“Whole life insurance” terminology is used to designate the policy that provides protection for the “whole of life.” There are two types of whole life policies:
1. ordinary life, where the premiums are paid throughout the insured’s lifetime, or
2. limited-payment life where premiums are to be paid only during a specified period of time (20-pay life, etc.)
The reason for there being a difference is simply because many life insurance policies are purchased with the insured not intending to pay the premiums for the rest of his life or, for whatever reason; he only wants to pay premiums for a certain number of years. Another reason could be that because of dividends, premiums will only be payable for a period shorter than the life expectancy of the insured. For retirement purposes, life insurance is often purchased to provide protection until retirement, at which time the policy will be surrendered and an annuity purchased. There are many other reasons, but the point is that life insurance should be viewed, not as a policy that absorbs premiums and provides death benefits for the lifetime of the insured, but as an extremely flexible plan that provides the maximum protection for the lowest premium and which can be adjusted to meet the changing needs of the insured regardless of how long he may live.
There are many forms of life insurance, as this text describes, but basically, the ordinary life insurance is the most basic of all of the policies and is the most popular product. There is no doubt that an ordinary life insurance can not only provide the foundation for a financial or estate planning program, it can serve as the entire program in many cases.
The ordinary life insurance policy is comprised of several basic and highly important features.
Ordinary life insurance provides permanent protection—it never has to be renewed or converted and the length of the protection does not expire. As long as the policyowner continues to pay the premiums, the protection will remain in force. This particular feature is so important that many years ago agents often called it “permanent insurance.” This is so important because nearly everyone will need protection against premature death as long as they live, some more so than others.
In some ways, ordinary life insurance is really endowment-to-age-100, i.e. the face amount of the policy is a matured endowment if the insured lives to age 100, and pays the face amount of the policy whether the insured lives to age 100, or not. Actually, some companies will offer an “endowment to age 95” in lieu of an ordinary life insurance policy. Amazing that so many people will buy an endowment to age 95 instead of an ordinary life insurance policy…
The ordinary life insurance policy has also been described as a level premium term to 100, provided that the assumption would be that all insureds that live to age 99 would die before their 100th birthday.
Think about it (if you haven’t already)—since the premiums for an ordinary life insurance policy assumes that the premiums will be payable throughout the lifetime of the insured, the lowest premiums are therefore, produced. When premiums are calculated, the actuarial assumptions produce a net single premium, which is the base premium for a life insurance policy, and these assumptions do not include the manner in which the periodic premiums are to be paid. Also, at each age the net single premium is the same for ordinary life insurance and any form of limited-payment life insurance. Of course, the longer the period over which the single-sum payment is spread, the lower each payment will be.
The net annual level premium (simply put, which does not take expenses and other costs into consideration, but is the simple cost of death at that particular age plus interest on the accrued premium) of an ordinary life insurance policy would, of course, be less than the net annual level premium for a 20-pay life issued at the same age. Limited payment insurance policies justify the higher premiums by providing certain benefits, such as, principally, the lifetime protection but premium payments are limited to, for instance, 20 years.
However, if the objective of the insured is to be provided with the maximum benefits of permanent protection at the lowest premium-dollar-per-dollar-of-protection, then the ordinary life insurance contract best serves the insured.
As explained earlier, an ordinary life insurance policy accumulates a reserve, such reserve eventually equaling the face amount of the policy. For limited payment plans, the reserves are higher that those of ordinary life because they must equal the face amount much earlier. However, all things considered, ordinary life still produces the most combined benefits of protection and savings.
The cash value accumulated under an ordinary life insurance policy can be used as surrender values, paid-up insurance, or extended term insurance. Generally, cash values are not available during the first couple of years of insurance because of the insurer’s cost of putting the business on the books—administrative cost and commissions— except, of course, for single-premium policies and some other limited-pay policies, in which case the first year premiums are high enough to exceed the first-year expenses to create the policy and still maintain the policy reserves.
