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Understanding Life Insurance
The Need for Life Insurance
Whatever an individual's circumstances, his needs can be determined by means of an insurance program analysis. The head of a family might analyze his insurance needs based on the following considerations:
Clean-up fund. The amount necessary to pay medical expenses, funeral costs, and large outstanding bills if he dies.
Readjustment income. The amount necessary to tide over his widow and children for a year or so while the widow adjusts herself to her new circumstances.
Family income. The amount that, in combination with any social security survivors' benefits or other funds, will adequately support the widow and her family until the youngest child reaches the age of 18.
Critical years income. An amount that will support the widow after her children are grown and she has lost social security benefits for survivors. This period will last until the widow reaches the age of 62, when she herself will probably be eligible for social security payments.
Old-age income. An amount that, with any social security old-age benefits, will give the widow an income for life.
Reserve fund. An amount to cover unusual expenses, such as a serious illness.
Special purpose funds. Amounts to cover such expenses as the cost of college education for the insured's children, whether or not he is living at the time they reach college age.
Retirement income. An amount that would supplement company pension benefits, social security, and other sources of income for the insured.
Relatively few men can afford enough insurance to meet all these objectives. However, a man may build up an insurance program by meeting one objective at a time, as his income and circumstances allow.
Women buy life insurance for the same reasons that men do. They want to protect their dependents and provide savings for retirement. Whether a wife contributes to the family income or not, insurance on her life can serve several important purposes if she dies. It can provide a clean-up fund for her medical and funeral expenses. It can also provide readjustment income to pay for household help for the children while their father is at work.
Types of Life Insurance and Annuities
Life insurance differs from other forms of insurance in that it covers a situation for which the question is when, not whether, it will occur. This is true both of the straight life insurance policy, which pays benefits upon the death of the policyholder, and of the various policies that provide income to the policyholder at an agreed-upon age or time. There are basically three kinds of life insurance: whole life insurance, term life insurance, and endowment insurance.
Whole Life Insurance. A policy that covers the policy-holder until his death is called whole Me insurance. There are several different ways that the holder can pay for this coverage. By taking out straight, or ordinary, life insurance, the insured agrees to pay a premium until he dies. When the insured dies, the face amount of the policy is paid to his survivors.
Some people do not like the idea of paying premiums throughout their lives. They prefer to pay more when they are younger and to discontinue premium payments after a certain number of years. This form of policy is called limited payment life insurance. Because the payments are limited, they are higher for limited payment life than for straight life insurance. Both, however, provide protection throughout the poli-cyholder's life.
Term Insurance. Term insurance gives only temporary protection. Benefits are paid only if the insured dies within the term specified in the policy. Protection and premiums cease at the end of this period. These terms extend from a year to as much as 20 years. Because term insurance, like fire or theft insurance, buys protection on a temporary basis, premiums are lower than for ordinary life insurance.
Term insurance is sometimes bought by persons who want to make sure that payments are completed on their home mortgages in case they die. Also, breadwinners with young children supplement whole life insurance policies with term insurance in what are known as family income policies. These policies increase protection in the years when the policyholder's death would impose a financial hardship on his family.
Endowment Insurance. Endowment insurance provides a protected form of savings plan. The purchaser sets a future date for payment of the face amount of the policy. On that date, payment is made to the insured. If he should die before then, the face amount is immediately payable to his beneficiary. Endowment insurance is often used to set aside money for the future, perhaps to finance a child's education or to provide retirement funds. When endowment insurance is used for retirement, the face amount is usually converted automatically to an annuity.
The term "annuity" means annual payment. An annuity provides that, in return for the payment of a sum of money, the insurance company guarantees a regular income to the insured for the rest of his life.
There is an important difference between life insurance and annuities. Life insurance provides protection to the breadwinner's family in case he dies prematurely. An annuity serves a somewhat different purpose. It provides income protection for the breadwinner himself if he outlives the years of his gainful employment.
A life insurance policyholder makes payments over a period of years until the death of the insured or the maturity of an endowment. Then the company pays him, or his beneficiary, a single sum or the equivalent in monthly installments. An annuity policyholder can either pay the insurance company a lump sum or pay in periodic installments over a number of years. In return, the company makes him periodic income payments as long as he lives.
Some people purchase annuities from the proceeds of a matured endowment or ordinary life insurance policy. Annuity payments can be scheduled to start immediately or, in a deferred annuity, in the future.
A straight life annuity pays a guaranteed income to an annuitant as long as he lives. Payments cease at his death. In the cases where death occurs soon after the annuity payments begin, the annuitant will lose a portion of his investment. But if he lives well beyond his statistical life expectation, his annuity payments will exceed the amount of his payments. The insurance company takes the principle of risk sharing into account when it sells annuities. Funds paid in by the annuitant who dies early help to pay the annuity for those who are long-lived.
For people who dislike this kind of risk sharing, insurance companies offer other types of annuities. They eliminate the possibility of losing a portion of the investment because of early death. The smaller the risk, however, the lower the annuity payments will be.
A cash refund annuity pays an income to the annuitant for life. If he dies before he has received as much as the amount he invested originally, the remainder is paid to his beneficiary in a lump sum.
A joint life and survivorship annuity is payable to one or even more survivors as long as they live. Such annuities are frequently purchased by couples in their later years. Two brothers or two sisters may also purchase this kind of annuity. After the death of one annuitant, payments continue to the other as long as he or she lives.
