Life Insurance Fundamentals
A life insurance policy is a valued insurance policy that pays a specified amount to the beneficiary, when the insured dies. A beneficiary can be a person, business, trust, or estate. The owner of the policy is the person or organization who pays the premiums and has ownership rights: the right to name the beneficiary; the right to receive dividends and to surrender the policy for cash; the right to change ownership; and the right to assign a policy as collateral for a loan.
So that life insurance companies can make a profit, they must engage in both medical and financial underwriting. Medical underwriting generally requires that the insurance applicant receive a physical exam to determine the health of the applicant as well as supply medical information on the insurance application. An applicant in poor health would probably have to pay higher premiums or the company may refuse to insure the individual at all. There are generally 4 underwriting classes for life insurance: preferred, standard, substandard, and uninsurable. Insurance applicants who are adjudged a standard risk are charged the standard premium, without a surcharge or a policy restriction. Preferred risks, who are considered healthier than average and who have lower risk occupations, are charged a lower premium than the standard rate. Substandard risks are those whose health, occupation, personal habits, such as smoking, or other variables predict a shorter lifespan, so they are charged a higher rate. Uninsurable risks include those people in poor health, with unhealthy habits, or who work in hazardous occupations, of course, but it may also include people with characteristics for which the insurer has insufficient information to set an accurate premium, such as those with rare diseases.
Financial underwriting requires that the company determine that the beneficiary would suffer a loss if the insured died, if the beneficiary is also the owner of the policy. Otherwise, the beneficiary would not have insurable interest, since state law does not permit anyone to take out life insurance policies on other people unless they would suffer a financial loss if the insured died. So, for instance, spouses would have insurable interest to insure each other, a partnership would have an insurable interest in insuring its partners, and a company could purchase life insurance on its key employees.
Death is certain, but when it occurs is not. Life expectancy is the average number of years that a person can expect to live. For people with a given life expectancy, half will die before then and half will die afterward. If someone dies early, then they may leave behind a family or other financial dependents that depended on the decedent's income.
Premature death is, for insurance purposes, the unexpected death of someone who provides financial support to others, and life insurance helps to provide that support.
There are pecuniary costs of premature death:
- lost earnings,
- funeral expenses and uninsured medical bills,
- estate settlement costs,
- and possible federal and state taxes on the estate.
Since life insurance is mainly used to provide financial support for the financial dependents of the decedent, life insurance is usually purchased only for the breadwinners of a family. If a family member provides no support, or if it is a single individual living alone, then there is generally no need for life insurance, except, maybe, to cover funeral costs.
Life insurance is a valued policy, not a contract of indemnification. Death is certain, only the time of its arrival is uncertain. After the death of the insured, the face amount of the policy is paid to the named beneficiary.
The Distribution of Life Insurance
The distribution of life insurance is classified as group, industrial, and individual life insurance. Group life insurance is provided to specific groups, such as employees at a firm, or members of an organization. Often, the employer pays for it. If the insured pays for it, it is usually at a reduced cost. However, group life insurance has no savings value, and its face value is usually low—inadequate for most families. Credit life insurance is a specific type of group insurance that is sold by creditors to their customers that pays off their debt to the creditor if they should die. These policies are expensive compared to the benefits and are a poor value.
Individual life insurance is the purchase of insurance by individuals. Generally, these policies have a greater face value, and the individual can choose policies that have a savings or income value, and other preferred items.
Industrial life insurance (aka debit life insurance, burial insurance) was sold by insurance agents, sometimes called debit agents, to low income workers. The debit agent would visit the workers weekly, usually on their payday to collect the premiums. Industrial life insurance is rarely sold today. These policies were very expensive because the life expectancy of low income workers was less than the general population, but most of the expense was incurred to pay for the debit agents to visit the individual homes to collect the premiums.
How Much Life Insurance?
The amount of life insurance needed depends on the family and their situation. There are various methods at estimating the amount of life insurance to purchase. The human life value method simply calculates the present value of all earnings of the breadwinner that would have gone to the dependents. The amount of these earnings would be the estimated amount earned from work or other sources, minus the amount that would be paid in taxes, and minus the amount that the breadwinner would keep for himself.
While the human life value method is one way to calculate the amount of life insurance needed, it is not very valuable. It makes more sense to calculate the amount that the financial dependents will need rather than what they would have gotten if the breadwinner had lived.
The needs calculation would involve estimating and providing a fund for all known expenses, and paying off all debt; then determine the amount of financial need after all debts have been paid off. It can be paid as a lump sum or as income using a capital retention approach.
Some needs are temporary; others are permanent. As temporary needs are eliminated, the total amount of life insurance can be reduced. Most people have the following needs:
- Final expenses, which include funeral expenses and unpaid medical bills.
- A debt retirement fund to retire all debt, including mortgages, credit card bills, and auto loans. Being debt-free will allow a family to live with less income.
- An income fund provides an income to the surviving members of the family, which would be especially helpful if the surviving spouse would have to stay at home to care for children, or to pay for their care while the surviving spouse works.
- An education fund to pay for the future education of children. The cost for a 4 year college education can easily be more than $100,000, and this will no doubt continue to increase, probably faster than inflation as it has in the past.
- An estate preservation fund may be desirable for those with substantial estates that may incur high attorney fees, court costs, and taxes.
Once the needs have been determined, then other sources of income should be considered that would reduce the amount of life insurance needed. These would include social security benefits; benefits from other insurance policies, such as from work; investment income; and other possible sources of income, such as from a business that the deceased had an ownership interest.
