1 ESO 455 No. 6 LIFE INSUfW[E AND ANNUITIES When developing a sound insurance program a person must face the possibilities of dying too soon or living too long. Very few people will die at the "right time," whatever that may be. Either event can result in economic hardship; for the survivors if death comes too soon or for the person in question in the event of living too long. Living too long is used in the sense of outliving their financial resources. Insurance is available that provides protection for each of these risks; life insurance to protect against premature death and life annuities to protect against living too long. LIFE INSURANCE A person's most valuable asset is the ability to earn an income. This asset is the basis for life insurance. Many types of life insurance are available to protect a farmer's family, business, and/or creditors in the event this asset is lost because of premature death. Selection of the best life insurance is a difficult task, especially for the person who is familiar with the various types, form, and uses of life insurance. l./ Series prepared by A. Lines, Extension Economist, and J. Howell, D. Miller, W. Smith, and D. Moore, Area Farm Management Agents in the Department of Agricultural Economics and Rural Sociology, The Ohio State University, Columbus, Ohio.
2 -2- Types of Life Insurance There are basically two types of life insurance: (1) "protection only," commonly known as term insurance and (2) "protection plus investment," usually referred to as cash value insurance. Term Insurance Term insurance on a person is similar to fire insurance on a building; it is 100% protection against loss. If the building burns, the owner collects - if it doesn't, he doesn't. When a person covered by term insurance dies, the beneficiary collects. If the person doesn't die while covered, no one collects. Term contracts are written for a specified period and RO cash value is accumulated. Term: insurance is available in a variety of forms. Straight or level term is characterized by a constant face value, a constant premium, and a specified length of contract. Renewable term has a specified contract length (one, five, ten,. years), a constant face value, and a premium that increases each time the policy is renewed. With decreasing term -,. (also known as mortgage insurance) the premium is constant, the life of the contract is specified, but the coverage decreases each year from the initial amount at the beginning to zero at the end of the contract period. Each of these policies level, renewable,and decreasing is true term insurance in that no cash value is accumulated. Other variations of term insurance are available and for the most part attach some sort of savings program to the pure protection provided by the term policy. Convertible term may, as directed by the insured or automatically, convert to a cash value type of insurance. With deposit term the policy owner makes a one-time depisit with the company in addition to paying the annual premiums. If the policy is allowed to lapse in its early years the deposit
3 -3- is reduced by a given amount. If the policy is kept in force for a specified period of time, the deposit plus interest is returned to the owner. Family income insurance is a form of decreasing term coupled with a cash value policy that increases as the term decreases. Properly used term insurance can be a part of a sound insurance program. Misused it can create difficulty. The purpose of term insurance is to provide temporary protection. When used for this purpose it is a good buy. The most connnon wise uses of term insurance include: (1) to protect a business when unusually heavy financial obligations have been assumed, (2) to provide a fund for liquidation of a particular debt (i.e., mortgag~), (3) to provide adequate insurance when the most protection is needed and funds are not available to purchase higher priced cash value policies (i.e., young families), and (4) when the insured can successfully develop a consistent pattern of savings. Blindly purchasing term insurance because somebody said "you get the. most protection for the least cost" can be mistake for some people. They may not be able to force themselves or they may not have the opportunity to invest. Insurance may be needed for a longer period than was anticipated and may be unavailable because high cost or medical problems. For those who can afford it or for other reasons find term insurance an unacceptable solution to their needs, a variety of cash value policies are available. Cash Value Insurance Cash value policies combine protection and savings. A portion of the premium covers the cost of protection with the balance accumulating with interest. The accumulating portion of the premium is the "cash value" of ~ the policy. As might be expected, cash value policies are more expensive than term policies for comparable protection.
