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Life Insurance and Annuities
Introduction
Even at its most basic, the subject of life insurance and annuities is complex. There are so many variations and assumptions involved that even an avid student will soon have glazed eyes and a numb mind. Furthermore, the insurance industry is constantly inventing complicated “new” products. Nonetheless, most of us will have the need or desire to purchase and rely on some kind of life insurance product, so it is advantageous to have at least a basic knowledge of the subject. In fact, the more you know, the better you can ask questions and relate relevant information so that you can eventually purchase the right product from the right company to meet your needs.
Steps to Take
First, take the time to know what kind of company you want to have as your insurer. Each type has its advantages and disadvantages. There are primarily three types of life insurance companies:
· Mutual: Many years ago virtually all insurance companies were mutual companies, but there are not many left. These companies tend to be run conservatively, but are limited in the amount of capital they can raise. The policyholders own the companies, and profits and premium excesses are returned to policyholders in the form of dividends or lower premiums. These dividends may be used to purchase additional insurance or pay part or all of future premiums. Not as a recommendation, but as an example, mutual firms currently include New York Life, Northwestern, Mass Mutual and State Farm Life.
· Publicly owned: The shares of these companies are traded on various stock exchanges. The primary purpose of these companies is to make a profit for their shareholders. Profits accrue to the shareholders, not the policyholders. However, some publicly owned insurers do pay some dividends to their policyholders. The managers of these companies may choose to take risk or take short-term oriented decisions in an effort to immediately increase shareholder profits, so they are often run less conservatively than the mutual companies. Access to public money allows these companies to sometimes raise critical assets on short notice. Many companies have converted from mutual companies to publicly owned companies because of the high capital requirements required in the industry. Not as a recommendation, but as an example, publicly owned companies include Hartford Life, MetLife, John Hancock, and MONY. Many publicly owned companies are primarily owned and located in countries other than the U.S., which may add another level of potential risk to their U.S. policyholders.
· Privately owned: These companies are owned by one or more individuals or companies. Their primary purpose is to make a profit for their owners. There are not many of these companies left and they are usually small.
Second, understand how you want to purchase your insurance. If you choose to use an agent, get recommendations from friends, family, or other reliable sources, and make sure that the agent is qualified to meet your needs. If you are not completely satisfied with the agent, find another one! Some of the more common ways to buy insurance are:
· Through an agent of a particular company. The agent will likely have excellent knowledge of that company’s products, be able to make some comparisons to a few other companies’ products, and will be able to provide information on that company. The agent will be paid a commission by that company. Some financial advisors act in this capacity.
· Through an independent agent or an agent that sells products for several companies. This type of agent will possibly have more widespread, but less specific knowledge, and will be paid a commission by the company whose policy is purchased. Some financial advisors act in this capacity.
· Through a fee-only insurance planner. One of these might be useful to review all of your insurance needs.
· Over the internet or through the mail. Keeps the insurance company costs to a minimum, but inhibits the client’s ability to have sufficient information to make an informed decision.
Third, understand that the fundamentals for pricing insurance and annuities are true for all companies. Prices for policies and services vary from company to company based on their assessments and requirements concerning these fundamentals. However, the specifics as they apply to each policy are mind-bogglingly complex, and so it is almost impossible for most of us to adequately compare policies and pricing.
· An insurance company must make a profit over a period of time or it will go out of business. The federal government typically does not guarantee insurance products (although a number of states do provide some protection). If the company that issues your policy goes out of business, you may find that the policy you own is worthless or will take many years to collect upon. Therefore, the financial quality of the company is of primary concern! Be careful that a policy isn’t priced too cheap just because the company is in financial difficulty. Since you may be expecting payments fifty years from now, make sure that the company will be there to pay you. Financial data and ratings for all insurance companies are readily available and should be obtained and analyzed. Financial sources are A.M. Best, Moody’s, and Standard and Poor’s. However, this data concerns current financial conditions – not the conditions in five, ten, or fifty years from now. Prior to purchasing a policy, it is a good idea to contact your state insurance department to confirm the insurance company’s status.
· The primary motive in the company’s assessment of a potential policyholder is to determine when he/she is most likely to die. Complex computer programs assess this likelihood using statistical models primarily dependent on gender, age, health, family history, life-style, race, occupation, education, etc. The whole basis for life insurance is this very indifferent, dispassionate statistical analysis of mortality rates, not being nice or socially conscious. Be ready to answer a lot of personal questions, and even take a medical exam.
· The risks to you versus the insurance company can be greatly shifted by the “small print” in the policy. The insurance company relies on using the small print to reduce claims and increase its profits. Take the time to read each policy you may own or buy to recognize exclusions and limitations which could mitigate the protection you think you have.
· Features in many policies are dependent on the quality of investments made by the life insurance company. Examples that are shown by the company or agent are always predicated upon certain results from the company’s investments. Understand the effects of changes in returns or interest rates, and be aware if a certain performance level is guaranteed. There have been untold numbers of policies sold to and owned by unsatisfied clients because of their belief that an example will come to fruition.
