawn. If not used in one year, the 5% allowance can roll over into future years, subject to a maximum tax deferred withdrawal of 100% of the premiums payable. The withdrawal is deemed by the HMRC (Her Majesty's Revenue and Customs) to be a payment of capital and therefore the tax liability is deferred until maturity or surrender of the policy. This is an especially useful tax planning tool for higher rate taxpayers who expect to become basic rate taxpayers at some predictable point in the future (e.g. retirement), as at this point the deferred tax liability will not result in tax being due.

The proceeds of a life policy will be included in the estate for death duty (in the UK, inheritance tax (IHT)) purposes, except that policies written in trust may fall outside the estate. Trust law and taxation of trusts can be complicated, so any individual intending to use trusts for tax planning would usually seek professional advice from an Independent Financial Adviser (IFA) and/or a solicitor.

Pension Term Assurance

Although available before April 2006, from this date pension term assurance became widely available in the UK. Most UK product providers adopted the name "life insurance with tax relief" for the product. Pension term assurance is effectively normal term life assurance with tax relief on the premiums. All premiums are paid net of basic rate tax at 22%, and higher rate tax payers can gain an extra 18% tax relief via their tax return. Although not suitable for all, PTA briefly became one of the most common forms of life assurance sold in the UK until the Chancellor, Gordon Brown, announced the withdrawal of the scheme in his pre-budget announcement on 6 December 2006. The tax relief ceased to be available to new policies transacted after 6 December 2006, however, existing policies have been allowed to enjoy tax relief so far.

History

Main article: History of insurance

Insurance began as a way of reducing the risk of traders, as early as 5000 BC in China and 4500 BC in Babylon. Life insurance dates only to ancient Rome; "burial clubs" covered the cost of members' funeral expenses and helped survivors monetarily. Modern life insurance started in late 17th century England, originally as insurance for traders: merchants, ship owners and underwriters met to discuss deals at Lloyd's Coffee House, predecessor to the famous Lloyd's of London.

The first insurance company in the United States was formed in Charleston, South Carolina in 1732, but it provided only fire insurance. The sale of life insurance in the U.S. began in the late 1760s. The Presbyterian Synods in Philadelphia and New York created the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers in 1759; Episcopalian priests organized a similar fund in 1769. Between 1787 and 1837 more than two dozen life insurance companies were started, but fewer than half a dozen survived.

Prior to the American Civil War, many insurance companies in the United States insured the lives of slaves for their owners. In response to bills passed in California in 2001 and in Illinois in 2003, the companies have been required to search their records for such policies. New York Life for example reported that Nautilus sold 485 slaveholder life insurance policies during a two-year period in the 1840s; they added that their trustees voted to end the sale of such policies 15 years before the Emancipation Proclamation.

Market trends

Life insurance premiums written in 2005

According to a study by Swiss Re, the EU was the largest market for life insurance premiums written in 2005 followed by the USA and Japan.

Criticism

Although some aspects of the application process (such as underwriting and insurable interest provisions) make it difficult, life insurance policies have been used in cases of exploitation and fraud. In the case of life insurance, there is a motivation to purchase a life insurance policy, particularly if the face value is substantial, and then kill the insured.

The television series Forensic Files has included episodes that feature this scenario. There was also a documented case in 2006, where two elderly women are accused of taking in homeless men and assisting them. As part of their assistance, they took out life insurance on the men. After the contestability period ended on the policies (most life contracts have a standard contestability period of two years), the women are alleged to have had the men killed via hit-and-run car crashes.[9]

Recently, viatical settlements have thrown the life insurance industry into turmoil. A viatical settlement involves the purchase of a life insurance policy from an elderly or terminally ill policy holder. The policy holder sells the policy (including the right to name the beneficiary) to a purchaser for a price discounted from the policy value. The seller has cash in hand, and the purchaser will realize a profit when the seller dies and the proceeds are delivered to the purchaser. In the meantime, the purchaser continues to pay the premiums. Although both parties have reached an agreeable settlement, insurers are troubled by this trend. Insurers calculate their rates with the assumption that a certain portion of policy holders will seek to redeem the cash value of their insurance policies before death. They also expect that a certain portion will stop paying premiums and forfeit their policies. However, viatical settlements ensure that such policies will with absolute certainty be paid out. Some purchasers, in order to take advantage of the potentially large profits, have even actively sought to collude with uninsured elderly and terminally ill patients, and created policies that would have not otherwise been purchased. Likewise, these policies are guaranteed losses from the insurers' perspective.

See also

References

Specific references

  1. ↑ IRS Retirement Plans FAQs regarding Revenue Ruling 2002-62
  2. ↑ IRS Bulletin No. 2002–42
  3. ↑ [http://www.actuary.org/pdf/life/interim_aug06.pdf "AAA/SOA Review of the Interim Mortality Tables Developed by Tillinghast and Proposed for Use by the ACLI from the Joint American Academy of Actuaries/Society of Actuaries Review Team"] August 29, 2006
  4. ↑ Medical Information Bureau (MIB) website
  5. ↑ MIB Consumer FAQs
  6. ↑ "Financial Planning and Retirement: "How Equity Indexing Works"".
  7. ↑ Internal Revenue Code § 264(a)(1)
  8. ↑ Internal Revenue Code § 101(a)(1)
  9. ↑ "Two Elderly Women Indicted on Fraud Charges in Deaths of LA Hit-Run," Insurance Journal, June 1, 2006 [1]

External links