As this text goes more deeply into variable products, the success of variable products has been because of the low interest rate credited on cash values of whole life insurance products—typically, 3 to 5 percent, during a time of increasing return on other investments. The reason that the companies have kept this guaranteed rate so low is that companies are required by law to invest in conservative investments, government bonds, etc, so the insurer must earn a rate that they can guarantee regardless of economic fluctuations.
The cash value of a life insurance policy serves as collateral for a policy loan in the same way a house serves as collateral for a mortgage loan. Therefore, in order to borrow $1,000, there must be at least that much cash value in the policy. Actually, there must be slightly more because, typically, a 100% loan is prohibited in order to protect the insurance company. The policyowner could borrow nearly 100% of the cash value, but a small portion would be deducted, equal to one year's interest. For example, if the policyowner wants to borrow the full cash value of $1,000 and the interest rate for the loan is 8%, the insurer will keep 8% of $1,000 or $80 and lend the balance of $920.
As described in a later section, Variable life policies typically restrict the amount that may be borrowed to an amount less than 100% of the value of the separate account.
The low interest rate traditionally charged for policy loans is one of the features that have made such loans attractive, with a 4% to 6% fixed rate being common in the past. With the overall interest rates at the lowest in many years, it is still attractive, provided the insurers keep their interest rates “in the ball-park” of other commercial loans. In any event, they will probably always be much lower than credit card loans (debt) and that would make these very attractive to many of today’s consumers. Variable interest rates are also available, tied to a financial indicator such as the rate on U.S. Treasury bills or Moody's long-term bond rate. When a variable rate applies, the policy specifies when the insurer will adjust the rate, such as on the first day of each calendar quarter.
Direct recognition is the immediate consideration of present interest rates, mortality experience, and expenses in premiums currently charged. This is critical to the formulation of Current Assumption Whole Life and Universal Life products.
Under the Direct Recognition principle, a policy loan can have a significant negative impact on dividends paid under participating policies. When determining the dividend to be paid on a particular policy, companies that use direct recognition take into account the interest rate the insurer earns on the loan and the dividend interest rate the company has assumed it would have earned on the cash value if part of it had not been borrowed. The difference reduces the dividend.
Insurers believe direct recognition is a fairer proposition for all policyowners because it rewards those who do not borrow money. Under this arrangement, non-borrowers "earn" the higher dividend because all cash value is left with the insurer for earning purposes. Borrowers receive a smaller dividend because not all of their cash value is available to the insurer to earn interest.
As detailed later in this text, for Universal and Variable life policies, insurers might pay a lower interest rate on the borrowed portion of cash value that is serving as collateral for a loan. That is, the typically higher current interest rate is paid on cash values that are not collateral and a lower rate, often the guaranteed rate, is paid on the portion borrowed. Additionally, Universal Life policy loans might be "wash loans" with the interest charged on the loan canceling out the interest paid on the cash value that serves as collateral.
Policies other than Universal and Variable life also have arrangements for paying a lower rate on loaned cash values. Some companies, for example, pay 1% less on the loaned values than on the remainder of the cash value.
Because borrowing cash values represents a loan, repayment is expected, even though the loan need never be repaid. The policyowner may continue paying interest on the loan indefinitely. The negative consequences for not repaying loans from cash values include:
If a policy is about to lapse because of outstanding loans and/or interest due, the insurance company must notify the policyowner in time to repay the loan or make premium payments to keep the policy in force.
The reinstatement clause allows the policyowner to reinstate a policy that had lapsed, under certain requirements. The most important requirement is to furnish evidence of insurability and pay past-due premiums.
