Life Insurance Policy

A life insurance policy is probably the most well-known form of insurance, the most widely held, the most well-developed and the most flexible form of insurance. The history of life insurance dates back to the ancient Greek and Roman Empires around 600 BC although the concept of insurance dates as far back to the Babylonian Empire around 1750 BC. The modern form of life insurance developed in the US around the 1760s and today, as much 60% of Americans own a life insurance policy compared to about 30% of Britons and a global average of about 4%. The global life insurance market was worth about $2.7 trillion in 2017 compared to non-life insurance that was worth about $2.2 trillion in the same year.  A life insurance policy is a contract between a policyholder and an insurer, in which the insurer guarantees a policyholder that if they pay the agreed premiums when they are due, then, insurer will pay out a defined amount to a designated beneficiary upon the policyholder’s death [death benefit]. The purpose of life insurance is to provide peace of mind to the policyholder through an assurance that in the event of their death, their family or the persons that they care most about will inherit a sum of money that leave them in a good financial position. As such possession of a life insurance policy is not only a recognition of mortality but also provision for loved ones from the other side. In addition to its primary use as an inheritance, a life insurance policy also has other uses such as:

  1. Covering final costs such as: medical bills, estate administration costs and funeral expenses of the policyholder.
  2. Paying off mortgages, college debts and other debts.
  3. Replacing the deceased policyholder’s income.
  4. Off-setting estate taxes of the deceased policyholder’s estate.
  5. Donations to causes of importance to the deceased policyholder or their beneficiaries.
  6. To pay for business partners shares. In this case, life insurance policies are taken out against each partner in the business by mutual agreement so that in the event of the death of either of the partners, the surviving partners can make a claim and use the proceeds to pay for the deceased partners shares.

All life insurance policies are not created equal.

They can be remarkably different, but good policies some common features such as:

  1. Possibility for adding death cover for a spouse and children.
  2. Possibility for increasing coverage [upgrading the policy benefit].
  3. A terminal illness benefit paid out immediately after a terminal illness diagnosis of less than 12 months to live. A specific amount from the total death benefit is given to cover expenses during these final months.
  4. Advance payment immediately after death up to a certain maximum lump-sum. The rest will follow later after all the bureaucratic processes have been completed.
  5. Long-term care riders that allow one to draw some of their benefit for long-term care.
  6. Waiver of premiums in the event of serious illness or disablement.
  7. Provide dividends or some cash value back to the policy holder that they use to pay premiums and that way save them some money in monthly payments depending on the size of the dividend or cash value.
  8. Financial planning benefit for designated beneficiaries that have financial responsibilities for the family.

 

How much coverage?

It is important to determine just how much coverage will be reasonable for beneficiaries to continue living a good lifestyle. There are a number of factors that should inform this decision such as: expected future incomes given the rate of inflation, the desired standard of living, ages of the children and the need for school and college fees and the existing budget to pay for premiums.  Therefore one can apply the following formula and create a worksheet:

 

Total Insurance Coverage = Total current household income X the expected average inflation rate from now until the age of 90 + expected school and college expenses X duration + expected healthcare costs X duration + mortgage expenses X duration + total debts X duration + funeral expenses + Emergency needs.

It is possible to apply the net present value formula for each variable and then to add these to arrive at comprehensive estimates.

This formula results in a generous life insurance provision for surviving spouse or beneficiaries especially for later years in life. However, it is better to prepare well than to under-prepare.

Coverage can be on a whole life basis or on a term basis that is say for 5 years up to 30 years, for example, depending on the terms available from each insurer. Whole life insurance has higher premiums. Term life cover has lower premiums but these rise substantially with each term renewal.

Advantages

  1. Protects beneficiaries from financial distress
  2. Some policies have cash value that they accumulate which can be used to fund premiums.
  3. Loans can be borrowed from the life insurance policy. Insurance policy loans are tax-free. In general life insurance policies enjoy favourable taxation treatment.
  4. Loans can be borrowed from third parties and secured by a life insurance policy.
  5. The life insurance policy death benefit is tax-free.
  6. Life insurance policies are generally flexible in accommodating individual needs. For example, death benefits can be increased or decreased as needed.

Disadvantages

  1. Opportunity cost. The money used for insurance purposes could have been used to finance current needs and investments.
  2. The cash amounts paid out are usually smaller than the premiums that have been paid up to the point of cash surrender value payment. If the same premiums were paid into a self-managed investment fund over the same period of time that premiums were paid to an insurer, they are likely to return a significantly higher income than the death benefit.
  3. The process of acquiring a life insurance policy is cumbersome. Life insurance policies are poor investment vehicles. Therefore, one should only buy enough cover and then invest any excess funds elsewhere.
  4. Mis-selling of life insurance policy plans and mis-information about benefits and access to them leading to lack of trust in some insurers and the industry in general.
  5. It can be expensive for those that are in poor health and for those that are old. In some cases, a worthwhile life insurance policy may not be available for people in these two groups.
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