· Values inside of insurance products grow tax-deferred. This gives them a tremendous advantage of many other financial instruments.
Fourth, be very clear about the reasons why you want a particular product. It is impossible to determine how much insurance you need or what type of insurance you need unless you are clear about the reasons you are buying insurance. Do not buy a policy because the agent is persuasive or is a friend. Virtually everybody is either under-insured or over-insured. That is not necessarily a reason to buy or drop a policy. After you are presented information concerning a potential product, take a few days to study the situation and even ask advice from another person. The following is a list of common reasons why people buy life insurance products:
· To mitigate the financial effects of an unexpected or untimely death. It is likely that at least one person has some financial dependence on you and will need a replacement of your financial support. Life insurance proceeds can be used to replace income, pay debt, provide savings for future costs, or pay the cost of household services needed to raise children.
· To help provide for education or retirement expenses.
· To aid in estate planning and in the payment of estate taxes. Life insurance proceeds can mean that certain assets won’t have to be sold just to pay estate taxes.
· To aid in business planning for changes in ownership or the purchase of a large asset. Insurance is used to protect the company or family in case a key manager or owner dies.
· To gain from the tax advantages inherent in certain insurance products
Fifth, understand that there are only two basic types of life insurance policies. However, there are an infinite number of variations on these two.
- Term Insurance: Term insurance covers you for a certain number of years, and pays a death benefit only if you die during that time period. Premiums are usually paid annually. As an example: A term policy might pay your beneficiaries a death benefit of $100,000 if you die within the next ten years if premiums have been paid until the time of death; at the end of the ten years the policy would expire by its own terms and you would not have life insurance. Term insurance offers the largest insurance protection for the least cost during that period, but has no coverage afterward. However, many term policies have a renewal clause for an additional time period which will have substantially higher premiums and may have health restrictions or qualifications. Some term policies have a feature that allows you to convert the term insurance to permanent insurance. Term insurance is often purchased by those on extremely tight budgets or to cover a specific need which will disappear with time. Most insurance companies strive to sell term insurance because their risks are well defined and the profits are good, since only a very tiny number of these policies ever pay off. In fact, one agent estimates that only 1% of term policies are paid. Therefore, if you have to have insurance when you die, consider permanent, not term. The major disadvantages of term are when the coverage terminates, the premiums on continuing the policy may be prohibitively expensive or you may not qualify for insurance at all at the time when you most need it. As an example of how premiums could change over time, if you chose to purchase a one-year $100,000 term policy every year for the rest of your life, you might find your annual premium is a few hundred dollars at age twenty, a few thousand dollars at age fifty, and $80,000 at age 99.
- Cash Value or Permanent Life Insurance: This roughly equates to permanent term insurance. A portion of the premium goes to pay for the insurance, and a portion is invested and “saved” for you to pay for the increasing cost of the insurance (as shown in the above example). The second portion is called the “cash value” or “cash reserve”. In most of these policies, the cash value of the policy can be borrowed or used to help pay future premiums, or can be recovered if the policy is terminated. If you die while the policy is in effect, your beneficiaries receive the death benefit only, not the cash value plus the death benefit. The cash value grows on a tax-deferred basis, but if money is withdrawn, income tax is paid on the earnings. At retirement or in emergencies, many people use the accumulated cash value to supplement income. The amount of growth in cash value is dependent on the insurance company’s investment results, expenses, mortality claims, dividends paid (if any) and other factors. This is another reason why the insurance company you choose is important. The major disadvantage of permanent insurance is that the premiums are so expensive that it may be difficult to purchase a sufficient amount of insurance. Permanent insurance is designed for your entire life, not to be used for a few years then cashed in.
- Whole Life Insurance: Covers you for as long as you live if the premiums are paid in accordance with the policy. Generally, the premiums are a constant amount over the life of the policy, so these are sometimes called level-premium policies.
- Universal Life or Adjustable Insurance: A flexible policy that lets you vary premium payments, which varies the face amount of coverage and the amount put into “savings”.
- Variable Insurance: The death benefits and cash values depend on the investment performance of one or more types of investments which the policyholder chooses. The coverage and death benefit depend on the performance of the investments – poor investment choices can lead to the policy having little or no cash value or even reduced death benefits.
Annuities
There are also an infinite number of variations on annuities. A well-structured and well-priced annuity can be an excellent financial tool, while a poorly structured, high commission, or expensive annuity can cause a financial disaster. In its most basic form, an annuity is a contract between you and a company (often an insurance or financial services company) in which you give the company a lump sum of money now with or without additional amounts in the future, and they give you monthly payments starting at some designated point in the future continuing until you die, or will give you a cash-out at the end of the contract term. Life insurance helps if you die too soon – annuities help if you live too long. Think of annuities as “longevity insurance.” Like whole life insurance, an important feature is that the value of the annuity grows on a tax-deferred basis. When money is withdrawn, income tax is paid on earnings, not on principal. In some annuities, if the cash-out occurs prior to age 59 ½, an additional penalty tax is due. Again, annuities are not usually guaranteed by the federal or state governments. If the company that issues your policy goes out of business, you may find that the policy is worthless. Therefore, the financial quality of the company is of primary concern! Since you may be expecting payments fifty years from now, make sure that the company will be there to pay you.