“Evidence of Insurability” is required by the company to prevent adverse selection. Otherwise, it would be common for an individual to allow a policy to lapse, and then discover that it would be for their benefit to keep the policy in force (they have just been diagnosed with a fatal disease, for example). The insured is required to furnish evidence of insurability that is satisfactory to the company. While good health is the usual requirement, the company may also require information on the travels of the insured, occupation, financial condition, etc. An example frequently used is of an insured that is in prison and sentenced to the gas chamber. He might be in good health now…
What is interesting about this provision is its relationship to the incontestable clause. If a policy is reinstated, what happens? Does the incontestable period start all over again? While laws are really not very clear on this matter, the general practice is that the incontestable clause is also reinstated, making the policy contestable again but only to statements made in the reinstatement application. While other jurisdictions state that the original incontestable clause is still in effect (period dated from policy date), there are a few jurisdictions that take the view that the reinstatement (itself) is a separate contract that has no incontestable period. Fair? Hardly, because this also means that the policy can be contested for fraud at any time.
For the Suicide Clause, courts have been almost unanimous in holding that the suicide clause does not run again.
In respect to past-due premiums, there is a legitimate argument that there should be no premiums due for past mortality charges as no coverage was provided during the lapse period. Therefore, some jurisdictions limit the past-due premium to the increase in reserves between the time of lapse and reinstatement.
Incidentally, reinstatement is not permitted if the policy has been surrendered (or continued as extended term insurance) and the full term of the policy has expired. If the extended term portion has not expired, most companies will reinstate the policy with little or no evidence of insurability. Regardless, reinstatement seldom is allowed if more than 5 years has elapsed since the policy lapsed.
The nonforfeiture provision is applicable only to life insurance policies with cash values (although there are other types of insurance that may have this provision, such as some Long Term Care Insurance policies). This provision outlines the options that are available for the insured to collect the cash value if the policy is terminated. It also explains the method that is used to determine these options.
“Nonforfeiture” gets its name as, historically, early insurance policies had no cash values, so any excess premium paid after mortality and expense charges were deducted, was “forfeited.” This is not allowed in the United States and insurers must comply with the Standard Nonforfeiture Laws, which also require the policy to state what mortality table is used and the interest rate in calculating the nonforfeiture values. A table in each cash-value policy is required that shows the cash surrender values and other nonforfeiture options for the first 20 years. (Nonforfeiture options are discussed later in the text)
These laws set forth the situations under which a life insurance policy must have nonforfeiture values and they also stipulate the minimum required values and effectively, require that all policies that collect more than mortality and expense charges and provide nonforfeiture values. It should also be pointed out that the stated interest rate for nonforfeiture values is not the “rate of return” of the policy. Universal Life and Current Assumption Life policies are different, as cash values are derived using the so-called retrospective approach.
The differences between the prospective method of determining cash values for traditional policies, and the retrospective method used for UL and Current Assumption products, is quite technical and beyond the scope of this text. It is mentioned here as a note of interest. When actuaries were trying to develop an insurance policy wherein the cash value accumulation could compete with other non-insurance products, the Standard Nonforfeiture Laws would prove to be a major stumbling block. Finally, at an international reinsurance meeting in Monte Carlo, through the genius of American actuaries and a German actuary meeting privately, this retrospective method was developed and the Universal Life insurance policy was “invented.”
Since the cash value in the policy belongs to the policyowner, they will not be forfeited even if the policyowner is not able to pay the premiums. Therefore, the policy offers options as to how to how the policyowner can receive the cash values.
The policyowner may receive the cash surrender value of the policy. This involves withdrawing the entire cash value and surrendering or terminating the policy. The insurance company deducts any outstanding loans, interest on loans and unpaid premium before paying the cash value to the policyowner.
Cash value policies include tables showing the cash surrender value for every year the policy is in force, which is the basis for the amount due the policyowner. However, Universal life policies have only a minimum cash value guarantee and a Variable policy has no guarantee at all. These policies might include an illustration of potential cash values based upon assumed rates, but, unlike the tables in traditional policies, there is no guarantee that those potential values will be available at any given time.
