Premiums and Death Benefit

To better understand individual life insurance products, a number of basic elements must first be explained. Two of the most primary of these elements are premiums and death benefit.

The premiums are what the policyholder will pay the insurance company to keep the plan in force and the death benefit is what the company will pay the beneficiary at the death of the insured.

Several assumptions determine why a plan provides a certain death benefit and costs what it does, or what the relationship is between premiums and the death benefit. They include assumed mortality, assumed interest and assumed expenses.

Assumed Mortality

Assumed mortality is an estimate of when a policyholder is likely to die and is based primarily on age, but it can be influenced by health. Mortality tables, covering large cross sections of people in varying degrees of health, different occupations and multiple lifestyles, have been developed to help insurance companies determine the average number of people of any given age who will die within a certain year.

Mortality assumptions are critical to life insurance because they are used to predict the premium amount and how long it must be paid. An 80 year old man will annually pay more than a 25 year old with the same policy and same death benefit, based on the estimated number of premium-paying years.

Assumed Interest

Assumed interest, the second element, is an estimate of how much a company will earn on the money it receives from policyholders. Insurers do not just hold the premiums, they put that money to work in their investment portfolio. This provides assistance to policyholders because the interest earned from invested premiums is used to offset the actual cost of their coverage.

For example, an insurer may calculate that it would need approximately $300 annually to provide a $150,000 death benefit for a 30 year old woman. If the company assumes premium payments will earn 5 percent interest over the insured’s lifetime, they need to charge a premium that’s equal to the gross amount of $300 minus the earnings from the 5 percent yield.

Assumed Expense

Assumed expense, the final factor, refers to the amount of money that will be spent to get a policy into the hands of the policyholder. These costs include such items as commissions, underwriting expenses, salaries for company employees, state insurance filing fees and product development costs. Although it varies from plan to plan, it may take six years or more before premium payments and earnings above those credited to policyholders outweigh the initial expenses.

Again, variations of premiums and death benefit are what make up the different types of products offered by life insurance carriers. To back up your responsibility of recommending suitable plans to fit policyholders’ wants and needs, it becomes a necessity for you to understand the range of products available.

Term Insurance

The simplest form of life coverage, term insurance, is no more than a combination of premiums and a death benefit. The name is descriptive since the span of coverage lasts only a specified period of time. If the insured dies during the term, the death benefit will be paid to the designated beneficiary.

Term insurance has the advantage of providing the largest amount of coverage for the lowest amount of premium because it’s pure protection, providing a death benefit and nothing else. The major disadvantage of this type of plan is its temporary nature. It offers a death benefit for only a limited period of time.

Two basic types of term life insurance are level term and decreasing term.

With level term insurance, the face amount (death benefit) remains level during the full duration of the policy. At the end of the policy’s specified period of time it may be continued for a following term, depending on how it’s written. The following diagram illustrates a $50,000 ten year level term life policy. 

Level Term

Decreasing Term

With decreasing term insurance, the face amount and not the premium is reduced over the time period and at the end, no coverage remains. This plan easily provides coverage for a decreasing debt, such as a mortgage. This diagram clearly illustrates a $50,000 ten year decreasing term policy. 

There are different types of term plans, but they all fall within the above basic types.

Some term insurance plans have valuable features built into the policy or have options that can be added for extra premium.

Renewable term policies can be re-started at the end of their time period without providing proof of insurability. This is extremely valuable since it truly “insures insurability.”

Higher premiums must be paid after a policy is renewed because the insured is older and represents a greater risk to the company. To keep premiums at a reasonable level, term policies are renewable only for a certain number of times or until a specified age.

An additional feature allows a term policy to be converted to a permanent form of coverage sometime before it expires, whether or not the policyholder is insurable. Premiums for plans with this convertible feature will be higher than those without it. Please note that plans with the convertible feature do not allow the insured to eliminate it from the contract for a premium reduction.

Whole Life Insurance

Let’s move on now from temporary protection to a permanent form of coverage entitled whole life. As we discuss this coverage, we will also add the element of cash value to premiums and death benefits.

Level Premium

The concept of a level premium creates the cash build-up of whole life by keeping the amount of the premium the same throughout the term of the contract. The level premium is deliberately higher than the required risk charges in the early years. This cash excess and the interest it earns makes it possible for the insurer to build up a reserve that will be needed to help pay premiums in the later years of the contract, when the insured is older and more likely to die. In other words, the reserve established in the early years makes it possible to keep the premium level in later years when the cost might otherwise become prohibitive.

Cash Value

The cash value created by the reserve not only makes the contract affordable, it also provides what is known as a “living benefits.” Policyholders may take advantage of the funds when they are still alive, borrowing the funds at a reasonable rate of interest or making periodic withdrawals to supplement retirement income. This is all while the policy remains in force to provide a future death benefit.

A special advantage of cash value is that it will accumulate interest earnings without taxes being charged to the policyholder. Taxes are payable only when the funds are withdrawn, and then only on the difference between the cash value withdrawn and the amount of premiums paid to date.