Variable annuities are a new Insurance development. Instead of guaranteeing a fixed income to the annuitant, the company pays a fluctuating income. It is based on how much interest and dividend income the insurance company receives on the invested annuity. In general, as the cost of living rises, the variable annuity income increases; when the cost of living falls, so does the variable annuity income.
Industrial Life Insurance. This special form of life insurance is designed for people whose incomes are low. It is sold in small amounts, usually of less than $1,000. Policyholders make premium payments on a weekly or monthly basis to agents who usually come directly to their homes.
Group Life Insurance. In group life insurance, one policy is issued to cover a group of people. The group normally consists of the employees of a business. A medical examination is not usually required for group contracts. The insurance company issues a master contract to the employer and gives each employee a certificate. The certificate shows the amount of Me insurance coverage the individual has and the person the employee has designated as his beneficiary. Many group plans have a conversion privilege, which allows an employee to change over from the group contract to an individual one when he leaves his employer.
Costs of group insurance are sometimes paid entirely by the employer. Sometimes the employees share some of the cost. If the company pays the full cost, the plan is noncontributory. If employees pay part of the cost, the plan is a contributory one. Group life insurance is often simply term insurance, but there are also many group annuities and pension plans.
Life Insurance Costs
In life insurance the risks of death and illness increase as the policyholder grows older. If the principle of payment according to risk were applied, an individual's premium payments would increase as he grew older. In many of the early life insurance contracts, this was true. However, this meant that older people paid the highest insurance costs just when they could least afford to do so. Level premium plans were therefore adopted, and today almost all insurance premiums are figured on this basis.
Level Premium System. Under the level premium system the policyholder pays the same premium for his insurance each year. The accompanying illustration shows the difference between unchanging level premium payments and constantly increasing payments incurred under a yearly renewable term insurance policy. Under the level premium plan the policyholder actually pays more in the earlier years of his contract than it costs the insurance company to protect him. The surplus payments that his insurance company receives become part of the company reserves. These are used to offset the increased cost of protection to the policy-holder in his later years.
Cash Value. Because the young policyholder is paying in more than the cost of insuring him, his life insurance policy on a level premium basis builds up a cash value. The longer a policy runs, the greater its cash value. This means that if the policyholder wants to terminate his insurance, he can surrender his policy and get back a sum of money that represents its cash surrender value.
Policy Loans. The cash value that has built up in a policy may be used by the policyholder in another way. If he should be unable to pay his premiums, he may borrow against the cash value of the policy. The policy then remains in force until its cash value has been exhausted. The policyholder must then repay the company, with interest, the sum he has borrowed or else allow his policy to lapse. Some policies have an automatic premium loan provision. If a policyholder misses a premium payment, the cash value of his policy will be automatically applied toward the premium, and his insurance will remain in force. Because term insurance premiums are based on the company's cost of insuring the policyholder, most termpolicies build up no cash value. Such policies, therefore, have no provisions for loans to their holders.
Calculation of a life insurance premium is a complicated procedure. Such calculations are usually made by specially trained persons known as actuaries. The three basic factors involved are death or mortality rates, interest rates, and company expenses.
Mortality Rates. Premium payments must be sufficiently large to pay the claims when policyholders die. The expected rates of death are worked out in mortality tables.
The mortality table most life insurance companies use is the Commissioners 1958 Standard Ordinary Mortality Table. Based on death statistics in the years 1950 to 1954, the table shows how many deaths per thousand can be expected at every age level from birthto age 100. From this table, life insurance companies estimate how many claims they will have to pay.
Investing Reserves. The reserves that life insurance companies accumulate are invested to earn interest. The interest lowers the amount that the company needs to charge in premiums to meet death claims. Because the interest is calculated on a compound basis, the premium costs are brought down even more.
Expenses and Contingencies. Insurance companies must pay salaries and other costs of running a business. They must also protect themselves from the possibility that death rates may actually exceed the expected rates and that interest rates on investments will be lower than expected. Consequently, an amount to cover both expenses and contingencies is included in premium calculations.
Life Insurance Glossary
Beneficiary. The person named in the policy who receives the insurance proceeds when the policyholder dies.
disability clause. A provision that if the policyholder becomes disabled before a specified age, his policy continues in force without the payment of premiums. This is sometimes known as a waiver-of-premium clause.
Double Indemnity. A clause stating that if death is accidental, the company will pay double the face amount of the policy to the survivors.
Grace Period. The period, usually one month, following the due date of a premium, during which the premium may be paid. The policy remains in force during the grace period.
Incontestable Clause. A guarantee that after a period of one or two years the company will not dispute claims made under the policy. It will, however, adjust the benefits paid under a policy if it finds that the insured has falsified his age.
Nonforfeiture Provisions. Clauses allowing the policy-holder to borrow against his policy or to surrender it for cash if he is unable to continue his premium payments. He may also choose to obtain term insurance instead of taking the cash value of his policy. Another of these provisions allows the policyholder to use the cash value of his policy to obtain a reduced amount of insurance for the rest of his life without making further payments.
Optional Modes of Settlement. Choices available to the policyholder of the way he wants benefits paid to himself or to his survivors.
Reinstatement. Reactivating a policy that the insured has allowed to lapse. If the policyholder meets the company's requirements for reinstatement, he then pays back premiums plus interest charges.
Suicide Clause. A provision that the company will not pay insurance benefits if death is caused by suicide within the first year or two of the policy.