4 The cash value of a policy is available to the policy owner in either ~ of two ways: (1) "borrowing" against the policy or (2) terminating the contract. When the cash value is borrowed an interest rate, usually 4 to 6 percent, is charged. If a "loan" is outstanding when the insured dies, the a.mount of the loan is deducted from the face value of the policy before the beneficiary is paid. Even if the cash value isn't borrowed, the beneficiary will only receive the face value of the policy, not face value plus the cash value. The only way to get the cash value if terminate the policy while alive. There are two basic types of cash value policies -- whole life and endowment. Whole life is the only form of insurance that provides permanent protection; the insured is covered for life..with whole life the face a.mount of the policy is paid upon the death of the insured whenever that may occur. Endowment policies emphasize savings and coverage is only provided for a specified number of years. Whole life policies are available in different forms, based upon the way the premium is paid -- single premium, limited-payment premium, or continuous. The single premium plan, often referred to as paid-up life, requires a large one-time premium when the policy is purchased. -4- Limitedpayment policies require premium payment for a specified number of years. Some policies are for twenty years, others thirty, and others are paid up at age 65. Once "paid up," the insured is protected for life. The continuous-premium whole life policy, commonly known as ordinary or straight life, requires a premium each year until death occurs. There seems to be little reason for purchasing single or limitedpay life policies, except possibly for the "paid up at 65" type. Too many people are talked into purchasing this type of policy. They result in high premiums when a family is young and responsibilities are greatest
5 -5- and no premiums when earnings are highest and responsibilities fewest. For most people who decide not to use term insurance the ordinary life policy should be used since it combines the protection and saving features of term and endowment insurance. Pure endowment policies are rarely sold. They are pure savings and only pay off if the insured is alive at the end of the period. Most endowment policies are a combination of term, limited-pay, and pure endowment. If the insured lives to the end of the term, the face value of the policy is paid under the pure endowment. If, on the other hand, the insured dies during the term of the policy the face value is paid under the term portion of the policy. The insured can also select a limited-pay endowment where the premium payment period will shorten the endowment period. The face value at the end of the endowment period can be dispersed over a period of years or as a lump sum. Endowment policies create large savings and may be used as a retirement fund. However, a person's most important need is for death rather than survival protection. Young couples are often sold endowment insurance when they should purchase term or straight-life. The lure of a lump sum at the end of the endowment period often causes them to lose sight of the basic purpose of life insurance -- protection. Term or Cash Value: Which Is Best? There is no answer that is best for all situations. If there was, only one form of life insurance would be offered. For most people the decision will be between term and ordinary life. Term proponents state that by buying term insurance and prudently investing the difference (i.e., the difference ~ between the higher cost cash value and the lower cost term premiums) a person's total estate will grow larger than by buying any of the cash
6 -6- value insurances. Cash value proponents, on the other hand, state that most people will not invest the difference on their own. Consider the following points when buying insurance: (1) life insurance should be bought for protection, not as an investment, (2) life insurance should be bought only when you need it, not at an earlier age to obtain "lower" premiums, (3) in thinking about double-indemnity, remember that your family will need the same amount of money no matter how you die, (4) in accepting "pa.id up" or "extended term" options, you are likely paying unnecessary premiums in advance, and (5) remember the time value of money - a dollar today is worth more than a dollar tomorrow. Life Insurance and Estate Settlement Costs One of the main purposes of life insurance in estate planning is to generate liquidity - ready cash to pay estate settlement debts (Federal and Ohio Estate Truces, executor fees, attorney fees) and other obligations at your death. However if the proceeds of the insurance are included in the insured' s trucable estate, then estate settlement costs will be greater than if the proceeds are not included. How can it be arranged so that the proceeds are not included? First of all it should be recognized that there are three parties involved in every insurance contract in addition to the insurance company. These parties are: (1) the insured in the policy, (2) the owner of the policy, (3) the beneficiary of the policy. These may all be the same individual, or two or three distinct persons or entities. For estate settlement purposes it is important who those parties are. If the insured is also the owner of the policy or has any of the "incidents of ownership" then all the policy proceeds will be included in the insured' s ~ estate for federal estate trucpurposes. The "incidents of ownership" are
7 ~- ~ C -7- the rights to alter, assign, cancel, borrow against, or change the beneficiary of the policy. This is usually the case with "older" policies. It is. frequently the case with newer policies. If the insured's estate is the beneficiary of a policy or it is stipulated that the beneficiary use the proceeds to pay obligations of the estate, again as above, the policy proceeds will be included in the insured's estate for federal estate tax purposes. Furthermore, if the beneficiary uses policy proceeds to settle obligations of the estate (even though not stipulated to do so), the a.mount thus used will be included in the insured estate. To avoid this, the beneficiary can buy assets from the estate or loan money to the estate. Beneficiary designations can usually be changed at any time simply by writing to the issuing company. Ownership changes may be made by gifting the policy to someone else, ones spouse for example. If in gifting the insured gives up all "incidents of ownership" (and his estate is not the beneficiary and there is not a reversionary interest of more than 5%) then the policy will not be included in the insured's federal estate. The surrender value of the policy is considered to be the a.mount of the gift. The insured can continue to pay the premiums on the policy. However, it should be made clear that the premium amount is in fact also a gift to the "new" owner of the policy. Both the gift of a policy and its subsequent premiums are subject to gift transfer regulations.