Whole life’s cash value can also be used to keep the coverage in force if the policyholder inadvertently misses a premium payment. A provision of most whole life plans authorizes the company to automatically pay the premium by borrowing against the cash value if the premium remains unpaid following the due date. Thus, important life coverage will remain in place.

Traditional whole life premiums remain level for the entire term of the contract, usually to the insured’s age 100. The cash value starts at zero and increases to equal the face amount at maturity, which could be between age 96 and 103, depending on the plan and insured’s sex.

The following diagram of a $50,000 policy illustrates several whole life concepts. 

As with term insurance, there are several different types of whole life plans.

Modified Whole Life

This variation is issued with a level premium that’s lower than the normal whole life rate for the first few years (usually the first five), then is immediately stepped up to a level premium that’s higher than normal. The rate is only slightly more than term during those first few years, making the initial purchase of permanent coverage attractive to prospects who currently have limited finances but expect to have more funds in the future.

Graded Premium Whole Life

With this variation, premiums start out and remain lower than normal whole life rates for a period of time following issue (usually the first ten years). Following this, premiums increase gradually over a number of years until it becomes level. Like modified whole life, the insured ends up paying the equivalent average of traditional whole life premiums.

Limited Pay Policies

These policies are similar to traditional whole life except premiums are payable for only a limited period of time such as 15 years, 20 years, 30 years, to age 65 or in a single installment. Since the shortened period increases the payment size, a greater percentage of the premium is credited to cash value which in turn, accelerates the build up. The appeal for limited pay policies as opposed to traditional whole life comes from the reduced payment period as well as the more rapid accumulation of cash.

Like any insurance plan, the selection of a traditional or a modified whole life plan depends on the particular wants and financial situation of the prospect. The appeal of cash value plans, offering funds for loans, education or retirement, must be weighed against the higher premium needed to keep the policy in force.

Universal Life

Universal life insurance is a variation of whole life that offers a great deal of flexibility to the policyholder. Premium payments may be varied, death benefit levels may be changed (within limits) and cash value may be accessed either through loans or direct withdrawals.

With universal life, payment of the first year’s minimum premium is the only requirement. Premiums may be reduced or skipped following the end of the first year, but the policy will remain in force as long as there is enough value remaining in the contract to cover monthly mortality and administrative charges.

How It Works

Premiums paid by the policyholder are first charged a “load” which is a fee that includes company expenses and commissions. The remainder of the premium goes into the policy’s accumulation account where mortality charges and in some cases, additional administration expenses, are deducted monthly. Any premium above the mortality and administration fees is credited a “current” rate of interest. The flexibility of

the plan allows for additional contributions in excess of the regular premium that will substantially increase cash value.

The current rate of interest applied to the cash value account is substantially greater than the interest rate associated with traditional whole life policies. As with whole life, the earnings are tax deferred until withdrawn by the policyholder.

Level and Increasing Death Benefits

There are two different types of death benefits and the plan’s flexibility allows these to be changed at the discretion of the policyholder.

The level death benefit remains at a stated amount throughout most of the policy’s lifetime, similar to whole life. It’s made up of the increasing cash value plus the decreasing amount at risk (the pure insurance portion).

The increasing death benefit grows over the life of the policy, combining the increasing cash value and a level amount at risk (equal to the original face amount).

Here’s an example of how these two death benefits work:

■ A 35 year old insured purchases a $100,000 universal life policy with a level death benefit. If the insured were to die in 20 years and no changes had been made to the policy, the named beneficiary would receive $100,000.

■ If that same 35 year old purchased a $100,000 universal life policy with an increasing death benefit, the outcome would be different if death occurred at age 55. The named beneficiary would receive the $100,000 death benefit plus the total of the cash value that had accumulated in 20 years.

A key point to remember is that a level death benefit may not remain level. Because the death benefit is made up of both cash value and “pure insurance” (the amount at risk), the cash value proportion of the fund will increase as the policy grows older. However,-since the policy must always include an amount at risk to legally qualify as insurance, it may be necessary to increase the death benefit as the cash value approaches the level of the face amount. Because of the numerous adjustments and options that are available, a universal life policy can be adapted to a lifetime of changing needs. A single policy can be modified numerous times to fit almost any situation, making the plan extremely popular in both family and business markets.

Term/Whole Life Combinations

Beyond the basic plans, there are numerous types of insurance products designed to fit specific needs. The most common of these are combination policies which are nothing more than a base plan of whole life with a decreasing term rider attached (riders are optional policy additions that will be discussed later).

 Combination policies are advantageous because of the larger death benefit payable if the insured dies within the period of the attached term rider. There are different combinations. Either level or decreasing term may be used. The term period may be of different lengths of time, cash may be paid out in increments for monthly income, base plans with greater or lesser cash value may be used and different levels of coverage may be applied to the key income producer, spouse or children.

 A combination policy, $50,000 of whole life with a $10,000 twenty year decreasing term plan attached (both purchased at age 40), is shown below.

Non-Traditional Policies

Consumer demands, as well as life insurance usage in sophisticated markets have given rise to permanent products outside the definition of traditional whole life. Briefly, here are a few of these plans.