Another nonforfeiture option is to use the cash value to buy paid-up insurance. This provides a reduced amount cash value life insurance for which the policyowner never pays another premium. The paid-up policy is the same type of insurance as the basic policy from which the cash value is being used. No riders or other provisions added to the original policy are included. Cash values accumulate in the paid-up policy and the policy earns interest. If the original was a participating policy, the paid-up policy will also earn dividends.
The amount of the death benefit for the paid-up policy depends upon how much coverage the cash value will buy. Any outstanding loans and interest are deducted first and the insured’s attained age is used to determine the cost. Administrative expenses will be small because it costs insurers very little to provide a paid-up policy from cash values.
The policyowner may use cash values to purchase extended term insurance. In this case, the death benefit is the same as the original policy (unless a loan is outstanding) and the "extended term" is the number of years and days of coverage that can be purchased with the available cash value at the insured's attained age. Policies that have guaranteed cash values include a table showing how long the term will be, based upon these factors.
If there is an unpaid policy loan, the insurance company deducts the amount of the loan and any interest due from both the cash value and the death benefit amount before determining the length of the extended term. For example, if the original policy has a $100,000 death benefit, a cash value of $20,000 and an outstanding loan with interest of $5,575, then the death benefit of the extended term policy will be $94,425 and the cash value used to purchase the policy will be $14,425.
The outstanding amounts are deducted from both the cash value and the death benefit to protect the insurance company. If the insured should die soon after opting for the extended term insurance and before repaying the policy loan, the insurer would have lost the loan amount completely since there is no longer any cash value as collateral. If a policyowner simply stops paying premiums and does not choose a nonforfeiture option, insurers automatically set up the extended term insurance unless the policy also includes the automatic premium loan provision described earlier. This nonforfeiture option provides the most insurance protection for the cash value available.
A recently popular use of surrender values is to apply the surrender values to the purchase of an annuity or retirement income. If the policy does not give the insured the right to take the cash value in a life-income method, the insurer will allow the insured to do so upon request.
The reason for the popularity is that many persons purchase life insurance for protection during the child-rearing ages, and after the “chicks have left the nest,” they start planning for retirement. Life insurance is the perfect vehicle for this. As a general rule, the cash value of an ordinary life insurance policy that was purchased at age 25 will be about 50%-60% of the face amount at age 65, at age 35 it would be somewhere around 40% to 55%. Therefore, if the insured is 35 when he purchases a life insurance policy with a face amount of $50,000, the cash value at age 65 would be approximately $25,000, which would produce a life income amount of approximately $150 per month. OK, this may not sound like much, but when this is added to the Social Security benefits and any other retirement benefits (such as from an employer), it could be quite attractive. In today’s world (and in tomorrow’s), $100,000 is not be really a lot of money, but it could produce as much as $300 a month at age 65.
Some care should be exercised when approaching this retirement feature with a prospective insured, as the individual may feel that by taking the cash value at age 65 would in some way, interrupt the program. In some cases, this would be true, particularly if the life insurance program was intended to provide protection at the older ages. Of course, the cash value could be taken later if the situation changes—more proof of the flexibility and the value of ordinary life insurance.
The right to convert to another form of insurance in another flexible feature of ordinary life insurance, and the policy will contain a provision allowing the insured to exchange the policy for another type of policy, usually under certain conditions. Even if the policy does not specifically address this privilege, an exchange can usually be negotiated with the insurance company, and the conversion is nearly always permitted without evidence of insurability if the new policy calls for a larger premium.
Conversely, most companies will not allow a higher-premium policy to be exchanged for a lower-premium policy without evidence of insurability. There really are two reasons for this:
Conversely, if the insured is converting to a higher premium policy, the net amount at risk will be reduced more rapidly and the problem of adverse selection disappears.
