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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.
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:
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 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.
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:
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.
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 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 1st spouse to the 2nd.
Generally, the payment of a life insurance policy to a beneficiary is not taxable. However, 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—then, for the buyer, the difference between the cash value of the policy and the purchase amount is taxable when the policy is finally paid.
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.
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