Life Insurance in General
Life insurance has long been the mainstay of the individual life and health insurance industry. Individual life insurance comes in a variety of forms, including whole life, term, universal, and variable life insurance. (Scaringi Financial does not offer variable products). Additional benefits can be added through benefit riders to customize a policy to better meet the owner’s needs. Life insurance has a range of uses in both the personal and business markets.
Whole Life (Permanent) Insurance
Whole life insurance has been the flagship product of the life insurance industry for many years. It offers the strongest guarantees under any life insurance product and has certain characteristics that are generally not found in other types of life insurance:
- Level death benefit—The death benefit remains level for the life of the policy and is guaranteed to be in force at the insured’s death, assuming the timely payment of premiums.
- Guaranteed cash value—Whole life insurance builds guaranteed cash value, which can be accessed via loans, partial surrenders, and withdrawals for such things as retirement income.
- Endows at a limiting age—At the insured’s age 120 the life insurance policy endows for its face amount and the policyowner collects the face amount of the policy even though the insured is still alive.
Term life insurance is designed to last for a specific time-period, known as the “term” period. Term insurance comes in several different types, each of which serves a specific purpose. Term life insurance can be standalone life insurance, or it can be provided as a rider on other policies. The following are typical term life insurance characteristics:
- Builds NO cash value.
- Provides coverage for a specified term of years or to a specified age (i.e., one year, five years, ten years, to age 65, etc.). If the insured dies during the term period, the death benefit is paid to a beneficiary. If the insured survives the term period, the term insurance terminates without further value (like your auto insurance).
- May be renewable at the end of the term; however, the premium will increase to reflect the insured’s attained age. Such term insurance is referred to as “renewable term insurance.”
- May be convertible—that is, can be exchanged for a permanent life insurance policy without proof of insurability. Such term insurance is referred to as “convertible term insurance.” This is an important feature to lock in, because as you become older, your insurability may decline.
- May be continued for a renewal term at a lower premium by submitting acceptable proof of insurability (a “re-entry” provision).
Universal Life Insurance
Universal life insurance is an adjustable, flexible premium form of life insurance that accumulates cash values on which interest is credited at current interest rates. A policyowner can increase or decrease the death benefit without buying a new policy. If the death benefit is increased, then the owner may have to prove insurability. Universal life policies generally have a “back-end load,” which is in the form of surrender charges for early withdrawal or surrender. Universal life insurance cash values are affected principally by:
- Premiums paid
- Insurer expenses deducted from the cash value
- Cost of insurance (COI) deducted from the cash value
- Interest credited to the cash value
Uses of Life Insurance
Life insurance can be used in a variety of situations by both individuals and businesses.
Personal Uses of Life Insurance
Life insurance is purchased to offset the financial consequences following the death of the insured person. People buy personal life insurance most often to protect survivors against the loss of income the insured’s death causes. Survivors—who are usually family members—are typically the named beneficiaries of a life insurance policy. Often, they need the instant money from a death benefit to meet their immediate and long-term financial needs.
Common needs that survivors face and that life insurance can provide include:
- Providing family members with income to meet daily living expenses
- Retiring a mortgage on the survivor’s home so the family can remain in the home
- Setting up an education fund for the children of the deceased
- Paying off existing debts to avoid depletion of the estate from payment of debts
- Paying death expenses, such as medical and funeral costs
Using Life Insurance to Create an Estate
Life insurance is often described as a financial vehicle that can “create an instant estate.” Upon the death of the insured, a specified sum of money is automatically and immediately made available to the named beneficiary. That sum of money is paid, tax free, directly to a named beneficiary or the insured’s estate (although it is usually a good idea to not name your estate as beneficiary since it could create taxable situations). Moreover, the sum can be used for any purpose. If the proceeds are paid to the insured’s estate or named executor, the money can:
- Be applied to cover the costs or taxes the estate may face upon death
- Provide an inheritance for heirs named in a will
- Be used to make a charitable donation or gift
Using Life Insurance to Preserve an Estate
Life insurance is also a great way to protect an estate for many people who have substantial assets. A policy’s death benefit removes the need to sell assets to pay estate taxes, inheritance taxes, other costs, or debts the estate may face upon a person’s death. In this way, life insurance conserves the estate, which would otherwise have to be liquidated to pay these expenses. It allows the estate to be passed on intact to the deceased’s heirs.