Variable Life Insurance

This product has all the characteristics of traditional whole life, except in the area of risk. The insurer assumes the investment risk with traditional whole life, which means the company bears the loss if investment performance is less than what's needed to fund the contract (if performance is better, the difference is added to company profit).

With variable life however, investment risk is not borne by the company; both investment gains and losses will be passed through to the contract holder.

Because the contract holder assumes the investment risk, variable life is considered to be a security that's subject to federal and state securities regulations along with state insurance regulations. Those who sell the products must be dually licensed, having both a state life insurance license and licenses to sell securities as well.

Adjustable Life Insurance

Adjustable life insurance can best be described as a whole life policy with changeable features. Premiums may be decreased or increased or the face amount may be increased (subject to insurability) or decreased at the request of the policyholder. Premium increases could lengthen the period of coverage or shorten the premium payment period. Decreasing premium reduces future cash value, shortens the protection period or lengthens the payment period.

Variable Universal Life

This plan combines the characteristics of traditional universal life and variable life insurance. The variable universal life contract holder assumes the risk like variable life insurance, accepting both the gains and losses from investment experience. Variable universal life's specifications equal those of the traditional product in most respects. Those wishing to market the product must be dually licensed as well.

Riders

Riders are optional coverages that can be attached to life insurance policies. Some riders add more coverage for specific occurrences or provide benefits to meet special individual, family or business needs. Most riders require additional premium payment and all are limited by age to the extent of their coverage (they will go out of force before the policy does).

 Here’s a brief review of some of the more important riders:

■ Permits the policyholder, at stipulated intervals, to buy additional amounts of coverage without evidence of insurability.

■ Permits waiving of premium payments if the insured is totally disabled after a specified waiting period of usually three to six months.

■ Provides that the premium on a child’s life policy will be waived if the policy owner dies or becomes totally disabled.

■ If death occurs from some totally accidental cause, this rider will pay an additional amount usually equal to the face amount of the base policy.

Exact specifications of each rider are found on contract pages added to the base policy. It should be noted that all riders are not available with all plans. Availability varying among insurers.

Annuities

Although marketed by life insurance carriers, annuities do not offer a death benefit payment. It cannot be technically called a life insurance product. An annuity in its basic form is nothing more than an accumulation of a sum of money followed by its distribution, usually through periodic payments that could last a lifetime.

Most annuities accumulate funds through deposits made by the annuitant over a period of time, but a lump sum payment could be made if the payout of funds is to begin at once. Compound interest is applied to these deposits but the earnings are not currently taxed, which is an important reason why people buy annuities.

As noted above, annuities are different from life insurance. If the annuitant dies during the period when funds are being accumulated, a named beneficiary will receive the total deposits and interest earnings to date, less any previous withdrawals.

An annuity’s distribution or payout following the accumulation period can take a number of forms, depending on the needs of the annuitant. Lifetime income, payments for a specified period of time, periodic payments of a specified amount, income continuing to survivors or a lump sum payment are all available options.

Taxation of Annuities

Federal income tax laws view annuity distributions as a combination of deposits and interest that the deposits have earned. Taxes are charged only on that portion of the payment considered to be interest, excluding the remainder from gross income. These are deferred taxes since they become due when the payment is received, not at the time the interest is being earned.

Fixed Annuities

There are two general categories of annuities, fixed and variable. Under the fixed annuity, there are several types:

■ Single Premium Immediate Annuity - One lump sum payment is made into the plan and the periodic payout begins immediately.

■ Single Premium Deferred Annuity - The premium is paid all at once and the payout will not begin until a designated later date.

■ Flexible Payment Annuity - A plan purchased by a series of installments for a specified number of years or to a certain age.

Variable Annuities

Variable annuities pass investment risk on to the annuity owner and do not guarantee the level of distributions. Payments may fluctuate in relation to the earnings and market value of the invested assets. Like variable life and Variable Universal Life, special licenses are need to market this product.

The popularity of annuities has increased in recent years due to their tax-favored status and guaranteed interest rates. They should not be overlooked in your life marketing efforts.

Disability Insurance

Disability insurance is another coverage that falls outside the definition of term or whole life. Disability or disability income insurance is designed to replace a significant part of an insured’s earned income when he or she is totally and permanently disabled by injury or sickness.

The basic disability insurance policy contains a number of common elements that help describe the coverage.

■ Definition of Disability - The policy defines the extent of the disability that is necessary before benefits begin. It may require that the insured be unable to perform the duties of any occupation or the duties of his/her usual occupation.

■ Partial Disability - The policy may provide coverage and benefits for partial disability if the insured is able to perform some of his/her job duties.

■ Occupational Classification - What the insured does for a living will determine the premiums they will pay or if he/she are even insurable.

■ Renewal Provisions - Policies are classified by the way in which they may be renewed, such as cancelable or optionally renewable, guaranteed renewable or non-cancelable and guaranteed renewable.

■ Amount of Benefit - The benefits available from disability are usually limited to a percentage of the insured’s salaries or wages.

■ Elimination Period — A specified period of time following the start of the disability when benefits are not payable. This helps exclude claims for short-term disabilities and helps hold down the cost of coverage.

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