The capital retention approach (aka capital needs analysis) is much like the needs approach, but provides the surviving family with capital that earns income over time. This generally requires much more life insurance. If the owner of the policy cannot afford the capital retention approach, then it makes more sense to pay off debt, since debt usually incurs greater interest than can be safely earned from investments. In fact, paying off debt is like earning the interest that would otherwise be paid tax free.
Estate Planning with Life Insurance
Life insurance is frequently used to provide cash for an estate. Most large estates have most of their worth in the form of land, buildings, art, collectibles, and so on—items that are not easily converted into cash. However, any federal estate taxes must be paid within 9 months of someone's death, and the decedent may have wished to make cash bequests, and to cover the expenses associated with the estate without liquidating any assets.
Frequently, the proceeds of the life insurance are paid into a trust. This life insurance trust then purchases the assets in the estate, providing the estate with cash to pay expenses and provide for heirs, while maintaining the assets within the trust so that it can continue to earn income.
Another form of life insurance used in estate planning is the survivor life insurance policy (aka joint-and-survivor or second-to-die life insurance) which insures both spouses, but pays the estate of the last spouse to die, since no estate tax is due when an estate transfers from the decedent to the surviving spouse, because of the unlimited marital deduction. Survivorship life insurance can be term, whole life, universal, or variable insurance policies. Some variations of this type of policy include an increased cash value upon the occurrence of the 1st death or increased dividends. Another option is that the policy can be paid up after the 1st death, so no more premiums need to be paid. Survivorship policies are generally restricted to husband and wife, parent or child, or related business partners, owners or key employees.
Another type of policy is the first-to-die life insurance policy, which ensures 2 or more people and can be any type of life insurance policy. Usually the policy pays after the 1st death, but a rider is available that will allow the survivor to continue coverage. First-to-die life insurance policies have lower premiums than insuring each individual with a separate policy.
Life insurance proceeds are includable in the estate of the decedent if the decedent had an incident of ownership in the policy either at the time of death or within 3 years of death, or the proceeds were payable to the decedent's estate. Generally, an incident of ownership is one where the insured retained some control over the policy, including outright ownership, the power to surrender, cancel or assign the policy, the legal right to receive dividends or to borrow against the cash value of the policy, or to pledge the policy to secure a loan, or to change the beneficiary. For this reason, many wealthy people use an irrevocable trust or a business entity to own the policy. If the insured is the grantor of the trust, then the trust must be irrevocable; otherwise, the grantor would have control over the trust and, therefore, control over the life insurance policy, making it includable in his estate.
Taxation of Life Insurance
The payment of a life insurance policy to a beneficiary is not taxable. However, it may be subject to the alternative minimum tax if it is received by a C corporation. If the beneficiary takes the proceeds as an annuity, and the money not paid continues to earn interest, then the interest is taxable. If a life insurance policy is sold by the owner for immediate cash—transferred for value—to an exempt transferee, then the life insurance proceeds remains tax-free. Exempt transferees include:
- the insured,
- partners of the insured,
- partnerships where the insured was a partner,
- corporations where the insured was a shareholder or officer.
If the transferee was non-exempt, then, for the buyer, only the amount paid for the policy plus any additional premiums will be tax-free; the rest will be subject to ordinary income taxes. Any interest incurred on any debt to acquire the contract that is not deductible under IRC §264 can be deducted from the insurance proceeds. So, for instance, if you bought a $100,000 policy from the original owner for $50,000, and paid an additional $10,000 of premiums until the insured finally died, then you would receive $60,000 of the proceeds tax-free; the remaining $40,000 would be subject to ordinary income tax.
There are several safe harbor rules from the transferred for value rule, when transferring an insurance policy, including:
- from the insured to a grantor trust where the insured is the grantor
- to a partner of the insured, or to a partnership where the insured is a member or partner; or
- to a corporation in which the insured is a stockholder or officer
The proceeds of viatical settlements are also income tax-free, where the life insurance policy has been sold by the insured to pay for expensive medical care because of a terminal or a chronic illness. However, chronically ill patients have per day limitations under IRC §7702(d)(2), an amount adjusted for inflation, which, in 2015, was $330.
The proceeds of a life insurance policy are subject to federal estate tax and will be included in the gross estate if the proceeds are payable to or for the benefit of the estate; if the insured possessed any incidents of ownership in the policy at the time of death; or the policy was transferred as a gift within 3 years of death. Additionally, the fair market value of the policy, which includes the cash value plus unearned premiums, on another person's life is includable in the owner's gross estate.
Gifts of life insurance policies or premium payments may also be subject to the federal gift tax, based on the fair market value of the policy at the time of the gift or on the total value of the premiums paid. The exact value of the gift tax value depends on the type of insurance and can usually be obtained from the insurance company.
Dividends, Savings, and Accelerated Death Benefits
Participating life insurance policies pay dividends, which is not taxed. This is because the IRS treats the dividends as a return of premium rather than earned income.
Many life insurance policies have a savings value that the owner of the policy can withdraw. These policies have an adjusted cost basis which is equal to the sum of all premiums paid minus the sum of all dividends received. If the amount of money withdrawn is greater than the adjusted cost basis, then the income is taxed as ordinary income.
Many policies also have an accelerated death benefit, which allows the insured to withdraw some of the death benefits when the insured is terminally ill. Accelerated death benefits are fully excludable from income if the insured is a terminally ill individual, which is a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months from the date of the certification. Accelerated death benefits may also be tax-free for chronic illness. Chronic illness, or some similar level of disability, must be certified by a physician that the person is unable to perform at least 2 activities of daily living for a minimum of 90 days without significant assistance. A person may also be considered chronically ill if constant supervision is required to protect herself from threats to her own safety or to those of others, because of severe cognitive impairment, a condition that must be certified by a doctor within the previous 12 months.