The ordinary life insurance policy is the lowest-premium form of fixed premium permanent insurance so it can be converted to other forms of permanent insurance without evidence of insurability. This adds to the attractiveness of the policy for those who want a more-limited term and higher premium policy, but cannot afford it at that point in time. Ordinary life is superior to level premium term insurance in these situations, as if the financial status of the insured does not improve as desired, the insured still has the protection plus a modest cash surrender value, but if the conversion is ultimately completed, there will be little in the way of a financial adjustment.
Originally, dividends were issued by mutual insurance companies but in later years, dividends became more popular so now even stock companies offer participating policies. The US Supreme Court, years ago, rules that “dividends” paid on a participating life insurance policy is simply a return of the overpayment of premiums. Why, then, did companies not only continue to offer them, stock companies also offer dividends? There can be several reasons, one offered by many agents is that since the larger insurers were mutual companies, they advertised and marketed so aggressively that the general public interested in life insurance policies, would look for dividends, and would compare dividend returns in determining what policy to purchase.
During the 60’s and 70’s, many new life insurance companies were started that offered high dividends, such amounts to be “determined by the Board of Directors”. These “dividends” were offered on “special” policies, and were supposedly based upon the profits of the company. There probably are many of these old policies still in force, although most of them have either been dropped or cashed out, but in any event, they are now illegal because of the way that they were misrepresented by the agents.
Today, insurers offer dividends as it allows the insurer to maintain a stronger contingency margin and they still can adjust the cost downward after a period of coverage has been evaluated. The policyowner dividends are based upon the favorable experience of the company, such as higher than expected investment returns, or lower loss ratios or lower expense ratios.
These dividends are declared annually, with investment results accounting for the largest portion of the dividends. The amount cannot be guaranteed and it is illegal for an agent to present projections of future dividends as if they were guaranteed or certain (as the old “special policy” salesmen routinely did). Not advertised widely is the fact that dividends have been reduced during the 1990s.
Dividend options may be chosen by the policyholder, and the choices are:
The principal difference between “Current Assumption” policies and participating policies is that the participating policies are adjusted according to past experience of the insurance company, while the current assumption policies are adjusted according to anticipated experience of the insurance company. In affect, they discount in advance for expected favorable results.
Note: Do not confuse the current assumption policies with Current Assumption Whole Life policies, which are a variation of the whole life policy. See discussion in the following chapter.
With a limited payment whole life policy, the policy remains in full force for the “whole of life” but premiums are paid for a limited period of time only. After that point, the policy becomes fully paid-up. For definition purposes, a policy matures when the face amount is payable, usually at death. A policy expires when the term of the policy expires and there is no benefits payable, such as in term insurance.
Premiums for these types of policy are typically 10, 15, 20 or 30 year, or to age 65 or similar age. Because the premiums for these types of policies are (comparatively) high, there is not much demand in the individual life insurance market, however, limited payment policies can be used in business situations where it is important that the policy be paid-up within a certain time frame.
Single premium whole life policies are those whole life policies where, as the name implies, the entire premium for the life of the policy is paid from inception with a single payment. As one can imagine, the cash value of the single premium policy is substantial from the date of the policy. Because of the high premiums, these policies are not frequently sold but are used for special situations.
The joint life insurance policy is simply a life insurance policy that is written on more than one life, and is often called the “first-to-die” joint life policy. There are similar policies written on two lives and if benefits are paid upon the death of the second person, then it is a “second-to-die” policy, but it is much better known as a “survivorship” policy. These policies are often used to fund federal estate taxes of wealthy couples where their Wills are constructed so that they make maximum use of tax deferrals at the first death. Joint life policies are also used for funding business buy-sell agreements.
Actually, joint life insurance policies can cover two to as many as twelve lives, but because of the expense and the administrative headaches, most companies limit the policies to 3 or 4 individuals. Some companies will issue insurance on more lives if they have a related business interest. Generally, the policies are either ordinary life, limited pay life, or under a Universal Life policy. Rarely are they written on a term basis as the separate term policies could cost more than a joint policy and the ordinary life, limited pay or UL would offer protection to survivor(s).