Using Life Insurance to Save and Accumulate Cash
As permanent life insurance policies mature they accumulate cash value and interest (and possibly dividends) paid on the cash. The risk of investment of the funds is on the insurance company, and not the individual, as would be the case with market-based investments. The longer the whole life insurance policy stays in force, the greater its cash value. At all times, this cash value is available to the policyowner through a policy loan, withdrawal, or surrender. You can use the cash value however you want.
For example, the policyowner typically uses the cash value to:
- Pay for a child’s college education
- Supplement his or her income during the retirement years
- Serve as a source of funds in an emergency
- Save for retirement, retirement, or vacations
These are the “living benefits” to permanent life insurance ownership.
Using Life Insurance for Liquidity
Liquidity in any investment refers to how easy and inexpensive it is to convert the investment into cash. A life insurance policy with a cash accumulation feature has important liquidity options. For example, many policies allow the policyowner to take out loans or to make withdrawals.
Using Life Insurance for Financial Security
For individuals and their families, life insurance provides financial security. Knowing that one’s finances can meet any challenge the future might bring is priceless. No matter what type of life insurance a person chooses, what he or she is really buying is financial security and peace of mind. The main wage earner who buys insurance on his or her life finds peace of mind in knowing that surviving family members are taken care of in the event of his death. Likewise, the professional who builds cash value in a policy to use at retirement feels protected from financial disaster at a time when he or she can no longer work.
While life insurance is often thought of only in connection with meeting personal financial needs, a great deal of life insurance is bought to meet the needs of businesses. When life insurance is purchased to meet business needs, it is generally used to provide funds to:
- Enable business owners to meet the financial obligation arising from their contractual agreement to purchase a deceased partner’s or co-owner’s business interest under a buy-sell agreement
- Compensate a business upon the loss, through death, of an important employee (i.e., one considered a key employee)
- Enable a business to meet its contractual obligations under a deferred compensation arrangement
- Retire outstanding corporate debt upon the death of a majority business owner
- Permit an executive to meet personal life insurance needs
Personal Life Insurance Needs
Although life insurance has a wide range of uses, life insurance is purchased to meet personal, nonbusiness needs primarily when others are dependent on the insured for their financial well-being. The life insurance death benefit provides funds to meet the financial needs of survivors when an insured person dies. Although various methods have been used to estimate the amount of life insurance needed by family survivors, the most effective method is known as the needs approach. The financial needs faced by survivors upon the death of an insured person—typically a family breadwinner—normally fall into two categories:
- Lump-sum cash needs
- Income needs
Lump-Sum Cash Needs
The death of a breadwinner normally causes a significant financial vacuum that must be filled in one of two ways:
- Assets the family accumulated during the breadwinner’s lifetime or
- Life insurance.
The lump-sum cash needs that typically must be met upon the death of a breadwinner include:
- • Immediate cash needs for payment of:
- burial and final medical expenses
- estate administration costs
- federal and state taxes
- Funds to pay off debt
- An emergency fund to provide funds for unexpected expenses
- A mortgage redemption fund
- Funds to provide for dependent care if needed
- Funds to pay for survivors’ education
Immediate Cash Needs
Surviving family members may immediately need funds to pay for burial and final medical expenses. While final medical expenses may be impossible to determine beforehand, burial expenses often range from $5,000 to $12,000. A decedent’s estate must also be probated and settled. Estate administration costs normally include:
- Probate court costs that usually average about 5 percent of the value of funds distributed by the decedent’s will or state intestacy laws
- Attorneys’ and accountants’ fees
- Commissions to real estate agents, auctioneers, etc., for the sale of estate assets
- Executor’s fees
- Inheritance taxes or estate taxes
In Pennsylvania, beneficiaries of an estate will owe inheritance taxes, at varying tax rates depending on the relationship of the beneficiary to the deceased, which can be paid by the estate if the estate has sufficient liquid funds to do so. Federal estate taxes are normally significant only in the case of estates exceeding the applicable estate tax unified credit. In 2017, that amount was $5.49 million. However, when the estate exceeds this amount, the federal estate tax on the excess amount may approach 40 percent. Having a life insurance policy in place can alleviate the burden on the estate to pay this tax from possibly non-liquid assets within the estate, such as business or farm assets.
