Cost of Life Insurance CPA s Perspective

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1 Cost of Life Insurance CPA s Perspective Karim Dhanani Grambling State University, College of Business, Jacob T. Stewart, Grambling, LA Fax kdhananicpa@gmail.com Melissa Aldredge Grambling State University, College of Business, Jacob T. Stewart, Grambling, LA Fax aldredgem@gram.edu ABSTRACT The nation s economic growth and stability is becoming increasingly volatile. As a result, many individuals have taken a hard look at their finances and the choices they are making with respect to providing adequate insurance coverage for themselves and their families. This paper s focus is to explore the different types of life insurance available and provide insight into the critical issue of how insurance companies determine the cost. Practicing financial consultants and Certified Public Accountants can use the study to explain the advantages and disadvantages of different types of insurance as well as answer the question why do rates differ? Key words: Life insurance, insurance premiums, term insurance, permanent insurance INTRODUCTION Life insurance helps to ensure that your family and loved ones are protected against financial difficulties in the event of a premature death. Combined with investments, retirement and estate planning, life insurance is a fundamental part of a sound financial plan. The insurance premiums that we pay differ from individual to individual depending on a number of factors. The purpose of this article is to explain how insurance companies determine the cost of insurance. DIFFERENT TYPES OF INSURANACE This section gives you basic information about various types of life insurance. There are many kinds of life insurance, but they generally fall into two categories: term insurance and permanent insurance. 1

2 Term Insurance Term insurance provides protection for a specific period of time. The policy does not build up and provides only a death benefit. It usually appeals to parents with small children who won t be able to replace their income if they die before their children are grown. Most term insurance policies offered by major life insurance companies can be renewed when one reaches the end of the term. One, five or ten-year policy periods are the most common. Most term insurance is renewable until age 80. A major disadvantage of term insurance is that premium rates increase at each renewal date. There are several types of term insurance: Renewable Term Insurance These policies have a provision allowing you to renew coverage at the end of the term without having to show evidence of insurability. The company has to renew your policy even if your medical condition has deteriorated. However, the premium rate will rise with each renewal. Convertible Term Insurance These policies allow you to convert your term coverage into a permanent policy without providing evidence of insurability. Premiums for convertible policies are usually higher than premiums for nonconvertible policies. In addition, once converted, the premium for the permanent coverage is higher than the premium for the term policy with the same death benefit. The advantage however, is that while term premiums always rise; permanent policy premiums remain the same. Level Term Insurance These policies provide a fixed premium for a certain number of years, usually 10 or 20 years, while the death benefit remains unchanged. The death benefit is the amount the life insurance company will pay, as stated in the policy, when the insured person dies. The advantage is that you lock in a stable rate for the period of the policy. The disadvantage is that these premiums tend to cost more than premiums in the early years of a renewable policy. Also, when the level policy expires, premium rates will jump considerably if you want to renew with another level policy. Decreasing Term Insurance In a decreasing term policy, the premium does not change over the term of the policy. In this type of policy, the death benefit decreases. For example, you might start with $100,000 of coverage and the amount of coverage decreases by $10,000 each year for 10 years. This type of insurance allows you to pay the same premium for less insurance over time, rather than have your premium increase for the same amount of insurance. In most cases, Decreasing Term Insurance is purchased to cancel a debt such as a mortgage. Increasing Term Insurance This kind of policy starts with one level of death benefit, which gradually increases over the life of the policy. Normally, Increasing Term Insurance is purchased as a rider on another insurance policy. You may start, for example, with a $100,000 policy and increase the death benefit $10,000 each year for 10 years. The increase is tied to a specific amount of insurance on the main policy. The increase could also be tied to an index such as cost of living or Consumer Price Index. The premium will increase each year as one gets older. 2

3 This kind of policy may be appropriate if you anticipate your insurance needs growing in coming years. For example, if you expect to have more children, incur more debt, or need more insurance to cover estate taxes. Advantages Initial premiums generally are lower than those for permanent insurance, allowing you to buy higher levels of coverage at a younger age when the need for protection often is greatest. It is good for covering needs that will disappear in time, such as mortgages or car loans. Disadvantages Premiums increase as you grow older. Coverage may terminate at the end of the term or become too expensive to continue. The policy generally does not offer cash value or paid-up insurance. Permanent Insurance Permanent insurance provides lifelong protection as long as you pay the premium. These policies include not only a death benefit, but a savings or investment feature as well. They are designed to last for the policyholder s lifetime. Older consumers often buy these policies for estate-planning purposes. These policies are designed and priced for you to keep over a long period of time. Permanent policies are known by a variety of names: whole, ordinary, universal, adjustable, and variable life. Most of these policies have a cash value or cash-surrender value feature. This feature, not found in most term insurance policies, provides you with some options: You can cancel or surrender the policy in total or in part and receive the cash value as a lump sum. If you surrender your policy in the early years, there may be little or no cash value or you may have to pay a surrender penalty. If you need to stop paying premiums, you can use the accumulated cash value to continue your current insurance protection for a specified time or to provide a lesser amount of protection covering you for your lifetime. You usually can borrow from the insurance company, using the cash value in your life insurance as collateral. Unlike loans from most financial institutions, the loan is not dependent on credit checks or other restrictions. However, you ultimately must repay the loan with interest or your beneficiaries will receive a reduced death benefit. With all types of permanent policies, the cash value of a policy is different from the policy s face amount. The face amount is the money that will be paid at death or policy maturity. Cash value is the amount available if you surrender the policy before its maturity or your death. Moreover, the cash value may be affected by your insurance company s financial results or experience, which can be influenced by mortality rates, expenses, and investment earnings. 3