As in life insurance policies, features in many annuities are dependent on the quality of investments made by the life insurance company. Examples that are shown by the company or agent are almost always predicated upon certain results from the company’s investments and interest rates. Understand the effects of changes in returns or interest rates, and be aware if a certain performance level is guaranteed. There have been untold numbers of annuities sold and owned by unsatisfied clients because of their belief that an example will come to fruition. Furthermore, many financial advisors warn their clients against annuities because of large hidden fees and commissions. These fees and commissions are one reason insurance companies are being so aggressive in pushing annuities, and will likely figure into increased litigation. Also, investors are increasingly disenchanted with various annual expenses, especially the costs for the insurance features.
If you buy annuities, buy them as late in life as you can, for only as much income as you will need, and limit the amounts to any one company.
Don’t forget that there may be significant estate tax issues, especially with variable annuities.
Following are some of the more common variations concerning annuities. Many of these variations may be combined in the same policy:
· The annuity is purchased with a lump sum and/or a series of premiums.
· The annuity is paid out in a lump sum at a designated time, and/or paid out in a series of payments if the policyholder is still alive. If the payments start at once it is called “immediate” and if they start in the future, it is called “deferred.”
· Upon death of the policyholder, payments and the value of the annuity will be made to the heirs in the amount of the value of the annuity, the amount paid into the annuity, a set amount, or nothing. This is a hugely important term of the policy to understand!
· Earnings in annuities can either be tied to investments like stocks or mutual funds (variable annuity) and/or a set rate of interest (fixed annuity). Be aware that many policies are sold with a “teaser” rate that is lowered after the first year. No taxes are due until money is withdrawn. Investment gains are taxed at ordinary income rates.
· Payments made for one pension or for joint-and-survivor (as long as one of the spouses lives.)
Example One: Jane buys an annuity for $100,000 at age 60. It will pay her set monthly payments from the age of 70 until her death. At her death, the payments stop and the insurance company keeps the $100,000.
Example Two: Jack buys an annuity for $100,000 at age 60. It is a joint-and-survivor annuity with his wife Jill. They get monthly payments beginning when Jack turns 65 and lasting until Jill dies, then their estate gets the $100,000. Their payments vary based on fluctuating stock market returns. Their monthly payments will likely be much less than Jane’s.
Basic Questions for Insurance and Annuities
Last, don’t forget some of the most basic questions:
· Is all of the information you provided correct? If not, you run the risk of having your policy revoked in the future.
· Is the illustration provided to you reasonable based on all of the assumptions in it? Remember, small changes in the assumptions can have large effects on the outcomes shown. Few, if any, of the assumptions are guaranteed.
· Can you afford the initial premium and the premiums in the future? Many policies have premiums that will increase in the future. It may be very costly to you if future payments can’t be made. Don’t count on the returns or dividends shown in any example which reduce future premium payments. If the company doesn’t get these returns, you will still be liable for the full payment amount. Many a policy has been purchased expecting high returns which never get fulfilled. Experience shows that illustrations are usually too optimistic.
· Will this policy meet your needs five years from now? Replacing one policy with another can be very costly. Never cancel an old policy until the new policy is actually in hand. Further, make sure you understand any tax consequences of dropping a policy. It may be possible to modify the old policy or add to it instead of having a new policy.
· Have you read the entire policy and understood it? As your grandmother told you, the devil is in the details. Little words in the fine print can have devastating effects.
· Have you picked the right combination of policy premium and benefits in both the case of an early death or a long life?
· Have you considered owning your life insurance in an insurance trust? For most people, this should be thoroughly considered. Although no federal income tax is paid on proceeds paid to beneficiaries, the proceeds will be included in the total value of the estate of the policyholder, so that, in effect, they may be highly taxed!
Conclusion
Even at its most basic, the subject of life insurance and annuities is complex. Most of us will have the need or desire to purchase and rely on some kind of life insurance product, so it is advantageous to have at least a basic knowledge of the subject. In fact, the more you know, the better you can ask questions and relate relevant information so that you can eventually purchase the right product for your needs.
Additional Sources
National Insurance Consumer Helpline 800-942-4242
National Association of Life Underwriters
Life and Health Insurance Foundation for Education
American Council of Life Insurance, 1001 Pennsylvania Ave. N.W., Washington, D.C. 2004
DISCLAIMER: The content presented herein is presented as general information and is not intended to be a comprehensive overview of all of your financial options. Nor is it meant to imply any endorsement of any type of financial plan, product or service. Investing and spending money is a complicated and serious process that is constantly affected by conditions in the marketplace and changes in tax law and government policies. There is no guarantee that an investment product bought today will perform the same from year to year. You should research your choices as thoroughly as possible and, when in doubt, consult a trusted professional advisor.