The decedent’s debts become the liability of the decedent’s estate when he or she dies. Accordingly, such debts may significantly reduce the assets available to surviving family members to enable them to maintain their lifestyles. Because of the adverse effects on the surviving family members’ financial status, existing debts need to be retired. Among the outstanding debts that normally need to be paid are:
- Auto loans
- Education loans
- Credit card balances
- Unpaid notes
The purpose of creating an emergency fund upon the death of a breadwinner is to replace some of the financial flexibility that may have been available during the breadwinner’s lifetime. Generally, individuals are advised to set aside six months of income in an emergency fund. An emergency fund typically is used to provide funds for:
- Paying for medical emergencies
- Replacing major appliances when required
- Financing home or automobile repairs
- Periodically replacing a family vehicle
Mortgage Redemption Fund
A mortgage redemption fund is a fund equal in value to the outstanding mortgage balance on the family home or, in the event the family rents a home, an amount equal to approximately ten years of rent payments.
Dependent Care Fund
Immediate cash needs normally include funds required to provide dependent care for young children or aged family members. Determining the amount of funds needed for this purpose is relatively simple and is usually equal to the current cost required to provide those services multiplied by the number of years until the child no longer requires such care. Determining the amount required in the case of aged family members who are dependent upon the decedent is more difficult but may be estimated based on the dependent’s life expectancy.
Many breadwinners plan to pay for their children’s college education. To ensure that sufficient funds are available should they die before a child completes his or her schooling, it is important to establish an education fund. While the cost of education can vary significantly among public and private colleges, and from community college to state universities, insurance planners often suggest a minimum amount be set aside equal to $20,000 to $25,000 annually for each child.
Survivors’ Income Needs
In an addition to these significant lump-sum needs, surviving family members often face a significant decline in family income. The income that the breadwinner once earned must now be provided, in whole or in part, by invested assets and other sources of income. Surviving family members typically need additional income during three specific time periods to replace the income that’s been lost:
- A dependency period, during which young children are at home and Social Security may be providing income benefits (A typical American family will experience fluctuating income based on occupation and changes in the family. Because a surviving spouse may have children to care for, the income needs will generally be greater during this period.)
- A blackout period, during which any Social Security income benefits provided during the dependency period have ceased
- A surviving spouse’s retirement period, during which a surviving spouse again begins to receive Social Security benefits at age 60 and continues until he or she dies
Business Uses of Life Insurance
The principal uses of insurance in a business include providing:
- Funds to implement the purchase of a deceased or disabled business owner’s interest
- For nonqualified plans
- For key executive insurance coverage designed to compensate the business on the death or disability of a key executive
Let’s briefly examine these business uses of life and disability insurance.
A principal use of life insurance in a business situation is to provide funds to implement the purchase or other disposition of a business interest upon the death of a sole proprietor, partner, or stockholder. This may mean selling the business, keeping the business interest in the family, or liquidating the business because continuation of the operation is no longer practical. The decision on how this is to be accomplished should be made at the time the business is formed. The best way to ensure an orderly continuation of a business in the event of the death or disability of an owner or partner is with a buy-sell agreement. The agreement to sell and purchase the business interest when the event triggering the transaction occurs—the owner’s death or disability, in other words—is a legally binding contract that requires the estate of the deceased business owner or the disabled business owner to sell the business interest and the surviving business owners to purchase it.
The agreement establishes a price for the business interest by specifying the price or by providing a formula by which to determine it. The agreement usually references any life insurance or disability insurance designed to provide the cash with which to implement the purchase of the deceased or disabled owner’s business interest.
Types of Buy-Sell Agreements
There are two basic types of buy-sell agreements: a cross purchase plan and an entity plan. (An entity plan buy-sell agreement used in a corporation is referred to as a stock redemption plan.)
- Cross-Purchase Plan – In a cross-purchase plan, each business owner agrees to purchase the business interest of the other business owners upon the occurrence of the triggering event (i.e., death or disability). Under this plan, the partners or stockholders each buy insurance on the other partners or stockholders to provide the funds that each will need to buy his or her part of the deceased or disabled owner’s interest in the business. The number of policies required to fund a cross purchase buy-sell agreement is equal to n(n −1) in which n is the number of owners. Thus, a funded buy-sell agreement covering a partnership with three partners would require six policies. A four-person partnership would require 12 policies, and so on.