4 There are several types of permanent insurance: Whole life or ordinary life is the most common type of permanent insurance. The premiums generally remain constant over the life of the policy and must be paid periodically in the amount indicated in the policy. The premiums are based on the rate of interest fixed by the insurance company, which is usually 3%. Under whole life insurance, premiums would be higher if the market rate of interest is higher than the stated rate of interest given by insurance companies. The interest rate is fixed irrespective of market conditions. Adjustable life insurance premiums are recalculated at set time periods, typically every five years, to reflect current interest rates. While five years is the most common readjustment period, some policies may be based on three or even ten years. Universal life allows you, after your initial payment, to pay premiums at any time, in virtually any amount, subject to certain minimums and maximums. You also can reduce or increase the death benefit more easily than under a traditional whole life policy. The premiums are based upon the market rate of interest. The premiums would be lower if the market rate of interest is higher than the fixed rate of interest given by whole life. On the other hand, if the market rate of interest were lower, the premiums would be higher. The interest rate fluctuates from year to year. Variable life provides death benefits and cash values that vary with the performance of a portfolio of investments. You can allocate your premiums among a variety of investments offering different degrees of risk and reward. For example, you can invest in stocks, bonds, combinations of both, or accounts that guarantee interest and principal. You will receive a prospectus in conjunction with the sale of this product. The cash value of a variable life policy is not guaranteed and the policyholder bears that risk. However, by choosing among the available fund options, you can allocate assets to meet your objectives and risk tolerance. Good investment performance will lead to higher cash values and death benefits. If the specified investments perform poorly, cash values and death benefits will drop. Some policies guarantee that death benefits cannot fall below a minimum level. There are both universal life and whole life versions of variable life. Advantages Disadvantages As long as the premiums are paid, protection is guaranteed for life. Premium costs can be fixed or flexible to meet personal financial needs. The policy accumulates a cash value against which you can borrow. You can borrow against the policy s cash value to pay premiums or use the cash value to provide paid-up insurance. The policy s cash value can be surrendered, in total or in part, for cash. It can also be converted into an annuity. (An annuity is an insurance product that provides an income for a person s lifetime or a specific period.) A provision or rider can be added to a policy that gives you the option to purchase additional insurance without taking a medical exam or having to furnish evidence of insurability. Required premium levels may make it hard to buy enough protection. It may be more costly than term insurance if you do not keep it long enough. 4

5 People invest in life insurance mainly for the following reasons: Insurance creates financial provisions for the deceased s dependants. Insurance provides additional income for the policyholder as he ages and his earning power diminishes. Insurance also provides a legally authorized way to reduce the incidence of income tax. WHY INSURANCE RATES DIFFER Varying age levels: insurance premiums depend on age. Because the life expectancy rate is high at a younger age, insurance premiums are lower. Rates increase as you get older because of mortality. The following table shows expectation of life by age. Life Table for the Total Population: United States, 2000 Age Expectation Age Expectation Age Expectation life at age X life at age X life at age X years and over

6 Varying risk factors: the company s perceived risk affects premiums. In the risk classification process, the company takes the following factors into consideration; Current medical findings Medical history Use of tobacco and nicotine Family history High blood pressure and cholesterol. Weight Habits with respect to alcohol and drugs Personal and business reputation Motor vehicle record Insurable interest Finances Occupation Hazardous activities Foreign residence and recent immigration Military status Aviation activities Depending on these factors and combinations thereof, persons are classified as either preferred risk, non smoker, select standard, standard, substandard or uninsurable. A premium is charged based on the level of risk. Higher risk leads to higher premiums. Varying claims experience: Since each company has had different claims experiences with the groups of people they insure, the rates charged customers by different companies vary. Varying costs of doing business: Each company s cost of doing business, along with their financial goals, is different, resulting in different prices being charged to customers. Longer life spans and medical advances are prompting life insurers to lower rates for older Americans. At The Hartford Financial Services Group, for one, rates for Americans 70 and older have fallen 5% to 20% this year (2008). According to Census Bureau estimates, the 70-plus age group will more than double, from about 26 million last year to 57 million by the year REFERENCES National Vital Statistics Report, Life Expectancy Tables, October 2001, Vol. 49, No 12. 6