The premiums is usually larger than the combined premiums on separate policies that provides an equivalent amount of insurance—the premium for $200,000 coverage on two lives is larger than the combined premiums for two $100,000 policies. The reason is that the joint policy will pay $200,000 upon the death of the first to die, but under the two-policy format, they would only pay $100,000 upon the death of the first to die. Besides, a joint life policy costs less than two separate policies with half of the benefits.
The joint life policies offer conversion to single-life policies on separate lives if the conversion is on the same plan as that of the joint policies and the conversion is the result of divorce or dissolution of a business; or conversion by dividing the amount of insurance among the insured lives (equally or unequally); and dating the new policies as of the original date of issue of the joint policy.
Business partners or stockholders in a closely held corporation often use these policies. A problem that could arise in these cases is that since the insurance usually terminates upon the first death of the partner or stockholder, the remaining members of the firm may not only be without insurance, their health may be so that they cannot become insured.
However, some insurers have special joint life policies designed for buy-sell funding, some offering a short period of extended coverage for the surviving partners or shareholder, and further, they guarantee their insurability under a new joint life policy much like the previous one. Some offer joint life policies that allow uneven allocations of death benefits to coincide with the unequal ownership interests.
While joint life policies are sometimes offered to husband-and-wife jointly, especially if there is going to be a need for funds upon the first to die, such as for death taxes, the problem of the survivor losing insurance coverage under the policy can cause problems.
STUDY QUESTIONS
1. The most popular form of life insurance is
A. ordinary life insurance
B. term insurance.
C. Universal Life insurance.
D. endowment policies.
2. The most important feature of whole life insurance is
A. it is the cheapest type of life insurance for the purchaser.
B. it provides permanent protection.
C. that cash values are provided for the first year that are equal to the premium.
D. that premiums are paid for a minimum of 20 years before they endow.
3. The cash values accumulated under an ordinary life insurance policy can be used as
A. surrender values only.
B. paid-up insurance only.
C. extended term insurance only.
D. surrender values, paid-up insurance or extended term insurance.
4. When a policyowner applies for a policy loan, the collateral for the loan
A. is waived.
B. is the cash value of the life insurance policy.
C. is the separate account and subaccounts.
D. is the face value of the policy.
5. The immediate consideration of present interest rates, mortality experience and expenses in current premiums, therefore a policy loan can have a significant negative impact on dividends paid under a participating policy; this is called
A. direct recognition.
B. value-assumed consideration.
C. the net amount at risk.
D. the formulation of the cash value.
6. In reinstating a life insurance policy, the most important requirements are to pay the past-due premiums and
A. produce evidence of insurability.
B. to use the cash value to purchase a higher face amount policy.
C. to pay the agent first-year commissions on the reinstatement.
D. the waiving of pre-existing conditions.
7. The nonforfeiture provisions applies only to life insurance policies
A. written by a mutual company.
B. with a face amount (death benefit) of less than $1 million.
C. written in California, Texas and Florida.
D. with cash values.
8. Many purchase life insurance policies for protection during the child-rearing ages, and afterwards
A. the policy is voided.
B. the insured must provide evidence of insurability to continue the policy.
C. the cash value may be used to purchase an annuity for retirement.
D. the policy may be returned to the insurer for a full premium refund.
9. When dividends are declared by a mutual company, the largest portion of the dividends is a result of
A. investments of the insurer.
B. mortality experience of the insurer.
C. state requirement as exactly how much dividend must be provided.
D. the reduction of expenses through the contesting of claims.
10. Joint-life policies that provide coverage for several persons are usually
A. provided to a large family.
B. provided to business partners or stockholders in a closely-held corporation.
C. written only by mutual companies.
D. are guaranteed issue as they closely resemble group insurance.
ANSWERS TO STUDY QUESTIONS
1A 2B 3D 4B 5A 6A 7D 8C 9A 10B