Many people don't understand the financial instrument of life insurance because, as in other fields such as law or medicine, there are many terms peculiar to the industry. That terminology puts people off, leading to misunderstanding.
Perhaps explaining some of that terminology, will diminish the frightening aspects of life-insurance discussions.
PREMIUMS: That's the money you pay to a life insurance company to buy a life insurance policy.
DEATH BENEFIT: That's the money the life insurance company, or insurer, agrees to pay when the insured person dies.
BENEFICIARY: The person or persons, named on the insurance policy, who get the death benefits. Beneficiaries can be individuals, groups of individuals, corporations or trusts, among several possibilities.
OWNER: This is the person who controls the insurance policy. It could be the insured person or it could be the beneficiary, but the beneficiary has no inherent control of the policy. The owner can change beneficiaries, cancel the policy, change the way premiums are paid, cover a loan with the policy, borrow from the policy (explained later) or transfer ownership to someone else.
There are two general categories of life insurance: term and whole life, which is also known as ordinary or permanent insurance.
TERM: This kind of insurance is the less expensive of the two at first. There are many types of term policies, but the most popular and economical is yearly renewable and convertible term insurance.
If you die, your beneficiary will get a fixed amount in death benefits. Each year the policy may be renewed, without a physical examination, at a predetermined cost that rises annually.
That built-in increase is the biggest drawback to this type of policy, making the premiums very expensive in later years.
In some cases, the policy will terminate at a set age. Term insurance provides no benefits if you choose to terminate the policy, so someone who feels he or she is going to keep a policy more than 15 years should consider whole life insurance.
If you can't decide that, or if ability to pay for the policy is a consideration, you can start out with term and convert the policy later to whole life, again without a physical examination.
WHOLE LIFE: This kind of insurance also comes in many forms, but we're going to consider just the two types most commonly purchased.
REGULAR WHOLE LIFE: This kind of insurance goes by different names at different companies, but one of the common descriptions is "life paid up at age 100."
This means that if you were to pay premiums until you reached age 100, you could stop making premium payments and be insured for the face amount for the rest of your life.
On the surface this seems like a very illogical way to purchase insurance. But the policy states that the premiums will ramain the same from the date of purchase.
CASH VALUE: Whole life also guarantees a portion of the premium will be applied to the policy's cash value. This is what enables premiums to remain constant. Cash value can be borrowed from the policy at a predetermined interest rate (altering the death benefit by a like amount if not repaid), or can be taken outright by the policyholder if he or she elects to cancel the policy.
PAID-UP VALUE: That cash value also has a corresponding "paid-up" insurance value which, in the "life paid up at 100" policy, will equal the face amount of the policy at age 100. If an individual wishes to stop paying premiums before age 95, which is likely to happen, he or she would be insured for an amount less than the face amount of the policy.
PARTICIPATING POLICY: This kind of whole life policy gives the policyholder tax-free dividends. Those dividends can be used to buy additional whole life or term insurance. They also may be left to accumulate at interest with the insurance company, taken in cash, or used to reduce premiums.
If you use dividends to reduce premiums, your premium payment will decrease each year until the dividends exceed the premium due. This usually occurs after the policy has been in effect about 25 years. In such cases, the policy, in effect, will be paid for long before the insured reaches 100.
GRADED PREMIUM WHOLE LIFE: This is the other kind of whole life that is most commonly purchased. The difference is that the premiums are smaller at first. They increase by a fixed amount each year until the 11th policy year, when they level off and remain so for the remainder of the life of the policy. The purpose is to provide the benefits of whole life at an initial cost similar to term insurance.
MINIMUM DEPOSIT: This is a popular way to buy whole life at term rates and to get a tax deduction at the same time. What you do is purchase a whole life policy and pay for four of the first seven annual premiums in any sequence.
After doing so, you borrow all future premiums from the cash value that accumulates. You are required to pay only interest to the insurance company, which is tax deductible. The net interest payments will be less than the premium payment for a policy, and you always will have excess cash value in the policy.
Future articles will go into more detail concerning determination of insurance needs, who should be insured, disability insurance, medical insurance, employe benefit programs, annuities and how to purchase insurance.