- Entity Plan – In an entity plan the business entity, rather than the business owners, agrees to buy the deceased or disabled business owner’s share of the business. Accordingly, the partnership or corporation buys one insurance policy on each of the owners. The policies are owned and premiums are paid by the business. When an owner dies, the insurance benefits are paid to the business, which in turn uses the funds to buy the deceased or disabled owner’s interest.
Nonqualified Benefit Plans
Nonqualified benefit plans enable an employer to provide certain employees, including stockholder/employees, with additional selective benefits while providing no comparable benefits to other employees. Nonqualified plans are designed to attract and retain highly valued employees and may be used to tie a valuable employee more closely to the company. Unlike qualified plans—pension plans, profit-sharing plans, etc.—that permit an employer to deduct amounts contributed, amounts paid by the employer are not tax deductible. Nonqualified plans do not require government approval or reporting under ERISA.
The principal nonqualified benefit plans include:
- Executive bonus plans
- Supplemental executive retirement plans
- Split dollar plans
- Group carve-out plans
Executive Bonus Plans
Executive bonus plans are incentive plans under which an employer pays the premiums for permanent life insurance owned by the covered executive. The employee pays income tax on the bonus, and the amount paid by the employer is deductible as compensation paid to the executive. When the covered executive dies, the benefits are paid to the named beneficiary who receives the proceeds income tax free. The life insurance policy funding the executive bonus plan is often used by the executive to provide supplemental tax-free retirement income.
Supplemental Executive Retirement Plans
A supplemental executive retirement plan (SERP) is a nonqualified plan under which an employer agrees to provide specified supplemental benefits to a valued executive. Those supplemental benefits normally include:
- Retirement income in addition to any retirement benefits under the employer’s qualified plan
- Survivor benefits payable to the executive’s family if the executive dies while employed by the employer
- Disability benefits if the executive becomes disabled before retirement
- In return for the employer’s promise to provide those benefits, the executive agrees to remain with the employer until retirement or for the duration of a specified period. If the executive leaves the employer’s service before the specified date, no benefits are payable.
To ensure that funds are available to pay the benefits for which the employer becomes liable under the SERP, the employer typically purchases sufficient permanent life insurance and, if disability benefits are provided under the plan, a disability income policy. The life (and, possibly, disability) insurance is owned by the employer who pays the premiums and is its beneficiary. Premium payments are not tax deductible, and the employer generally receives any benefits tax free. When the triggering event occurs—the executive’s retirement, death, or disability—the insurance benefits are available to make the employer’s required tax-deductible benefit payments. SERPs often enable employers to recover all costs of the plan when the death benefits exceed the funds needed to pay the plan benefits.
Split Dollar Plans
A split dollar plan is an arrangement under which a permanent life insurance policy is bought on the life of a valued executive. The premiums are “split” between the employer and the executive. The purpose is to allow the executive to buy additional life insurance at less cost than if it were bought individually. Upon the executive’s death, the employer receives a portion of the death benefit in an amount that equals the premiums it paid. The executive’s beneficiary receives the remainder of the death benefit. In a common split dollar arrangement known as a “traditional” split dollar plan, the employer pays a premium amount equal to the increase in cash value for the year in which the premium is paid.
Group Carve-Out Plans
A group carve-out plan is a nonqualified plan under which the amount of an employer’s group term life insurance coverage in excess of $50,000 is replaced by permanent life insurance coverage provided under an individual life insurance policy—often through universal life insurance—that the participating executive owns. The employer pays an amount of premium toward the policy that is generally equal to the amount it would have paid for the group term life insurance coverage that exceeds $50,000, and it deducts the amount as compensation. The covered executive must include the amount paid as income for tax purposes. The principal benefits of a group carve-out plan are the portability of the coverage if the executive changes jobs or retires and the possible build-up of cash value.
Key Executive Insurance
In a key executive life or disability insurance plan, an employer insures a key executive to compensate itself if the executive dies or becomes disabled. The employer pays the premiums and is the beneficiary of the coverage. The executive plays no role in the coverage other than acting as the insured and receives no benefit. The purpose of key executive insurance is solely to protect the employer. The employer’s premium payment for the life and disability insurance is not tax deductible, but benefits, when received, are normally entirely tax free.